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Oasis or mirage? Egypt's economic potential

From a distance, it is easy to conclude that Egypt is an arid environment for investors. Being only 0.13% of the MSCI Emerging Markets Index, the country is easily dismissed given its questionable democracy, high rate of inflation, recent currency devaluation and twin deficits. Look closely, and the conditions become more attractive: low labour costs, high literacy levels and a series of economic reforms suggest that real investment opportunities are shimmering on the sands.

Key points

1. Since the global financial crisis, Egypt has suffered a difficult decade characterised by political instability and economic turmoil. However, President Abdel Fattah el-Sisi’s recent re-election should help to provide ongoing stability

2. Intervention by the International Monetary Fund in 2017, which resulted in a dramatic devaluation of the Egyptian pound, seems to have set the country on the road to economic recovery, with both debt and inflation being brought under control

3. A range of underlying factors, including energy self-sufficiency– thanks to recently discovered natural gas resources – a youthful demographic and extremely low labour costs, point to a positive future, if stability continues

A superficial view of Egypt may provide little of interest for investors, but a closer look at factors including the country’s energy balance, its relationship with the International Monetary Fund (IMF), its demography and social development provides a more positive perspective. In this edition of Gemologist, we examine these dynamics to gain a fuller picture of Egypt’s economic and financial market prospects. Success is far from guaranteed, but the country’s future looks brighter than it has for a decade or more.

Regime and political situation

In April, President Abdel Fattah el-Sisi claimed a landslide election victory, winning just over 97% of the vote on a 41.5% turnout1. This was more in keeping with Vladimir Putin’s victory in Russia than Cyril Ramaphosa’s win in South Africa – a non-event in a struggling economy.

At the political level, Egypt’s governance is among the worst in the world, ranking below Indonesia, Russia and China, and just above Pakistan2. General el-Sisi has ruled over a highly authoritarian state since May 2014, which has 41,000 detainees, seen over 3,000 people killed in political violence and resulted in 269 deaths in custody, according to news service al-Araby.

The military is seen by many foreigners as an occupying force. From inside, however, the story is different. No doubt there are many Egyptians who, in the safety of their own homes pine for democracy, but the message we receive consistently on our visits is that the army works for the good of the people, is not corrupt (there may be varying definitions of this) and that, acting as a general contractor, is the only institution in the country that can complete large-scale projects on schedule.

Macroeconomic indicators

Egypt’s economy has gyrated along with its leadership since the financial crisis, recovering only to be hit by the Arab Spring and President Mohamed Morsi’s election and later removal. Confidence in Egypt has been in very short supply since the Arab Spring and the establishment of ‘order’ by the military under el-Sisi did little at first to restore it. However, there are signs that confidence is beginning to improve as Egypt’s economic policies have come under the guidance of the IMF.

The government has no choice but to provide a functioning economy if it wants to maintain its social mandate, much like the Communist Party of China or Narendra Modi’s Bharatiya Janata Party in India. The President has so far managed to keep a lid on economic grievances, partly by increasing food subsidies and providing cash transfers to 8m people. But in the future, further strengthening of both he US dollar and the oil price may require further sops to appease voters.

Pounded currency
The value of the Egyptian pound was steady from the immediate aftermath of the global financial crisis through the coup deposing Morsi in 2013, but became overvalued amid an annual rate of inflation of about 10%. Meanwhile, foreign exchange reserves excluding gold dropped from $31.8bn (which is worth almost eight months of imports) in 2010 to $14.5bn (worth three months of imports) in 2013 – well below the safety margin of six-to-nine months. Subsequent intervention from the IMF last year saw the Egyptian pound devalued by 100%, with the government required to run a primary surplus and slash subsidies. The pound crashed from 8.9 to the US dollar in 2015 to 18.1 last year, although it has since risen slightly to 17.7.

Debt levels: still chronic?
By the end of 2017, Egypt’s debt had grown to 103% of GDP, a dangerous level for a country with high inflation, a weak currency and dual deficits (its current account deficit was 3.3% last year, while the budget deficit stood close to 11%). The country’s sovereign debt is rated B3 by Moody’s and B- by Standard & Poor’s and Fitch.

The devaluation of the Egyptian pound in 2017 led to a spike in inflation, but this also spurred a dramatic change in policy. The IMF forecasts that the government will run a small primary surplus this year, increasing to 2% of GDP for the ensuing few years. This should reduce debt to well below 100% of GDP by 2023. Inflation has started to ease, with the consensus among the observers we spoke to being a decline from 23% last year (and 17% in January) to 12.5% this month.

