Egypt: facing the modern world

A SUPPLEMENT TO EUROMONEY/AUGUST 1996

Investment jewel on the Nile

When the new Egyptian government set to work this January, it began ­ like most of its predecessors ­ by announcing a raft of reforms. The markets had heard such pronouncements many times since the principle of economic reform was first established in 1990 and real steps were taken to liberalize prices, abolish subsidies and controls on foreign exchange and capital, and move towards liberalized interest rates. After four months virtually nothing had changed and the administration of premier Kamal el-Ganzouri was being written off.

Then in April something happened that galvanized the government. During a visit to Sharm El Sheikhin Sinai, president Hosni Mubarak was asked by a TV interviewer how he would judge the success of his new government. Turning to Ganzouri, with what one local banker described as “a significant look”, the president replied: “By the speed with which it pushes through the economic reform programme.”

Since then, hardly a Wednesday cabinet meeting has taken place without a welter of legislative changes seizing the headlines in the next day’s newspapers. Many of these ­ such as allowing limited foreign ownership of land ­ have been executive orders based on existing but never implemented legislation. Other recent changes include permitting foreign partners to own more than 49% of joint venture banks and the abolition of a cumbersome 2% capital gains tax on stock market transactions.

The perception is that after many false starts the Egyptian economy finally is moving away from the dead hand of Nasserite state planning. “The story has suddenly become very positive,” says Ahmed Elbardai, vice-president of Citibank. “The decisions being made are very conducive to business and this is filtering down to organizations like the Capital Markets Authority.”

Big global players are also turning bullish, led by Merrill Lynch which this June issued research describing Egypt as “the investment jewel on the Nile”. There is even talk of the government applying for a sovereign rating: this could be delivered in November when Cairo hosts the third gathering of the increasingly prestigious Middle East and North African economic summit.

According to one of its advisers, the Ganzouri administration is anxious to reach agreement with the IMF over the Extended Fund Facility. This has been held up since 1993 by disputes over adjustment policies, including the slow pace of privatization and what the IMF believed was the overvalued Egyptian pound. If, as is now expected, an agreement is put in place before the end of this year, the Paris Club will write off the last $4 billion of a debt relief programme worth $10.6 billion.

The macroeconomics mostly look good. For the last 15 years Egypt has managed to exploit its pivotal political position in the Middle East to secure a steady flow of aid ­ mainly from the United States and the Gulf States ­ in addition to debt forgiveness. The aid flows that followed the 1979 Camp David peace accord with Israel enabled Egypt to avoid major structural reforms urged by the IMF and World Bank. In 1990 Egypt’s prominent role in the Arab forces in the Gulf War against Iraq attracted more aid and let the government off the hook once again. Aid is still running at around $4 billion a year but, unless the Israeli-Palestinian peace deal breaks down, the country will have to attract funds on a commercial ­ not a political ­ basis.

In 1994 foreign investment totalled just $400 million. Yet foreign capital inflows are seen as essential, because domestic savings and investment represent no more than 17% of GDP, well below the minimum of 25% thought necessary to achieve sustained growth.

However, over the past five years, Egypt has increased its foreign exchange reserves by almost $11 billion to some $16.2 billion at the end of 1995, representing around 11 months of import cover and five times the current annual debt service obligations. From a peak of $41 billion in 1988, equal to 590% of goods and services exports, total external debt has been reduced to $28.5 billion. Servicing this has cost an average of $3.3 billion a year since 1993.

This has given the Central Bank the flexibility to defend the exchange rate on the internally-convertible Egyptian pound and to trim inflation steadily: from 11% in 1993 to 8.4% last year. This year it is on target for 7%.

Gross domestic product increased by just 0.5% in 1993, by 4% last year and is expected to rise by 4.5% this year. However, this is tempered by the 2% annual population growth which, although declining slightly, still brings half a million new job seekers to the job market every year and requires minimum GDP growth of 4.5% to absorb them. On a practical level, the authorities will lose the ability to create jobs in state industries as the government’s privatization programme finally picks up steam. Meanwhile, until there is a relaxation of the strict labour laws, private companies will be reluctant to hire.

