Egypt has been grappling with an economic crisis since last year, with the currency plunging, foreign reserves drying up, and inflation surging. This eventually led to the IMF stepping in with a $3 billion loan facility.
Yury Zusman, ex-Pharo emerging markets strategist and author of Emerging Market Dynamics, talks us through the background and what could lie ahead.
Can you describe what is going on in Egypt and how the situation came about?
Zusman: The situation in Egypt is challenging. The country has been running a wide current-account deficit, importing more than it exports, and has required capital flows to finance this deficit. It financed the deficit with very short maturity debt, which is very sensitive to outflows due to changes in risk sentiment. In 2022, there was a very strong rise in volatility globally, with geopolitical risks around Russia and Ukraine, and very fast tightening in monetary policy in US, and that led to capital outflows across different emerging markets.
But in the case of Egypt in particular, because the country was so heavily reliant on short maturity instruments to finance its deficit, that outflow was particularly harsh and particularly troublesome. And on top of that, Egypt had a fixed exchange rate, so it was maintaining that rate at a particular level and using its reserves in order to keep the exchange rate at that level. When there were big outflows, Egypt ended up spending its reserves very quickly, running them down. And that affected the market’s perception of the country’s ability to repay its foreign-currency debts in the future.
And so, Egypt ended up agreeing on a program with the IMF, whereby it would potentially receive a certain amount of money, and also an even larger chunk from some countries, in particular from some sovereigns in the Middle East. But all of this was tied to implementing a number of key reforms.
Has Egypt been carrying out the reforms that were attached to the IMF loan facility?
Zusman: Some of the required reforms were structural, such as allowing a reduction in the government’s footprint in the private sector and increasing tax revenue in order to reduce the fiscal deficit.
Since the initiation of the IMF program at the end of last year, Egypt has followed through on one of the important criteria, and that is privatization. It has been privatizing some of its state-owned corporations in a step towards reducing some of the government’s footprint in the private sector. So, that's an important structural benchmark.
But it has not fulfilled the flexible exchange rate criteria that is also an important part of the IMF program. And even though Egypt did devalue the exchange rate shortly after the initiation of the IMF program, it has essentially had a fixed exchange rate since the beginning of this year.
Prior to the IMF program, Egypt tended to keep its exchange rate fixed because it's a politically sensitive factor for households that import a lot of basic goods and for whom depreciation can be very painful. But the exchange rate in theory should be adjusting depending on the sustainability of the current-account balance of the country, and how easily the country can finance its imports. And in the case of Egypt, the deficit it was running was too high.
In 2022, there were capital outflows, and so there was pressure on exchange rate to adjust. But keeping it fixed meant spending reserves and potentially running out of foreign currency needed to pay foreign-currency debts. So, an important element in the IMF program is to allow the exchange rate to depreciate, to be more flexible, and to adjust depending on the market environment. But it's a politically sensitive factor.
What has been the impact of this?
Zusman: This has led to a number of delays for the review of the IMF program. Generally speaking, when a new program is launched, the IMF reviews it twice a year. When the country receiving the funds has fulfilled certain criteria, new funds can be released. And in the particular case of Egypt, if Egypt passes the IMF review, that not only releases IMF funds, but also some of the other donor funds from Middle East partners.
Due to the lack of flexibility of the exchange rate, which is the one really key outstanding issue, the reviews have been delayed for Egypt. And because of that, Egyptian euro bonds have been volatile, having risen on the back of optimism when Egypt started privatizing some companies. In early summer, the bonds rallied, but they have essentially sold off again.
In my view, the important factor here is the elections that are coming up in Egypt in December. Even though it's quite widely expected that the current president will retain power, it is a political event that prevents the Egyptian authorities from satisfying that one outstanding key criteria - the flexibility of the exchange rate - as it’s a politically sensitive topic and so unlikely to be addressed before the elections.
After the elections, it is likely that they will follow through on this criterion, which could release new funds from the IMF, on the back of which bonds could appreciate.
How is the market reacting, and could we see a default in Egypt?
Zusman: The question of whether Egypt will default depends on a number of factors.
First, the structure: Egypt needs to continue to implement these reforms that it has agreed with IMF. Not only will that open up additional financing from external donors - the IMF and Middle Eastern partners, and countries’ sovereign wealth funds - but it will also give confidence to private investors. That should lead to private inflows, which is an important element of any IMF program because no IMF program wants to continue to have to finance a country. The program wants to create an environment where the country can wean itself off IMF financing and be able to finance itself without external help. So, these reforms are important for that.
Certain factors mean Egypt is a country that could have a high risk of default: the country has a high fiscal deficit - a high level of foreign-currency debt as well as overall debt - alongside low tax revenue. But there are some mitigating factors because Egypt has a very good demographic story and a very young population that's growing. There's potential for a lot more people to enter the job market. So that could lead to higher growth overall, and growth is an important factor for credit and for fiscal sustainability.
But the country needs to implement these reforms. And that will be something important to watch over the next couple of years. There seems to be quite a lot of foreign-currency debt due in the next two years, and much of it is due to international finance institutions, essentially the IMF and the World Bank. If Egypt is not implementing the reforms and not able to instil confidence in private investors, then it is unlikely that the IMF will want to continue to roll over its own debt and at the same time allow private investors to get paid in effect with its money.
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