Economic reforms

President el-Sisi’s challenge is to enact tough reforms while ensuring social stability in a country where 28% of the population lives below the poverty line. Besides the devaluation of its currency, the population has recently endured cuts in fuel subsidies. Foreign investment has dried up. Among the recent reforms are laws to govern banking (including Egypt’s first-ever bankruptcy law), a reduction of the red tape required for an industrial licence and a move to end the state’s monopoly on natural gas production. VAT has been introduced to bolster government revenues, too, and a second phase of reforms is focussed on encouraging the growth of private enterprise while scaling back the reach of the public sector.

Egypt’s finance minister, Amr el-Garhy, has affirmed the government’s commitment to push ahead with these painful economic reforms as it aims to narrow its fiscal deficit and bring soaring debt levels back to earth. He needs to: foreign debt has risen from less than 15% to more than 40% of GDP, which added to high levels of domestic borrowing and has caused interest payments to swell to nearly 8% of GDP. Egypt’s economy has been fragile, with its stability at the mercy of foreign donors (mainly the Gulf countries) and more recently the IMF.

Fuel subsidies: emptying the tank?
Given the volatility of oil and wheat prices and the exchange rate, the only price levers that the government can control are subsidies for petrol and diesel. However, removing public subsidies is not an easy task, especially when a currency crash and subsequent inflation shock has slashed purchasing power for much of the population.

It will be politically difficult to raise fuel prices by 104%, the amount needed to meet the cost of fuel in April 2018 all at once. This would follow hikes in 2016 and 2017, which added about 50% to the price of petrol.

Egyptians as a population are not affluent enough to accept a further shock of this magnitude – dictatorship or not – at least not all at once. Two or even three hikes would be more palatable, one in 2018 and one in 2019, resulting in the complete disappearance of the fuel subsidy by the beginning of the 2019-20 fiscal year.

If electricity price increases continue to match those of previous years, Egypt’s inflation profile would remain close to 12% from June 2018 through June 2020, with the potential to drop into single digits in subsequent years. Unlike the Central Bank of Argentina, which raised its inflation target to justify interest-rate cuts, the Central Bank of Egypt (CBE) is in control of inflation and should remain so, absent a large and sustained spike in the oil price from current levels.

With this in mind, the country’s parliament recently began debating a budget in which the finance ministry is proposing to cut its fuel and electricity subsidy bills by 19% and 48% respectively. If approved, the total energy bill will account for 7.3% of government expenditure.

So far, so challenging. But all countries face challenges, and some face them down. Egypt is starting to do that, which is what has piqued our interest.

Interest rates trending downward
With a downward inflation trajectory, rate cuts are underway. The CBE cut its key policy rate by 1% in February to 17.75%, keeping rates marginally positive. Inflation hit 13.1% year-on-year, providing scope for further substantial rate cuts.

Our exposure: Commercial International Bank

We view Commercial Industrial Bank (CIB), a leader in the domestic banking sector with an 8% market share in deposits and 7% in loans, as a direct play on the Egyptian macro recovery. It is a well-run and profitable bank which has grown assets by 214% and profits by 8% in US dollar terms over the past five years.

CIB’s non-performing loans, as a percentage of gross loans, remained below 5% for seven years of the bank’s recent history, and only in the last two years rose to 6.9%-7.2%. Its coverage ratio is healthy, at 202%. Consensus expectations for earnings per share growth are for at least 15%-20% each year in US dollar terms over the next four years.

Hisham Ezz Al-Arab, CIB Managing Director, points to the opportunity presented by technology to integrate Egypt’s large informal economy with banking services: currently, mobile penetration is 110% but only 10% of the population has access to financial services.

With planned fuel subsidy cuts and currency normalisation and half of Egypt’s 2016 IMF package effectively drawn down, inflation should settle at single-digit levels by 2020. This should, in turn, encourage domestic and foreign investment and improve asset quality at the bank. CIB expects to be able to maintain its net interest margins despite the forecasted interest rate cuts, and should enjoy loan growth and maintain high levels of profitability.

CIB’s environmental, social and governance (ESG) characteristics are adequate, but can be improved. Its management team is highly regarded by the market, and a number of recent changes have improved the lender’s governance: the CEO and Chairman role has been split in response to pressure from the Central Bank of Egypt, and its shares are 100% free-float.

There are opportunities to engage the company to improve its ESG profile. CIB does not currently adhere to the Equator Principles for managing environmental and social risk, and is well placed to increase financial inclusion, particularly for small-to-medium-sized enterprises and retail customers. The company operates in a country with low banking penetration – the ratio of loans to GDP is 41%, more than 80% of the adult population is unbanked and the ratio of industry loans to deposits is 46% – and a young and rapidly growing labour force, presenting opportunities.

The CIB Foundation receives 1.5% of the bank’s net annual profit, with donations allocated towards development initiatives promoting child health and nutrition.

