Egypt-IMF Talks: Good Goals, Risky Business

| About: VanEck Vectors (EGPT)

Securing an IMF loan may be a positive development for Egypt's economic outlook, but it is riddled with risk.

Egypt is in advanced talks with the International Monetary Fund (IMF) to secure a three-year $12 billion loan. According to Egypt's Finance Minister Amr El-Garhy, these talks are making good progress and are set to conclude in the coming days.

Why now?

The context of these talks is important. The decline in world oil prices have lessened Gulf countries' will or capability to provide Egypt with aid, especially since Gulf aid comes with political demands that Egypt often cannot fulfill. Low oil prices have further reduced Gulf tourism, investment, and remittances to Egypt. This is forcing Cairo to turn elsewhere for financial assistance.

Timing is also right for talks. While the Egyptian economy has been struggling since 2011, it is not in a complete crisis. Growth is at 3-4 percent, inflation has reached 14 percent, unemployment is at 13 percent while youth unemployment is over 30 percent, and foreign exchange reserves are nearly half of what they were in 2010 at $17 billion. Unlike many other IMF-aided countries, Egypt can still walk away from negotiations if it feels the IMF's terms are too burdensome.

Egypt's government under Abdel Fattah el-Sisi has also initiated many policies the IMF would regard as essential. This includes reducing budget deficits, lifting fuel and water subsidies, forcing the domestic currency to depreciate, reforming the taxation system, and seeking to restructure the state's administrative apparatus. These initiatives would have been deemed unthinkable six years ago, and Sisi accordingly views the IMF loan as international recognition for his leadership since ousting Muhammad Morsi in 2013.

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What will an IMF loan demand from Egypt?

The IMF will demand a more flexible exchange rate. Egypt's Central Bank has been reluctant to devalue the rate and has maintained tight control over the Egyptian pound through foreign exchange intervention and interest rate hikes. While the Bank devalued the currency by 13 percent to 8.85 pounds per dollar this March, it has remained uncertain about additional devaluation. The IMF will likely insist Egypt weaken its currency further and adopt greater flexibility to increase exports and attract foreign investment.

Greater fiscal restraint. Government deficits are nearly 12 percent of GDP, which is contributing to inflation and its current-account deficit. The IMF may insist that Egypt trim its budget deficits to 8 percent of GDP by fiscal year 2018-2019. This will force Egypt to curb wage increases and tighten state administrative practices, introduce value-added taxation and possible raise the tax rate on higher earners. It also will include further lifting subsidies, which still account for 8.5 percent of GDP. All this may be accompanied by the Central Bank decreasing government lending to reduce liquidity and discipline Egypt's economic policy.

Goals and benefits

Securing an IMF loan can signal confidence in Egypt's economy. Egypt's economic struggles have made investors reluctant about capitalizing on long-term projects or even short-term treasury bills. Markets view an IMF arrangement favorably, as the announcement of talks led to a 5 percent jump in the Egyptian stock market. An infusion of foreign capital could jumpstart growth and aid Egypt's struggling tourism industry, contributing to the country's positive outlook.

The program could also reduce inflation as a consequence of fiscal discipline. While there may be a short-term inflation spike following the subsidy reduction and the pound devaluation, inflation may slow down over time.

The IMF loan is more importantly a key reform anchor. If the Sisi government soundly implements IMF-touted reforms to make Egypt more business and investor friendly, jobs and incomes may rise over the long-term.

Risks and drawbacks

It is important to note that a three-year IMF program is not a catch-all solution to Egypt's economic woes. The benefits of economic reforms may take many years to realize, and the success of capital infusion for key sectors like tourism is still dependent on Egyptian security. This is especially true given the recent EgyptAir flight crash as well as violent unrest in Cairo and the Sinai.

One risk is whether Egypt can repay its loan with high budget deficits and 30 percent of public spending devoted to servicing its debt. The risks of default increases as Gulf aid thins, making some Egyptian economists doubt whether the IMF loan will be approved at all.

Another issue is Sisi's ineffective governance record. In 2013, Egypt's government received a $23 billion in Gulf aid - double to what Sisi is requesting from the IMF - yet Egypt's financial situation has not improved. Sisi also hastily tried to implement his $8.2 billion Suez Canal extension project by promising Egyptians inflated returns, yet the project crossed the budget ceiling and received nearly $8 billion less in projected revenue.

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Suez Canal, Egypt

Furthermore, IMF requirements for austerity, privatization, subsidy reduction, and higher taxation may disproportionately affect poor Egyptians - 27 percent of the population - by increasing basic commodity prices in the short term. While Sisi has already warned of these "harsh" measures, the combination of subsidy cutbacks and short-term inflation with continued cronyist state practices could foster a wave of public anger similar to that of the 2011 uprising that overthrew Hosni Mubarak.

Bottom line

While securing the IMF loan may be a positive development for Egypt's economic outlook, there are numerous obstacles and risks associated with implementing the IMF program. Garnering broad public support for its implementation will be crucial for the Sisi regime.