After unprecedented monetary loosening in 2020 to soften the blow of the COVID-19 pandemic, global central banks are turning their attention to tackling rising inflation and asset prices as demand recovers. Several emerging markets have already raised interest rates, including Brazil, Mexico, Russia, and South Korea. With U.S. headline CPI at 5.4% in June-July--propelled by supply bottlenecks, fiscal stimulus, and high commodity prices--the risk persists that the U.S. Federal Reserve will roll back its quantitative easing policies earlier and more aggressively than projected, setting off a "taper tantrum" in emerging markets to echo 2013 (see "Credit Conditions North America Q3 2021," published on June 29, 2021).

Capital outflows from emerging markets are likely whenever monetary policies in advanced countries start to normalize. However, we could see elevated balance-of-payment risks for Egypt if there were a sharp withdrawal of funds while current account receipts remained weak owing to pandemic-related damage to tourism and export receipts. This could result in a substantial decline in foreign exchange reserves and reduce Egypt's ability to service its debt.

Our base case is that Egypt will maintain sufficient buffers and funding sources to manage liquidity. High real interest rates (RIRs; equal to nominal interest rates minus inflation) compared to other emerging markets will likely also maintain some investor interest. However, the government has a very high interest burden and this will continue to weigh on public finances.

Here we answer some of the questions investors have been asking about the risks Egypt is facing and why.

Frequently Asked Questions

Why is Egypt vulnerable to rising U.S. rates?

Egypt's external debt, particularly the share of short-term local currency government securities held by nonresidents, has risen rapidly since 2017 (see chart 1).

Chart 1

Nonresident holdings of local currency government bills and bonds increased to $33 billion (13% of total securities) in early August 2021, from a low of $10 billion in June 2020 and above the pre-pandemic peak of nearly $28 billion in February 2020 (see chart 2). These inflows have been supported by strong international liquidity, high RIRs, and a more-resilient macroeconomic environment in Egypt than in many similarly rated peers.

This trend in rising nonresident holdings allows the Egyptian government to diversify its funding sources, but also raises the risk of a sudden halt to funding if investor sentiment worsens. Authorities have also increased longer-term commercial and concessional external borrowings in order to lengthen debt maturity and reduce the overall cost of debt. Egypt had $30 billion of Eurobonds outstanding as of August 2021.

Despite these efforts, Egypt is more vulnerable to sharp capital outflows today, compared with several years ago, because of its higher exposure to external debt and elevated government financing needs of more than 30% of GDP annually (partly driven by its large proportion of short-term debt). Egypt's fiscal challenges are not unrelated to its recent external performance. The lingering impact of the pandemic on tourism, remittances, and global trade is also weighing on Egypt's key sources of foreign currency. We estimate that Egypt's total public and private external debt (based on residency) increased to nearly 220% of current account receipts (CARs) in fiscal 2021 (ending June 30), from 176% in fiscal 2020 and 110% in fiscal 2016, mainly on the back of higher portfolio inflows and lower CARs.

Chart 2

How vulnerable is Egypt to sharp capital outflows compared with other emerging markets?

Egypt has faced periods of volatile capital markets before. If, over the next 12 months, U.S. interest rates start to rise more sharply or sooner than expected, we would likely see nonresidents withdraw funds from Egyptian government securities as real returns become less attractive than "risk-free" assets such as U.S. treasury bills--absent an increase in interest rates in Egypt. Early in the pandemic, the country saw outflows of $19 billion. This followed the $10 billion in outflows during April-September 2018 amid monetary tightening in the U.S. and risk-off sentiment toward emerging markets. Between March and May last year, the Central Bank of Egypt (CBE) deployed $7 billion-$8 billion in foreign reserves to absorb the effect of outflows on the exchange rate.

Compared with some other emerging markets, however, we think Egypt may fare somewhat better in the event of U.S. interest rate hikes, mainly due to high RIRs (see chart 3). These have supported high returns for investors, foreign reserve accumulation for the CBE, and a modestly appreciating Egyptian pound to the U.S. dollar. The latter has been a big draw for foreign investors in local currency debt, as well as a trend that benefits Egypt's debt-to-GDP ratio by lowering the local currency value of foreign currency debt. However, the CBE now has lower foreign reserve coverage of short-term external debt and the exchange rate would take a larger hit following outflows, in our view. Therefore, we will likely see increasing pressure on the CBE to maintain high RIRs to limit potential outflows.

Relatively robust medium-term growth prospects and stronger policy stability and credibility compared to similarly rated peers have also been a draw for some investors. That said, medium-term challenges such as high public debt stock, social pressures, and the structure of the political economy have limited some investors to buying shorter term debt instruments.

Chart 3

What will help cushion Egypt against a sharp and sudden reversal in investor sentiment?

We think Egypt has sufficient buffers to guard against market pressures. Most importantly, it has maintained sizable foreign exchange reserves of about $41 billion as of end-July, albeit lower than the $45 billion at the onset of the pandemic. We see external liquidity as adequate, with reserves covering slightly more than five months of current account payments in fiscal 2021 and close to 180% of short-term external debt. The CBE had other foreign currency assets of around $7 billion deposited in banks as of end-July, which are not included in official reserves.

The government has also sought to diversify its investor base and increase the average maturity of public debt. Egypt issued a bond in Euros and a green bond in 2020, and recently passed legislation to allow the issuance of sovereign sukuk. Egypt's inclusion in the Financial Times Russell Bond Index and JP Morgan's Emerging Markets Bonds Index (expected by end-2021) should help reduce volatility in portfolio flows by shifting some investment to passive management, and perhaps generate lower yields.