In state sector industries, which still dominate the economy, it is estimated that “under-employment” runs at around 30%, but many government workers supplement their pay with second jobs ­ often in the service sector. Given the large unofficial economy and widespread tax evasion, unemployment may not be so bad. (Official figures indicate 17% unemployment.)

However with per capita income at $600 per annum, there is widespread poverty, especially in the crowded run-down suburbs of Cairo. The consequent social pressures have resulted in an increase in religious fundamentalism, and extremist groups have mounted terrorist attacks in recent years ­ principally against tourist targets, but also against intellectuals and Israelis.

Egypt has a diverse economy. Revenues from the service sector, including tourism and the Suez Canal, accounted for 51.5% of GDP in the 1991-1992 financial year. Industry produced another 18.3%, while agriculture ­ a third of the labour force still work on the limited but highly productive land around the Nile and its delta ­ contributed a further 16.5%. Hydrocarbons accounted for 10% and gas is replacing petroleum as the main energy source, thereby freeing crude production for export.

Prudent spending by the last government meant that the fiscal deficit was some E£3 billion ($884 million), or 1.7% of GDP, in the year to June 1996. Expenditure was contained at just below 8.3%. In line with IMF demands, import tariffs were reduced, but the government managed to offset the loss with higher-than-expected earnings from the Suez Canal and increased receipts from stamp duty.

As Merrill Lynch notes in its enthusiastic research: “This fiscal outcome places Egypt among the best performers in the emerging markets of east Europe, Middle East and Africa ­ second only to the Czech Republic.”

The new government’s budget was drafted before the 2% capital gains tax was abolished on stock market transactions. It proposes an expenditure of E£77.4 billion, an increase of 8.3% over last year. Although observers believe the deficit will increase, they are expecting it to remain below 2% of GDP. A major budget item is social spending, which reflects the government’s concern over social unrest among the poor. Subsidies on sugar, oil and wheat flour ­ subsidized bread costs the government around $1.2 billion a year ­ remain in force. Privatization revenue, which could amount to E£27 billion, will be used to reduce the outstanding liabilities of state sector companies ­ currently estimated at E£70 billion ­ says the government.

The Central Bank’s standing has risen, thanks to its successful negotiations with the IMF over both the valuation of the Egyptian pound and the actual total of Egypt’s external debt, which a senior Egyptian source says had been overcalculated by almost $6 billion.

Both the World Bank and the IMF had long held the position that the Egyptian currency was overvalued by up to 30% and that the effectively fixed exchange rate which the Central Bank maintained was harmful to exports and encouraged imports. At one point the IMF made devaluation a core requirement for further borrowings under its Extended Fund Facility.

The Central Bank argued that the majority of the country’s foreign exchange earnings came from tourism, Suez Canal revenues, workers’ remittances and oil sales, and that they were denominated in US dollars and unaffected by local exchange rate movements. Devaluation would therefore have little effect on foreign exchange earnings, but would push up the cost of imports, especially capital goods. It would also, through the higher cost of food subsidies, impact directly on the budget. At the end of last year, the IMF backed down on the point.

Re-evaluating the stock market

An ambitious privatization programme is set to boost foreign investment and encourage domestic institutional investment in Egypt’s stock market

“There has been more change in the markets in the last five months than there has been in the last five years,” says stockbroker Aladdin Saba, co-founder of Hermes Financial, which was merging this July with the other leading Cairo stockbroker, Egyptian Financial Group (EFG). The new company, EFG Hermes, will have a market share of 30%.

The active minority among the 110 registered stockbrokers views the link-up of the two strongest players with some alarm. The consolation for them is that, because in-house broking is forbidden, they may now pitch for the brokerage business of the EFG and Hermes fund management operations, which used to trade through each other. (The fund management operations of the two companies remain separate.)

“The main change on the Cairo Stock Exchange is that there is no longer a liquidity problem,” explains Saba. “Volumes have grown quite significantly in the past year ­ and dramatically so if you start from 1993 when trades averaged 240,000 a day. Last year the figure was 3.1 million, and to May this year we were averaging 5.8 million daily. The June figures are going to be much higher and it is significant that these latest figures don’t include new issues, which have to be traded for three months before they are included in the index. And we are due to have more public offerings before the year is out.”

