Hermes: Egypt’s economic potential – Oasis or mirage?

From a distance, it is easy to conclude that Egypt is an arid environment for investors. Accounting for only 0.13% of the MSCI Emerging Markets Index, the country is often overlooked given its questionable democracy, high rate of inflation, recent currency devaluation and twin deficits. Since the global financial crisis, Egypt has suffered a difficult decade characterised by political instability and economic turmoil.

Yet on closer inspection, things are beginning to change. An increasingly stable political and economic climate, coupled with low labour costs, high literacy levels and a series of economic reforms, suggest that the country’s future may look brighter than it has for a decade or more. Gary Greenberg, Head of Emerging Markets at Hermes Investment Management, explores these factors and explains why Egypt is becoming distinctly more attractive.

Economic reforms
Egypt’s economy has gyrated, along with its leadership, since the financial crisis, recovering only to be hit by the Arab Spring and President Mohamed Morsi’s election and later removal.

Investor confidence in Egypt has been in short supply since the Arab Spring and the establishment of ‘order’ by the military under el-Sisi initially did little to restore it. However, there are signs that confidence is beginning to improve, as Egypt’s economic policies have come under the guidance of the IMF.

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President el-Sisi’s challenge is to enact tough reforms while ensuring social stability in a country where 28% of the population lives below the poverty line. Intervention from the IMF last year saw the currency devalued by 100%, with the Egyptian pound crashing from 8.9 to the US dollar in 2015 to 18.1. While this led to a spike in inflation, it also spurred a dramatic change in policy. The IMF forecasts that the government will run a small primary surplus this year, increasing to 2% of GDP for the ensuing few years. This should reduce debt to well below 100% of GDP by 2023.

Fuel subsidies
Given the volatility of oil and wheat prices and the exchange rate, the only price levers that the government can control are subsidies for petrol and diesel. However, removing public subsidies in a single blow would be a difficult move following the currency crash and inflation shock, which slashed purchasing power for much of the population.

However, two or three smaller hikes across the next two years could result in the complete disappearance of the fuel subsidy by the beginning of the 2019-20 fiscal year. Equally, if Egypt’s electricity price increases continue to match those of previous years, Egypt’s inflation profile would remain close to 12% through June 2020, with the potential to drop into single digits in subsequent years.

Firing up the gas
An important milestone for the country’s economic health is the development of its offshore gas fields. With the addition of 22tn cubic feet (Tcf) of recoverable gas in the Zohr field, Egypt’s gas reserves stand at 65 Tcf, making them the 16th-largest in the world. As production from Zohr ramps to 2.7 bn cubic feet (Bcf) per day by 2019, the country should have a self-sufficient gas supply, moving the current account from a deficit to balance.

Egypt is not the only country discovering gas in the Eastern Mediterranean. The development of Israel’s giant Tamar field is also good news for Egypt; unlike Israel, it has two inactive liquefied natural gas (LNG) plants on the coast, which can be revived to process Israeli gas for export.

An aspiring workforce
When it comes to the labour market, Egypt’s demography could emerge as a significant source of competitive advantage. First, its population of nearly 100m is young (more than 50% are under the age of 25 and roughly 40% are between the ages of 25-54) and it is growing much faster than its closest competitors both in Eastern Europe and the Middle East and North Africa (MENA).

There is also a historical correlation between literacy rates and economic development. Low literacy levels among adults may explain why former President Hosni Mubarak’s reform plan to build a manufacturing base failed to take off in the early 2000s. But since then, literacy rates among Egyptians breached 70% in 2010, reached 76% in 2015 and is estimated to hit 80% by 2020.

Labour costs are another advantage. Wages in North Africa are roughly half those of the cheapest country in Europe.  Egypt seems particularly competitive, where wages are half those of Tunisia, one quarter of those in Morocco and one eighth of the cost in Turkey. Together, labour costs, higher literacy and attractive demographics should support the case for Egypt being a destination for foreign investment.

Egypt: oasis or mirage?
Egypt’s economy has yet to achieve sustainable growth, but the development of the Zohr gas field and the improving tourist trade – which should benefit from the resumption of Russian flights to major resorts in April – should combine over the next two years to dramatically lower its current account deficit. This should arrest the climb in external debt as a percentage of GDP.

Other signs are relatively healthy as well. The Egyptian pound has depreciated enough, credit-rating agencies are likely to upgrade the country’s sovereign-debt rating as the government adheres to the IMF package, and demand for loans should increase as interest rates decline.

The country’s stock market has been becalmed since 2013: it now trades at an 11.2x price-to-earnings multiple (on a 12-month blended forward basis) in US dollar terms, roughly 0-1.5 standard deviations higher relative to both its own history and to global emerging markets. But with consensus forecasts of earnings growth of 46% for this year and a return on equity of 21%, we think the market provides an opportunity to access an improving macro story despite its relatively high current valuation.

With ongoing economic reform and progress, Egypt could truly emerge, and its large, long-suffering population could begin to experience the rising standards of living enjoyed by the Asian and Eastern European populations that have walked the path of industrialisation before them.

Are we witnessing an economic oasis or mirage? In our view, Egypt has begun to realise its growth potential and investment opportunities are within grasp, rather than forever shimmering in the distance.

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