Firing up the gas

An important milestone for the country’s economic health is the development of its offshore gas fields. With the addition of 22tn cubic feet (Tcf) of recoverable gas in the Zohr field, Egypt’s gas reserves stand at 65 Tcf, making them the 16th-largest in the world. As production from Zohr ramps to 2.7 bn cubic feet (Bcf) per day by 20193, the country should have a self-sufficient gas supply, moving the current account from deficit to balanced.

Egypt is not the only country discovering gas in the Eastern Mediterranean. The development of Israel’s giant Tamar field is good news for Egypt; unlike Israel, it has two inactive liquefied natural gas (LNG) plants on the coast which can be revived to process Israeli gas for export.

Lower inflation and a balanced current account can provide a respite from some of the economic pressures the country has been enduring. But if Egyptians are to enjoy a persistent rise in their standards of living, more secular changes are needed. We outline what these might be in the next section.

Demographics

No country for old men
Egypt’s demography could emerge as a significant source of competitive advantage. First, its population of nearly 100m is young (more than 50% are under the age of 25 and roughly 40% are between the ages of 25-54) and growing much faster than its closest competitors both in Eastern Europe and the Middle East and North Africa (MENA)4.

Figure 1. Workers, arise! Forecast change in the working-age populations of East European, Middle East and North African countries

Source: Renaissance Capital, UN as at March 2018

Low labour participation
Much of the workforce is not employed. According to estimates from the International Labour Organisation (ILO), Egypt’s labour participation rate was about 48% in 2017, far below the 80% achieved by Central Europe, the destination of much of Western Europe’s foreign direct investment in the past few decades5. The overall workforce is set to rise by 9%, or 6m, between 2015 and 2020, but could comfortably grow 50% by including its increasingly educated female population, a potential watershed development (of which more below).

Literacy
There is a historical correlation between literacy rates and economic development in many countries, including the UK, Japan, Korea and the Soviet Union. A literacy rate of about 40% is typically needed for sustainable economic growth, with industrialisation usually requiring a rate of 70% or more.6 For instance, 20% of Korea’s manufacturing sector consisted of value-added industries in 1972, but neither Morocco, Nigeria or Pakistan – nor the 38 other countries shown in figure 6 – had achieved this by 2015.

Figure 2. Levels of literacy and value-added manufacturing in emerging and frontier markets

Source: Renaissance Capital, World Bank, UNESCO as at July 2017

Figure 3 shows the literacy rates of a selection of lesser developed countries. Those with a total literacy rate of 40% or lower, beginning with Chad, are largely subsistence economies with little prospect of generating sustainable growth. However, immediate success isn’t guaranteed – even for countries with literacy rates of between 70% and 80%. Some with strong literacy levels, like Pakistan, Morocco and Bangladesh, may demonstrate sustainable growth, but only India has embarked on industrialisation thus far.

Figure 3. Literacy in 2015: which of these countries are likely to industrialise?

Source: Renaissance Capital, UNESCO as at July 2017

Low literacy levels among adults may explain why former Egyptian President Hosni Mubarak’s reform plan to build a manufacturing base failed to take off in the early 2000s. However, the country’s current plan, Vision 2030, has plausible goals for growth which are backed by suitably high literacy levels: literacy among Egyptians breached 70% in 2010, reached 76% in 2015 and is estimated to hit 80% by 2020.

Figure 4. Egypt has achieved a level of literacy that should support industrialisation

Source: Renaissance Capital, UN, World Bank as at March 2018

As previously mentioned, Egypt has the potential to grow its labour force significantly by encouraging women into the workforce. With over 85% of 11-to-17-year-old females now attending secondary school, compared to less than 70% two decades ago, women represent a huge potential resource of literate workers for the country.

Higher literacy and attractive demographics should support the case for Egypt being a destination for foreign investment. Other building blocks for sustainable growth that need to fit into place include infrastructure, tourism and exports.

Figure 5. Female literacy in Egypt is rising steadily

Source: Renaissance Capital, World Bank as at June 2017

Advantageous labour costs

After the fall of the Berlin Wall, Western European multinationals poured billions into Central and Eastern Europe, which offered a paradise for manufacturing investment thanks to the former bloc’s high levels of education, low costs and abundant labour.

However, with labour participation high – it is 77% in the Czech Republic, 69% in Poland, 72% in Hungary and 79% in Germany – unemployment low and labour costs rising, only Romania now exhibits an attractive wage profile in Eastern Europe. In addition, many of these countries will have fewer young people in the coming decade: figure 6 shows the change in the number of people aged 15-24 years in North African and Eastern European countries.

Figure 6. Egypt is forecast to have a large population of people aged 15-24 by 2024

Source: Renaissance Capital, United Nations as at June 2017

While foreign direct investment in Central Europe will persist, its workers will move up the value-added curve, treading the path set by Japan in the 1950s and 60s, then by Korea, Hong Kong, Singapore, Taiwan and China, and most recently by Vietnam and Bangladesh. Meanwhile, wages in North Africa are cheaper than those of all European countries except Ukraine (see Figure 7)7.