Despite improved liquidity, analysts accept that there is still a lack of product on the Cairo Stock Exchange. Out of the 745 listed companies, only 172 are ever traded and only 40 actively traded. The exchange also boasts a five-year government bond issued in 1995 and a handful of corporate bonds, including a first Pharaoh bond ­ a E£200 million FRN (floating rate note) for Citibank which was 2.5 times oversubscribed during the mandatory 10-day offer period.

Until this year, many of the privatizations had been very small deals involving only 10% of equity, says Saba. “This was not, in truth, privatization. It was merely taking money into the public sector.” When the privatization agency announced this May that 10% of Medinet Nasr Housing and Construction was to be sold off, it looked like another unappetizing offer. Then, to the market’s surprise, the government did an about-face and said that it would sell 75% of the equity.

“This was a momentous decision,” says Saba. “It meant that for the first time in a public share offering, the control of a company was really going to the private sector. With the sale, the board was privatized and this now looks like an excellent little company. The stock was offered at E£65 and is now trading at E£91. I think the government was as impressed by what happened as we were. The challenge now is to keep the momentum going. Since Nasr, there have been a few other deals, including Starch and Glucose in which a 60% stake was sold as originally planned. However, we need more to prove that privatization is a success, and that the private sector is up to the challenge of buying and running these assets profitably.”

Until the Nasr deal, the government’s programme to sell 314 fully-owned public enterprises with a book value of around E£85 billion had been moving slowly. After private placements of three companies, including Egyptian Bottling (PepsiCo) and El-Nasr Bottling (Coca Cola), only five enterprises had been fully
privatized and 17 minority holdings sold.

“One of the problems has been that all these state companies were parcelled out among holding companies on a sectoral basis,” explains a local banker. “This was ostensibly to have them converted into joint stock companies in readiness for their sale. This has indeed been done ­ far better by some holding companies than others ­ but virtually all the managers in both the holding companies and the companies that have been passed into their control are bureaucrats or technicians. There is hardly a business brain among them. And like all officials, they never like to relinquish any little piece of power they have unless they are forced to. It is probably more serious for them, since once their company is sold off they will probably find themselves out of a job.”

The Ganzouri government aims to sell off 80 companies involved in steel, cement, fertilizers and textiles before the end of the year. Mohamed Ozalp, senior general manager at MIBank (Misr International Bank), whose latest privatization was a 10% stake in the El Nasr Transformers and Electrical Products Company (Elmaco), says there are still investors with money prepared to buy into new products.

“The last time I saw the Central Bank figures,” says Ozalp, “liquidity stood at E£160 billion ­ E£62 billion of which was household sector deposits in the banking system ­ and it is estimated that there is approximately $40 billion of Egyptian funds abroad, either in the form of flight capital or of workers’ remittances which have been kept out of the country. If a small proportion of this money comes into the stock market, it will make a definite impact.”

Ozalp’s own bank underwent a partial privatization when Banque Misr sold 10% of MIBank’s shares. He comments: “There appears to be greater commitment now than two years ago when there was a recommendation that public sector ownership of joint venture banks be decreased to a maximum holding of 20% before the end of 1996. Since then there has been much talk and statements of intent, but only one move of major significance transpired. That exception was the Commercial International Bank (CIB), where the National Bank of Egypt, which owned 100% of the bank, proceeded to sell 56% to individuals, employees and private corporate investors. Today CIB’S shares are among the most actively traded in the Egyptian stock market.”

CIB went on to become the first internationally-listed Egyptian security when one million shares in the form of GDRS, representing 25% of the equity, were placed by a consortium led by Barings.

With the exception of investment funds, which represent perhaps 8% of the market with some E£2 billion under management, domestic institutional investors are notable by their absence. The insurance sector, dominated by three state companies which account for 75% of all business, in 1994 generated a premium income of only E£1.5 billion ­ less than 1% of GDP. This is partly because premiums are still not fully liberalized and partly because policies are generally sold only when there is a legal requirement for them: most Egyptians have yet to recognize the benefits of standard insurance products.

