Egypt’s fiscal shock therapy makes investment-driven growth a priority
Egypt’s recovery story under-appreciated, boosted as it is by sustainable inflows of GCC aid, a much more credible economic policy and nearly three years of pent-up demand.
Newly inaugurated Egyptian President Abdel Fattah el-Sisi and his Cabinet of Ministers have surprised many observers with their rapid adoption of what amounts to a self-imposed structural adjustment programme just days into the state’s 2014-15 fiscal year.
Many had expected this to be a game of inches – particularly during the first year of the president’s mandate – after three years of economic, social and security dislocations that exhausted the electorate.
The first signs that change is now afoot began to emerge with President El-Sisi’s refusal in late June to approve the 2014-15 state budget, calling it overly reliant on deficit financing.
That was quickly followed by Minister of Investment Ashraf Salman’s determination to stay the course on the newly introduced 10% capital gains tax on Egyptian Stock Exchange (EGX) transactions and dividends, a decision traders had already absorbed.
With the rapid liberalization of energy prices that followed, El-Sisi and his economic team are wagering that their current popularity and the weakness of the political opposition will help the nation accept economic medicine that will likely prove as tough to swallow as it is necessary to take.
The imperative to act is clear not just in the streets but in law: the new government formed by Prime Minister Ibrahim Mehleb faces a constitutional imperative to increase spending on health, education and scientific research to a combined 10% of gross national product by the 2016-17 fiscal year from c. 5.5% today.
By any measure, the El-Sisi government is pursuing a radical change in course – one that is higher risk than the policy of ‘balanced gradualism’ we had expected, but one which could pay off significantly sooner if it catalyzes new foreign and domestic investment.
This last point is key: only growth will make the reform programme palatable to the electorate, and the country cannot rely solely on continued aid flows from its allies in the Gulf Cooperation Council (GCC) to make it possible.
Against this backdrop, investors will need to be watchful in the months and years ahead for signs that the government’s reform agenda continues to comprehensively tackle Egypt’s key challenges: from revenue via taxation, expenditures (subsidies) and liquidity (currency market reform).
What has changed?
It shouldn’t be surprising that the reform programme began almost entirely on the expenditure side with the third rail of Egyptian politics: the subsidy programme.
In its present incarnation, this accounts for nearly a third of total state spending, with food subsidies being a relative sideshow to a ruinous programme of energy subsidies that has resulted in industrial slowdowns and work stoppages, rolling blackouts, line-ups at filling stations and pressure on foreign reserves.
The El-Sisi government began taking action on 5 July: all fuel products save butane have seen their prices rise, as has electricity; a five-year plan for the phase-out of electricity subsidies is now clear; sales taxes on tobacco and alcohol have been hiked; and Egyptian citizens and corporations alike are now taxable on their global incomes.
The most significant increase is that of diesel prices, up 64%, given that it is the most widely used fuel product – consumed for transportation, irrigation and heating – and therefore accounting for 50% of the fuel subsidy bill.
|Summary of Fuel Price Changes at the Pump and for Industry
Action on the expenditure side of the equation looks set to be accompanied by revenue-generating reforms. A new value-added tax will be introduced in 2015, and the recently finalized property tax law will also help, as could a mooted additional tax on mobile telecommunications services.
These measures come on the heels of an additional 5% income tax on individuals and companies earning more than E£1 million per year, raising the effective income tax rates for both groups to 30% through 2016.
Like a recent move to tax Egyptians on their worldwide incomes regardless of residency status, this is essentially low-hanging fruit, and should be followed not by further tax hikes, but clampdowns on evasion and a sharp improvement in tax collection.
The across-the-board price shock associated with the subsidy-reform measures will together have a predictable impact on private consumption, which accounts for around 70% of GDP.
We believe the short-lived monetary-easing cycle the market enjoyed in recent months has now come to an end and expect inflation to accelerate to 10% in the current calendar year and then 14% next year, leaving little room for the Central Bank of Egypt to cut rates further.
We’re thus downgrading our real GDP growth forecasts and are now looking for 2.9% in the current fiscal year (which began on 1 July, 2014) and 3.4% in 2015-16 from our previous estimates of 4.3% for both years.
We estimate these measures will together trim the state budget deficit to 10.9% of GDP in the current fiscal year, representing considerable narrowing from 12.2%.
That said, the simultaneous implementation of these inflationary moves comes at a time of depressed GDP growth – and at a time when the government has only a few shields at hand to protect vulnerable groups from rising inflation. New social safety nets, in the form of targeted cash transfers, may take eight-12 months to become operational.
With the current pace of fiscal consolidation, the pressure is quickly mounting to deliver on economic growth. Structural reforms and the stimulation of growth are fundamentally opposing forces, leading us to expect the government will rely on GCC-financed stimulus spending, particularly on infrastructure and housing.
Energy and foreign-exchange shortages, the upcoming parliamentary elections, rising input costs and an uncertain timeline for a recovery in tourism are all potential constraints on growth.
What does this mean for investors? Broadly speaking, we see the ‘Egypt story’ underpinned by sustainable inflows of GCC aid, a more credible economic policy and nearly three years of pent-up demand. Winners in this climate will include real estate – a traditional hedge against inflation in Egypt – construction and building materials, energy and logistics, financial services and health.
Banks, as usual, are strong proxies for Egypt. A flood of state paper in recent years and a dearth of foreign-currency liquidity have resulted in a shallower pool for private borrowing, with the result being not just limited capex but difficulties financing working capital needs.
While a pick-up in domestic investment will be slow, we are already seeing signs of loan growth, and continued GCC funding for large scale products will stem the flow of government paper into the market.
This is all good news for the nation’s private sector banks, which account for around half of banking sector assets. Blue-chips could become a more compelling play than usual in such circumstances, as would a number of well-managed Islamic banks with strong GCC parents who are aggressively growing their businesses in Egypt.
Energy producers and distributors with exposure to alternative production technologies – from solar to refuse-derived fuels (RDFs) – will have advantages in a new landscape. So, too, would producers in energy-intensive industries that have been designed to operate on multiple energy sources, such as RDF and coal, or who can quickly convert to include the same in their energy mix.
Further afield, some manufacturers reliant on national networks have already seen the handwriting on the wall and have started reconfiguring their logistics tails and distribution networks to become more fuel efficient. Producers of more energy-efficient building materials, river-based alternatives to land transport and the nation’s nascent green technology sectors all bear watching.
Less nimble in reaction to the shocks will be the ceramic, cement, steel and telecommunications sectors, which will be particularly hard hit by rises in prices of natural gas and diesel. The few consumer cyclicals listed in the market may also suffer from the hit to real incomes.
But for many industrials, we expect it to come down to this: margins will narrow, but after nearly two years operating well below 100% utilization, their top lines will swell as they lock in adequate fuel supplies at higher prices. Bottom-line growth remains entirely possible.