Figure 7. Labour costs in Europe and North Africa

Source: Renaissance Capital, Eurostat, IMF as at June 2017

Figure 8. Egypt’s minimum monthly wage, in US dollars, is low among emerging and frontier markets

Source: Renaissance Capital, national media as at March 2018

Expansion of essential infrastructure

As well as labour, manufacturing requires infrastructure. While more needs to be done, the exploitation of Egypt’s offshore gas fields, leading to self-sufficiency in electricity generation will remove a major obstacle to growth for Egypt. At the same time, reduced government spending on subsidies frees investment capital for major projects, including the recent deepening of the Suez Canal, the planning for a new capital city to the east of Cairo, five new airports, a nuclear power plant and several monorail lines. Finally, plans are being finalised for the development of the Golden Triangle region in the south of the country in which private businesses reportedly operate largely free of red tape and are generally being managed efficiently and free of corruption.

Tourism: resort trade resumes

Tourism, Egypt’s biggest export, is recovering and should benefit from the resumption of Russian flights to major resorts in April (see figure 9). Security remains a concern, but since the primary threat is from jihadist group Al Qaeda in the Sinai Peninsula, which operates near the Gaza Strip, the impact on the industry is limited.

Figure 9. Tourism growth is likely to accelerate as Russian sun-seekers return

Source: Renaissance Capital, CAPMAS, Bloomberg, CBE as at March 2018

More than oil: exports

Egypt’s other major export is oil, which brings in $1bn of revenue annually. Others include fertilisers, textiles, ready-made clothes, chemicals, wires and cables and household electrical appliances. They each accounted for between $500m-$800m in 2017 (see figure 10).

Figure 10. Beyond oilfields and resorts: Egypt’s other export industries

Source: Renaissance Capital, Central Bank of Egypt as at March 2018. *Provisional data

Egypt's economic prospects: oasis or mirage?

Egypt’s economy has yet to achieve sustainable growth, but the development of the Zohr gas field and the improving tourist trade should combine over the next two years to dramatically lower its current account deficit. This should arrest the climb in external debt as a percentage of GDP.

Other signs are relatively healthy as well. The Egyptian pound has depreciated enough, credit-rating agencies are likely to upgrade the country’s sovereign-debt rating as the government adheres to the IMF package, and demand for loans should increase as interest rates decline.

The country’s stock market has been becalmed since 2013: it now trades at an 11.2x price-to-earnings multiple (on a 12-month blended forward basis) in US dollar terms, roughly 0-1.5 standard deviations higher relative to both its own history and to global emerging markets. But with consensus forecasts of earnings growth of 46% for this year and a return on equity of 21%, we think the market provides an opportunity to access an improving macro story despite its relatively high current valuation.

While today it may seem a stretch that Egypt could attract investment from a Siemens – or a Kia, for that matter – its low-cost, young and literate workforce is an attractive asset. Historically, multinationals have invested in Egypt to service its growing population; with the political situation relatively quiet, P&G and Unilever are both starting to expand and upgrade their factories in the country again, targeting domestic consumers. Another year or two of stability could attract investment in manufacturing, starting a new chapter in the country’s development.

We see Egypt’s GDP growth accelerating from 4.2% in the last fiscal year to 4.7% this year, and possibly 5.5% by 2020. A substantially higher oil price or a much stronger dollar may cause problems, but we don’t view these as sustainable phenomena. While it is likely that the nation’s current account deficit could reappear in a positive growth scenario, it would likely be due to capital goods being imported rather than a deterioration in exports growth.

With ongoing economic reform and progress, Egypt could truly emerge, and its large, long-suffering population could begin to experience the rising standards of living enjoyed by the Asian and Eastern European populations that have walked the path of industrialisation before them.

Are we witnessing an economic oasis or mirage? In our view, Egypt has begun to realise its growth potential and investment opportunities are within grasp, rather than shimmering in the distance.

1 “Sisi wins landslide victory in Egypt electionhttps://www.theguardian.com/world/2018/apr/02/sisi-poised-to-declare-landslide-victory-in-egypt-election,” by Ruth Michaelson. Published by The Guardian on 2 April.

2 Worldwide governance Indicators, published by the World Bank. Data as at 2016

3 “Egypt’s supergiant Zohr natural gas field in numbers,” published by energyegypt.net in 2018

4 United Nations as at March 2018

5 “Labour force participation rate, totalhttps://data.worldbank.org/indicator/SL.TLF.CACT.ZS,” published by The World Bank and based on data from the International Labour Organisation, as at November 2017.

6 Charles Robertson, Renaissance Capital, as at July 2017

7 Hermes calculation based on hourly labour costs from Eurostat and per capita GDP figures (in US dollars) from the IMF, as at May 2018.

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