ECR: Egypt’s finances will weather the storm

It is the biggest geo-political story since the invasion of Iraq. The military leadership of Egypt, the most populous nation in the Arab world, had been a staunch ally of the US since Anwar Al-Sadat signed the Camp David Accords in 1978. After two weeks of popular protest, this convenient model of Egyptian governance has come to an abrupt and unexpected end. Prompted by widespread political oppression, high levels of youth unemployment and allegations of corruption among those closest to the ruling clique, Egyptians took to the streets in numbers not seen since the assassination of Sadat in 1981 to demand the removal of President Mubarak. The unity of purpose displayed by the protesters in Tahrir Square stunned observers around the world. Now, that unity of purpose must be matched by a unity of action within Egypt’s interim government if the country is to avoid serious economic deterioration.

Despite growing concerns over Egypt’s ability to cope with a significant hit to its economy, the relative strength of the country’s finances mean that the regime has some breathing space. “Public debt peaked at 110% of GDP in the mid-noughties, but is now only 70% in gross terms,” says Gabriel Sterne, an economist at Exotix, a frontier-market investment-banking boutique. “When the crisis began, external debt was only 20% of GDP, hardly enough to ring even faint alarm bells.” Although a $1 billion Eurobond is scheduled to mature in July, this represents only 3% of end-2010 reserves. Egypt’s finance minister has assured investors that Egypt will not default on any of its debt obligations in 2011. However, a prolonged political impasse could pose a problem for a country with a hefty public sector wage bill. For Ayah El Said and Rachel Ziemba, analysts at Roubini Global Economics, the concern is that foreign reserves are already being drawn upon to support the Egyptian pound and government expenditure. “In addition to the $36 billion of official foreign reserves – equivalent to six months of exports – that the government has amassed recently, $20 billion in state funds are also being held in Egyptian banks. However, we fear that the latter already have liabilities attached,” says El Said. The government’s fiscal position is likely to come under pressure from increased public expenditure in the form of wage rises and subsidies. Subsidies already consume as much as 25% of government spending, with wages the next largest expenditure. Increased pensions alone could cost the economy as much as $1.1 billion, according to Roubini. These pressures, allied to lower growth estimates, are likely to send the budget deficit to 10% of GDP.

Dangers

The danger is that the economy will be badly hit by reduced tourism, a sector that employs 10% of the workforce; 90% of all tourist bookings for 2011 have already been cancelled. Meanwhile, international companies including BG and Nissan have announced cuts in production and the repatriation of foreign staff. The government will have to work fast in order to reassure investors that normality is returning to Egypt and that, aside from some suspicion of foreign journalists at the peak of the crisis, the country welcomes foreigners.

“Investors shouldn’t see the protest movement as an un-invitation to do business in Egypt,” says Bernie de Haldevang, head of political risk at Aspen Insurance. “It is highly unlikely that any successor government would wish to pull up the drawbridge to foreign investment.” For Sterne, the worst-case scenario is an extended flight of capital from Egypt accompanied by devaluation of the pound. “A situation with parallel exchange rates and dollarization of the economy could easily ensue, with profoundly damaging effect.”

Contagion

Investors have just about got used to using the term contagion being bandied about with reference to bad loans in the global financial system. Now, the infection is the struggle for political reform. Since February 13, Bahrain’s capital Manama has seen continuous protests against a lack of political freedom. Villages inhabited by the country’s Shia minority have been the scene of pitched battles between the police and young Shiites. Scenes of violence between protesters and the armed forces on February 17 led to martial law being imposed on the capital. The main Shiite opposition group, Al Wefaq, has since suspended its membership of the Bahraini parliament. “It is important to understand the sectarian dimension of the conflict in Bahrain,” says Anthony Skinner, associate director and principal analyst at risk analysts Maplecroft. “We are seeing a reaction to discrimination by the Sunni minority against the Shia majority.”

The king, Hamad ibn Isa Al Khalifa, has already pledged to give parliament a bigger role in the governance of the country and to increase the role of the opposition. Food and fuel subsidies have also been increased. “Bahrain has the weakest finances of any of the Gulf states,” says Ziemba. “It has relatively small reserves of oil and gas but remains heavily dependent on natural resource revenues. This means that its breakeven oil price is high, around $80 dollars a barrel.”

