Investment case summary
The recipe to make money on frontier market bonds is simple. Buy high interest rate local currency bonds in a country where you believe in improving macro conditions, which causes interest rates to go down and currency to strengthen. Egypt might be an ideal candidate. The IMF reforms caused a significant macro turmoil, which created an opportunity to make money on the macro normalization. In one sentence, this is a bet that Egypt will successfully implement the reforms agreed with the IMF and that political situation would not worsen.
If the above assumptions prove correct, bond returns would be significant. An investment in local currency bond would be affected by the FX movement. If, for example, the EGP strengthens by on average 10% annually, an investor would more than double the money on 3-year bond with a 33% IRR. If EGP does not strengthen, the high interest rate protects against further devaluation, assuming the bonds remain in good standing (see the table at the end of the article). As the EGP recently devalued by 100% (after the termination of the fixed FX regime), and as the Egypt is delivering on IMF reforms, the second scenario seems more likely than the first.
Introduction to Egypt
Egypt is a 90% Muslim north African nation with a population of 93 million and GDP per capita of USD 3,740 (nominal) and USD 12,560 (PPP).
Egypt has the oldest continuous parliamentary tradition in the Arab world. The first popular assembly was established in 1866. Since 2014 Egypt has been ruled by elected president Abdel El Sisi within a system of a firm hand democracy.
Egypt is the second largest economy in the Arab world after Saudi Arabia. Egypt is facing strong macro challenges – the large budget deficit that reached 12.2 percent of gross domestic product in the fiscal year ended in June 2016 is expected to drop to 10.1 percent in the current year. The enacted reforms should ensure the continuation of this trend. Domestic debt is high at 95 percent of GDP.
Since 2014, the government started implementing a bold and transformational reforms program, aimed at spurring the economy, enhancing the country’s business environment and staging a balanced and inclusive growth. The reform program is widely endorsed by key Development Partners, including through the World Bank’s programmatic DPF series, the IMF Extended Fund Facility (EFF) and the African Development Bank parallel financing.
In August 2016, Egypt has signed up to IMF three-year $12 billion credit facility. The IMF loan is tied up to defined package of further economic reforms.
The first wave of the reforms package focused on rebalancing the macroeconomic aspects. The aim was to raise revenue and rationalize spending, to reduce the deficit and to free up public funds for high-priority spending, such as infrastructure, health and education, and social protection. The government committed to floating the EGP, reform tax system (including the introduction of VAT), and rationalize energy subsidies. The most significant first wave reform steps were:
In 2013/14, Egypt spent over 6 percent of its GDP on fuel subsidies — more than on health or education. Ironically, fuel subsidies tend to benefit the well-off segments of the population — think owners of gas guzzling cars — more than the poor who need more social protection, and better health and school systems.
Floating Egyptian pound
The pound had been fixed to USD at an overvalued rate. In October 2016, the currency was allowed to float which resulted in almost 100% devaluation of the Egyptian Pound. The flexible exchange rate should strengthen competitiveness, attract foreign investment, and support exports of new industries. This should create jobs and support long-term growth, and hence, raise living standards.
The second wave of reforms targeted improving governance and investment climate, which includes the Civil Service Reform Law that was passed in October 2016, in addition to a set of undergoing reforms targeting to removing investment barriers and attracting local and foreign investments, such as the Industrial Licensing Law, the Investment Law and the Company Law.
The IMF stated:
"We expected inflation to go up, as it did, for several months after the launch of the reform program. This reflects higher energy prices, to some extent the introduction of the VAT, and pass-through from the exchange rate depreciation. The key task now is to make sure that these factors don’t translate into permanently higher inflation. The central bank is very aware of the risks, and it is taking the right actions to make sure that inflation does come down, as targeted."
The IMF's first review of the progress allowed for the disbursement of US$1.25 billion on July 14, 2017, bringing total disbursements under the program to about US$4 billion.
Consequences of the reforms
The end of fixed currency regime resulted in 100% devaluation of EGP
According to the Economist's BigMac Index, EGP became the world's second most undervalued currency, after war-thorned Ukraine.
As stated above, the IMF designed reforms - mainly the devaluation and the elimination of the petrol subsidies - caused the inflation to triple. After the initial shock, the interest rates have started to decrease. IMF estimates that inflation would decrease to 22% and 16.9% in 2017 and 2018, respectively.
The increase in inflation caused the interest rates to rise and the yield curve to invert.
The local currency yields rose to quite attractive levels for new buyers.
The reforms are starting to bear its fruits
The IMF and the World Bank are estimating that the macro situation in Egypt is stabilizing. IMF estimates that the inflation should go down from over 30% to 22% and 16.9% in 2017 and 2018, respectively, and the growth should pick up to 3.5% and 4.5% in 2017 and 2018, respectively.
Foreign investment is starting to increase.
Demand for Egypt's debt is also increasing. In January, Egypt received US$13 billion in orders for its 4 billion bond issue. In May, Egypt returned to the markets and took orders of US$11 billion for 3 billion of bonds. The interest rates on the bonds ranged from 5.45% to 7.95% depending on the duration were significantly lower than for the January issue.
The main risk in this investment is political instability and the threat of terrorist attacks. Political violence and terrorist incidents, including the downing of a Russian airliner in 2015, are affecting the tourist sector that employs 12% of the workforce. The government is working hard to maintain the stability. The government maintains a heavy security presence at major tourist sites in and around greater major cities. The tourist numbers are going up despite occasional incidents.
Significant return potential
As stated above, the 3-year Egyptian local currency government bond yields 20%. If held to maturity, the actual yield would be affected by the EGP movements. Partial reversal of the initial 100% devaluation would increase the actual returns significantly. For example, 10% pa revaluation of EGP would double investor money over the 3-year period (33% IRR).
At the same time, the 20% interest rate provide a cushion against a devaluation. The currency would have to devalue by more than 65% for an investor to actually losing money.
The table below indicates IRR for 3-year Egyptian government bond under different currency devaluation (+) / revaluation (-) scenarios.
*Total FX compounded devaluation (+) / revaluation (-) at maturity
Source: own calculations
The above focuses only on FX rate movements. Improving macro situation should also cause the interest rates to normalize. Decreasing interest rates would create capital gains on bond investments.
The elimination of currency peg regimes and significant policy changes result in major macro shocks and increase in volatility. Egypt government is working with the IMF to restructure the economy and bring back stability. This creates a unique opportunity with significant upside potential, with capital largely protected by high interest rates.
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