In addition, as a backstop, we expect that domestic banks will be willing and able to absorb further government issuance. The domestic banking sector remains very liquid, with high deposit growth off a low base of financial inclusion. That said, banks already have high sovereign exposure of close to 50% of total assets, raising the risk of crowding out the private sector and a sovereign-bank doom loop.

Will high RIRs continue to constrain fiscal progress?

While Egypt's high RIRs have enabled it to attract nonresident inflows, they have come at a significant fiscal cost. Egypt's overriding credit vulnerabilities are its weak public finances and high debt servicing costs, even though the government has achieved notable progress in its fiscal metrics. Egypt's general government primary budgetary position has undergone a consolidation of more than 8 percentage points (ppts) of GDP over the last eight years to reach a surplus of 2.3% in fiscal 2020. Indeed, despite the global health crisis, last year Egypt posted its highest general government primary surplus in over a decade. Yet, it continues to spend more on interest as a percentage of its GDP than any other rated sovereign--an estimated 9.4% this year, up from 8.3% five years ago. Interest costs made up about 45% of government revenue on average over the last five years (lower only than Sri Lanka, see chart 4). We expect this ratio will peak at 49% over 2020-2021 due to the pandemic's effect on revenue.

Chart 4

Egypt is more exposed to the effects of interest rate hikes given its high debt rollover needs. To better understand the sensitivity of public finances to potential rate hikes, we ran stress scenarios that measured the first-round effects of a rapid rise in various governments' borrowing costs on budgetary deficits (see "Take A Hike: Which Sovereigns Are Best And Worst Placed To Handle A Rise In Interest Rates," published on May 24, 2021). The four emerging-market sovereigns most vulnerable to a 300 bps rise in refinancing costs would be Egypt (where interest expenditure would rise by 1.2 ppts of GDP over the first year), South Africa (1.3 ppts), and Ghana and Kenya (both 0.9 ppts).

Other than its substantial central government debt stock, at an estimated 91% of GDP, Egypt's interest burden reflects its policy decision to maintain some of the highest RIRs among emerging markets. It also reflects the 18 ppt decline in Egyptian inflation since 2017, as inflation has come down faster than the policy rate. Since the onset of the pandemic, the CBE has cut key policy rates by 400 basis points (bps). So far this year it has chosen to pause this monetary easing. The CBE had hiked interest rates by 700 bps to near 20% when the country liberalized the exchange rate in 2016.

How can Egypt reduce its interest burden?

Since 2015, only five emerging market sovereigns--Barbados, Brazil, Hungary, Lebanon, and Ukraine--have managed to lower their interest expenditure by more than 1 ppt of GDP. Of these five, all except Brazil and Hungary achieved this by defaulting on their financial obligations. What differentiates Brazil and Hungary from the others? Several things, but fundamentally both countries have been operating recurrent surpluses on the basic balance of their balance of payments (the current account position plus net FDI). Hungary has maintained a balance or surplus in its current account position, while Brazil has entirely covered its deficits through FDI and strengthened its net external asset position. Brazil and Hungary have deeper domestic capital markets compared to the others, including Egypt; and, unlike Egypt, their financial systems are essentially devoid of any dollarization.

These lessons can partially apply to Egypt. We believe that a potential path for Egypt to lower its interest bill, while maintaining capital inflows, is to increase investor confidence in its economic model such that investors cut the risk premium they require on Egypt's government debt to levels more in line with peers such as Ukraine (which pays 3% of GDP in interest per year), South Africa (5%), or Brazil (5%). Lower average yields will likely be tied to achieving higher primary surpluses and economic growth, alongside improved external performance.

We expect additional fiscal gains could come from cuts to subsidies and broadening the tax base. Egypt's tax revenue base contributes only about 13% of GDP, reflecting a large informal sector. The government's efforts to broaden the tax base are ongoing but some measures were postponed due to the pandemic. The sociopolitical environment in Egypt remains fragile. Sporadic small-scale protests reflect social discontent in more vulnerable and younger sections of the population and could soften or delay potential fiscal reforms.

Egypt's medium-term economic growth prospects are relatively strong, and we expect GDP will average 5.3% in the fiscal years 2022 through 2024. However, public investment in infrastructure and other projects will drive much of this growth, contributing to fiscal and external deficits. More sustainable economic growth would come from the private sector's deeper engagement, which would be driven by structural reforms to improve competitiveness, governance, and the business operating environment.

Egypt's main external weaknesses stem from a low goods and services export base (at 13% of GDP in 2020, low exports make Egypt a relatively closed economy) and limited FDI into non-oil sectors. Net FDI inflows made up only about 2% of GDP in fiscal 2020. Given the country's level of development, we think it will continue to run a current account deficit as investment needs outpace its ability to generate domestic savings. However, keeping current deficits low will require much stronger growth in non-oil exports. Regarding funding these deficits, a shift in the composition of external financing away from debt and toward equity would support the exchange rate and allow the CBE to gradually cut RIRs further. Attracting more FDI would therefore result in a structural improvement in Egypt's economic growth model and fiscal position. Some of the issues for Egypt to address include the structure of the political economy, non-tariff trade barriers, and labor skills.

Related Research

• Emerging Markets Monthly Highlights: Delta Variant Causes The Summer To End On A Bleak Note, Aug. 12, 2021
• Midyear 2021 EMEA Emerging Market Sovereign Rating Trends Published, June 29, 2021
• Global Sovereign Rating Trends Midyear 2021: Recovery Will Be Uneven As Pandemic Risks Linger, June 29, 2021
• Credit Conditions North America Q3 2021, June 29, 2021
• Take A Hike: Which Sovereigns Are Best And Worst Placed To Handle A Rise In Interest Rates, May 24, 2021
• Research Update: Egypt 'B/B' Ratings Affirmed; Outlook Stable, May 7, 2021
• Banking Industry Country Risk Assessment: Egypt, Aug. 6, 2020