Until earlier this year, the insurance companies were limited to placing no more than 15% of their assets in securities. This has now been raised to 30%. Ahmed Heikal, director of the Egyptian Fund Management Group, points out, however, that the insurance companies’ assets are hugely undervalued: if property in the centre of Cairo, still accounted at book value, was to be revalued, they would have substantially more to invest in securities.

The local investment funds have not all had an easy time. From a high in March 1995, the Hermes Financial Index (HFI) has been in gentle but inexorable retreat. The mainly open-ended funds have been hit by redemptions as investors have sought more robust investments. Egyptian dividends have always tended to be high: Khalil Nougaim, managing director of Cairo Funds Management, points out that while the market has an average p/e of seven, some Egyptian shares are having to pay dividends of up to 12%.

Saba is philosophical about working in a gently sliding market. “I think that it was very healthy that we had a collapse in prices. Certainly, it created disillusionment for a lot of investors, but not enough to kill the market. People pulled back but, since the Nasr deal, they have started to return because they think something different is happening. I think privatization is going to continue and this market is going to be totally different within a year from now. I think that it is going to go up by at least 30%. The value is going to go through the roof and when the central depository comes on stream by next January, settlement is going to improve dramatically.”

It is the undervaluation of the Egyptian market that is attracting foreign investors, who can be responsible for up to 35% to 40% of daily volumes. (International investors accounted for 20% of the E£3.3 billion of stock traded on the Cairo Stock Exchange in the first six months of this year, compared with 6% of the E£3.8 billion traded in the whole of last year.) “I have a nice feeling in terms of foreign investors,” says Aly el Tahry, co-founder of Hermes Financial, “but it may be a little too early.”

He says he will welcome a sovereign rating for Egypt, whatever it is. “Even if it came out below investment grade it would not be negative. There are still quite a few investors who would like to know where they are, and the rating will fix the price. Both the government and investors would know where their benchmark is.”

Banking opportunities

With foreign banks free to trade in local currency, Egyptian banks will have to reform rapidly to compete

Since interest rates were liberalized, Egyptian banks have been scrambling for good assets. There are few genuine blue-chip borrowers; these, together with the next best risks, make up a relatively small market of little more than 400 firms with sales of over $20 million.

Analysts point out that the banking system now has a serious funds mismatch. Between 80% and 85% of deposits are for less than three months, and only 5% of these on average are free.

However, wholesale credits are being extended to five or six years. A recent five-year loan to the local franchise of an international bottling company carried a one-year grace period and a first-year rate that was effectively 1%. “The name will look good, but it is not a good deal,” says an analyst. “These low-earning loans have been going on for two years now. They are neither good for the banks in the short term nor the customers in the long term.”

There is also disquiet among some brokers that banks have been investing in the shares of some of their borrowers, raising the possibility that they are using inside information to shape their investment strategies.

“One problem is that the system lacks non-bank financial institutional players as a source of long-term funding,” says Omar Mohanna, who has just taken over as general manager of the Egypt Arab African Bank. “The pension funds are still out of the system because their funds go primarily to the National Investment Bank and don’t find their way to the capital market. Meanwhile, the insurance companies are only now becoming more active in the capital markets. They remain in property and classic hedges. Without these two main sources it is very difficult to create a long-term source of funding.”

Some bankers argue that the Egyptian banking system is over-banked, while others maintain that this applies only to wholesale business. The winnowing process has already begun: there are now 81 banks, 20 fewer than two years ago. Others in the market point out that lower-capitalized banks may face problems that will propel them into mergers.

“There will be mergers and acquisitions, and restructurings,” says Ahmed Elbardai, vice-president at Citibank. “Banks are trying to improve their efficiency but, inevitably, it is the private banks that are doing better because they are newer, have built-in controls and have avoided a build-up of non-performing debt. And a lot of them have joint venture experience with a foreign bank.”

Until two years ago foreign banks could only access the local currency market as part of a joint venture bank. Now that they can compete on equal terms, they are likely to expand from the bread-and-butter, trade-related wholesale work into the retail market. “Citibank has been successful here for 20 years,” says Elbardai. “And now we are free to deal in local currency, we wish to become a significant retail bank with a market share of about 5%. We already have 4,000 personal banking clients.”