Jordan too can ill afford the kind of unrest witnessed in Tunisia, Egypt and Bahrain. A $225 million package to reduce food and fuel prices was announced shortly after King Abdullah dismissed his cabinet. “The incentives are not addressing the underlying grievances, but they are an attempt by the Abdullah to do something,” says Ziemba. However, the government has little fiscal room to manoeuvre. Even before the increase in food prices, Jordan was running a 5.5% government deficit. With the cost of maintaining food and fuel subsidies, that figure is likely to rise to 6% or 7%.

The demands for political reform are closely linked to ethnic tensions between the Hashemite and Palestinian members of Jordan’s 6 million inhabitants. Bedouin tribes have been quick to protest at what they see as their marginalisation from the political process and remain deeply suspicious of King Abdullah’s Palestinian queen. Although King Abdullah is still held in high regard by the majority of his subjects, this esteem is not inexhaustible. “Since King Abdullah is personally responsible for appointing the prime minister, it is not inconceivable that he could attract a higher level of personal criticism if the promised programme of reforms does not materialise,” says Skinner.

Military resistance

While the government attempts to reopen Egypt for business, the first objective for the protesters is constitutional reform – overseen in the short term by a council of jurists – to enable fair elections to take place. “The protesters are adamant that constitutional reform must take place before the elections to avoid any interference by the military”, says Michael Moran, vice president and executive editor of Roubini Global Economics. “With the rigging of the 2010 elections still fresh in the memory, they are unlikely to accept any other arrangement.” Egypt’s military rulers are said to planning a referendum on the reforms to take place in March.

The danger remains that figures within the military may prove resistant to the participation of a full cross section of Egyptian society in the reform process. Yet the signs so far are positive. The council of jurors appointed to oversee constitutional amendments includes Sobhi Saleh, a prominent member of the Muslim Brotherhood. A Coptic Christian is also present on the panel.

“The military are mindful of what happened in Algeria during the 1990s, where the refusal of key figures within the regime to negotiate with the Islamist opposition ultimately led to civil war,” says Skinner. “They are aware that the Muslim Brotherhood is well established and has strong grassroots support. Egypt’s military top brass is aware that attempts to quash the movement would take place under the full glare of the domestic and international media and would be seen as a serious challenge to the opposition movement.”

Bernie de Haldevang believes that certain parallels can be drawn with the compromise between secular and religious elements in Turkey. “In Turkey, the military has proved a responsible partner in a movement towards democracy. It has defended the constitutional, secular status quo and allowed president Erdogan to move forward with a process of constitutional change.”

The intentions of the Muslim Brotherhood will become clearer in the coming months. “The Muslim Brotherhood is not a homogeneous organisation,” continues Skinner. “It contains both liberals and conservatives. It has participated in the demonstrations but says it will not field a presidential candidate in the election.”

However, the Brotherhood has announced that it will form a political party once restrictions are lifted. With the military still in charge, is it possible that the Brotherhood is simply being cautious with its pronouncements? “It is true that the Muslim Brotherhood does not recognise the state of Israel as legitimate,” continues Moran. “But within it, there are a greater number of people who would be willing to accept a just peace with Israel than there are within Hamas, for example.” It is a compromise the Muslim Brotherhood must face if it is to gain wider support among Egypt’s largely secular society.

Role play

Longer-term questions about the future of Egypt’s role in the region remain unanswered. The US and Israel have relied upon Egypt as an important ally in a hostile region. The Mubarak regime also provided an important counterbalance to Iran. There is no guarantee that a democratically elected Egyptian government will wish to play either of these roles. For Moran at Roubini, the horizon is still brighter than it would otherwise have been. “Geo-political inconvenience notwithstanding, I think this is progress. The status quo could not have held. The Israelis have based their foreign policy on assumptions that were untenable. This is part of what happens when a situation you have failed to deal with for way too long blows up – but it is not a disaster.”

If there is a conclusion, it is that the US must learn that it can no longer influence Middle Eastern politics the way it did from 1991 to 2007. “Now that the US has become the largest member of the Piigs [a reference to the troubled countries of peripheral Europe], there is a very real cost attached to foreign policy,” observes Moran. “Before 2008, the US administration considered the costs of direct intervention as little more than a rounding error. Now the opportunity cost will be more closely scrutinised.”

Visit  Euromoney country risk