Discounting the Finances of Egypt

Exciting television images aside, financial analysts have a very sober way of looking at countries’ futures.

Sadly, in Egypt’s case, they see nothing but heavy capital outflows, rapidly falling foreign exchange reserves and, adding insult to injury, an increasing short position on the country’s currency, the Egyptian pound. Add to this sharply rising local government funding costs, and it’s clear that markets are nervous about Egypt.

The odds are that Egypt will turn to the International Monetary Fund for help. The government essentially has no alternative in the current environment. But even if it gets to announce a $3 billion (or so) program with the IMF in the coming month, how much help will that really provide to turn things around?

The bad news is that Egypt came into its political crisis — for that is what the revolution has morphed into — with one of the highest public debt and deficit positions in the emerging market world. Gross government debt, at 75% of GDP, now stands at levels more commonly seen in rich industrialized countries with large social welfare systems. Its public-sector borrowing requirement is 8% of GDP.

Both of these figures increased considerably last year as tax revenue collapsed, pushing the deficit back above 10% of GDP even in the face of sizable expenditure shortfalls.

Worst of all, though, is that Egypt has now completely lost its “natural” debt sustainability cover, as rapid nominal growth has vanished. For much of the past decade, the Egyptian government could live more or less comfortably with high public deficits. How so? Because its cost of funding was around 9% per annum, while the overall economy was growing at 14% or more in nominal terms.

Suddenly, that’s not true any more. The real economy is barely growing, if it is growing at all. The cost of domestic funding has jumped to nearly 16% per annum in 2012, a result of a local buyers’ strike on the new government debt being issued.

The first implication is that Egypt is now facing a rising debt spiral, which hardly instills confidence in wooing investors back to the market (whether at home or from abroad) in order to push interest rates back down again.

What the government is doing now — using the local banking system and, increasingly, the central bank to fund new debt — is not really a sustainable option either. Not only is available credit to business and households squeezed, but it increases the likelihood of higher inflation over the medium term. That, of course, puts increased pressure on the currency.

A very difficult future

There is one option that could fundamentally alter the budget situation: decisive and aggressive cuts to subsidies, social payments and other spending, which are sizable in Egypt’s case and, given its finances, unsustainable. But in today’s environment of near-zero growth and extremely fragile political institutions, this simply won’t happen — regardless of what might be penciled into an IMF funding program.

With or without help from the IMF, Egypt faces a very difficult future.

Compare this with the fate of the Eastern European economies — the Baltics and Balkans, Ukraine and the former Yugoslav states — in the 2008-09 crisis. They entered the crisis with overextended debt positions domestically and large external deficits. Thus, when the capital inflows stopped, everything collapsed in a hurry. New bank lending ceased, bubbles burst and real GDP dropped by anywhere from 10% to 20% in the first year alone.

At the same time, import demand also collapsed, while these countries’ external positions improved dramatically. Many of them are now running trade and current account surpluses. That gives them protection on the currency front and potential room for renewed upside once the deleveraging process has run its course.

Egypt’s case is different, however. It didn’t come into the Arab Spring with either a big domestic credit bubble or double-digit external funding deficits. In a sense, that’s a good thing — but it also means that Egypt cannot expect to get any help whatsoever from the external accounts, especially given the complete lack of global export growth since the beginning of last year.

So even if Egypt’s government receives a few billion dollars of assistance this year from the IMF, unless it can generate large, sustainable capital inflows — almost certainly an pipe dream in today’s political environment — it will still be left hanging by its fingernails. And it will still face the near-inevitability of significant further depreciation down the road.

None of that augurs well for Egypt’s revolution to transition to a constructive path any time soon. Chances are good, in fact, that the truly negative consequences of the country’s weak economic and financial situation are yet to come.

It seems as if true change is extremely hard to come by in the Middle East. From Iraq to Egypt, many different models have been tried, but the road to meaningful improvement for the population at large has yet to be discovered.