The retail sector is currently dominated by the big four state banks ­ National Bank of Egypt, Banque Misr, Banque du Caire and Bank of Alexandria ­ and is seriously underdeveloped. A recent study by Salomon brothers concluded that, in 1994, Egypt had a banking density of 48,000 customers per branch down from 79,000 four years earlier. This is still well behind other Mediterranean markets and the report concludes: “Egypt’s cash society is the cause of the low banking density. Cheques and credit cards are not commonly used.”

The interbank market is now well developed and in the last 18 months it has become more active, with banks no longer afraid to go short. The net lenders are the four big banks, and volumes range between E£200 million and E£300 million a day.

The foreign exchange market is more delicate and can be affected artificially because banks are allowed to hold positions only up to 10% of their equity. The excess must be sold on to the market. One dealing room manager comments: “We can do swaps or forwards. Counterparties are OK on spots and some understand forwards, which are all that is allowed and only for a client who has an underlying commercial transaction. We hope, however, that as the market becomes more experienced, the pressure will mount for a liberalization of the rules.”

Making foreign investment hassle-free

Investing in Egypt is getting easier and some big name funds are moving in, tempted by modest liberalization and good rewards

Egypt’s market participants regularly cite the billions of dollars of investment attracted by one south-east Asian country or another and then point morosely to the $400 million that Egypt has been attracting each year since 1993. Relatively few direct investors have chosen this country of 60 million people as their regional manufacturing base despite its large home market and excellent geographical location. Certain sectors, such as textiles and, recently, value-added agricultural products are an exception, but the general feeling is that the big money is still waiting.

The fast-track investment agencies designed to help an investor set up a deal were recently described as part of the problem by a local businessman: “The very fact that these organizations have some legal right to take you in hand means that, in fact, they become just another level of bureaucracy for you to deal with. Some people who arrived eager to invest had very bad experiences and months later pulled out angrily.”

Aly Wally, a former government minister who is now a senior member of the board of the Egyptian Businessmen’s Association, a pressure group of leading executives, says: “The new government appears to be listening to the markets. They are, of course, getting a lot of suggestions. I believe that in order to bring in major flows of foreign investment we need to cut corporate tax from 50% to 22%, extend and broaden the tax breaks that already exist for outside investors, replace our Napoleonic commercial code with something modern and workable, and make sure that the role of the government dwindles so that it is becomes only a helping hand for the economy, not the controlling hand.”

By contrast, overseas indirect investment has become largely hassle-free, not least because of the removal of the 2% capital gains tax. There are no limits on the amount that may be invested, its convertibility into and out of the local currency, or the timing of an investment. Only when a single investor is buying more than 20% of a company’s stock is an official notification necessary.

“The money that came in last year from overseas was from the daring foreign investor,” says Ahmed Elbardai, vice-president at Citibank. “Now we are seeing the big-name funds coming in, perhaps for their own investors rather than their own portfolios. I don’t believe they will come in, take one bite of the cherry and then leave, because the potential is so much greater now… You have a market today that is giving you a yield of around 10%, which is equal to the high interest rates, and which is selling at a multiple of between six and seven, which is very low. With a stable exchange rate, I do not think you can go wrong.” Elbardai reckons that 19% of the new transactions in the second quarter of 1996 were foreign.

Now that Egypt’s macroeconomics are under control, it is an outstanding candidate for international funds that are focused on Africa and the Middle East. “If they look around, outside of Morocco and maybe Tunisia,” says Elbardai, “there is not much for them to put their money in.”

Earlier this year HSBC’s James Capel launched the first offshore closed-end fund for Egyptian equities. When the Egyptian Stock Exchange (ESE) joins the IFC’s emerging market index next year, it is expected that many fund managers will start adding the ESE to their emerging market risk. A Pharaoh bond for Citibank was followed by another in May for the Egyptian American Bank, a joint venture between the Bank of Alexandria and American Express. Several merchant banks have been trying to market IPOs or bonds to corporates that have traditionally relied upon bank money or their own resources for expansion. One house believes that it is close to selling Egypt’s first convertible, but is being delayed by regulatory deliberations.

The detailed financial and operational analyses being prepared for the privatization of state assets also appear to be setting a standard for disclosure. Brokers, noting that companies are now happier to welcome analysts, have begun actively to seek research on them.