Abu Dhabi and IMF backing gives Egypt a shot at economic turnaround

With a little help from its friends, Egypt appears to have turned a corner in its economic crisis. The unprecedented $35bn investment in the country’s Ras al-Hekma project by Abu Dhabi has, in a stroke, eradicated concerns over dwindling foreign currency reserves and assuaged fears of a sovereign default.

The Emirati funds, the first tranche of which have already been received, enabled the Central Bank of Egypt last Wednesday to hike interest rates by an unprecedented 600 basis points in a decisive move against the country’s sky-high inflation. It also allowed the country’s currency to weaken against the dollar by 40 per cent — the deepest devaluation of the past 10 years — a long-called-for move to restore foreign investor confidence in the country.

The devaluation was followed the same day by a fresh agreement with the IMF for a higher-than-expected $8bn loan, in return for fresh commitments from the country to contain fiscal excess as well as tying monetary policy and the foreign exchange regime to an inflation-targeting regime.

“The likelihood of those pledges being met has been boosted by the upscaling of Egypt’s IMF programme from $3bn to $8bn — a sum that not only incentivises policy discipline, but, when combined with the [Ras al-Hekma deal], further enhances Egypt’s capacity to manage change,” says Simon Williams, chief economist for central and eastern Europe, the Middle East and Africa at HSBC.

The Ras al-Hekma and IMF deals have had an instant impact on market sentiment surrounding Egypt. Having lowered its outlook to “negative” from “stable” just two months ago, Moody’s Ratings on March 7raised its outlook to “positive” in recognition of a “marked change in economic policy … that, if maintained, will help Egypt maintain an upsized IMF program, reduce the risk of a renewed build-up of external imbalances and strengthen the economy’s shock resilience over time”.

Yet in spite of positive early moves, the country’s long-term commitment to reforms stipulated by the IMF, particularly a commitment to a free-floating currency and reduced spending on bloated megaprojects, is set to remain a concern unless further actions are swiftly taken.

“There’s a real risk that the leadership in Egypt will see these deals as confirmation the country is too big to fail and will continue to receive bailouts,” says Timothy Kaldas, deputy director of the Tahrir Institute for Middle East Policy.

“Unless big changes are made to the way the economy has been run over the past 10 years, the government could find itself back in a state of crisis in the not too distant future.”

Economic storms

Egypt’s economy has suffered more than its fair share of external shocks over the past four years; the Covid-19 pandemic saw tourism revenue, which represented 8.8 per cent of gross domestic product in 2019, drop by 55 per cent in 2020. Two years later, the country, the most populous in the Middle East and north Africa region, was hit by a surge in grain prices following Russia’s invasion of Ukraine.

Most recently, revenues from tourism and the Suez Canal have halved since the start of the year due to attacks on shipping by Yemen’s Houthis in the Red Sea and the war in neighbouring Gaza.

Yet much of the country’s economic pain has been self-inflicted; an over-reliance on hot money inflows from portfolio investors — lured by attractively priced short-term debt — was brutally exposed by rapid outflows in February 2022 following Russia’s invasion of Ukraine, prompting surging inflation that the CBE was ill-equipped to deal with.

Inflation hit a record high of 37.9 per cent in September, before easing back to 35.1 per cent in February, in spite of the bank raising interest rates from 8.25 per cent to 19.25 per cent in the 24 months to December 2023.

The foreign currency crisis of the past two years comes on top of long-standing structural issues in the country’s economy, which has largely relied on government spending — often on large projects of questionable value such as a New Administrative Capital and an expansion of the Suez Canal — and receipts from gas exports to maintain growth.

Particularly contentious has been the expanding role of the country’s military in all areas of economic life, which has stifled the development of the private sector and discouraged foreign investment. While the government has promised to reign in the army over the years, pledging last January to gradually withdraw the state from “non-strategic” sectors, progress has been slow on the ground thus far.

“[The government’s] policy framework leaves an irreconcilable gap between its declared goal of levelling the economic playing field with the private sector and the reality of the military’s economic role and business activities,” Yezid Sayigh, a senior fellow at the Malcolm H. Kerr Carnegie Middle East Center, noted last year.

A Gulf stream of dollars

Against the backdrop of negotiations for a fifth IMF loans package in 10 years earlier this year (Egypt is the fund’s second-largest debtor behind Argentina), the announcement on February 23 of Abu Dhabi’s investment in a new tourism and real estate development in Ras al-Hekma came as a miraculous bolt from the blue for Egypt’s finances.

Abu Dhabi sovereign wealth fund ADQ — which has invested $3.6bn in UAE assets since 2022 — is to plough a total of $35bn into the project to develop the 170 sq km coastal area, around 200km to the west of the country’s second city, Alexandria.

The first $15bn tranche, made last week, includes $5bn previously deposited by the UAE in the CBE, with a further $20bn — consisting of $6bn of UAE deposits in the CBE and $14bn of fresh funds — set to arrive in the next two months.

Egyptian Prime Minister Mostafa Madbouly anticipates that the project will attract more than $150bn of total foreign direct investment during its lifespan, with rumours growing of other similar projects in the works. Bloomberg reported on Friday that Egyptian and Saudi authorities are in talks over the development rights for another northern Red Sea coastal area known as Ras Gamila, citing people familiar with the matter.

The prospect of a large influx of foreign exchange provided instant balm to investor confidence at home and abroad; sovereign dollar bond spreads fell to their lowest level in nearly three years, while black market foreign currency rates — which had reached over E£70 to the dollar compared with the official rate E£30.9 — fell sharply in anticipation of a devaluation.

This duly appeared on March 6, triggering the IMF’s new $8bn loan package, together with the unlocking of two delayed tranches of funding worth $700mn from its previous arrangement with the fund.

The IMF on Wednesday praised the country for taking “decisive steps to move towards a credible flexible exchange rate regime”, noting that the country had also pledged additional reforms including “tightening of monetary and fiscal policies, and a slowdown in infrastructure spending to reduce inflation, and preserve debt sustainability, while fostering an environment that enables private sector activity”.

Yet while the devaluation and the higher-than-expected rise in interest rates drew praise from the fund, such positive words belie a wariness among officials about expectations for further meaningful reform. While the $8bn loan size comes in ahead of the earlier-mooted $3bn mark, it falls short of the rumoured double-figured package that was reportedly being sought by the government.

“The expansion of the IMF programme is a sign that the fund is now more comfortable with Egypt’s macro and funding outlook, but the fact that the total programme remains below $10bn signals that the IMF remains sceptical about the actual delivery on all key reform requirements,” says Gergely Ürmössy, an emerging market strategist with Société Générale.

In spite of the scepticism around the appetite for reform, a new deal is in both the IMF’s and Egypt’s longer-term interests.

“Egypt has been a poster child for the IMF over the years, particularly given its importance to the foreign policy of its largest donor, the US, even though it hasn’t fully complied with the conditions of any of the deals it has struck with the fund,” says James Swanston, a Middle East and north Africa economist at Capital Economics.

And while the influx of foreign currency from the Ras al-Hekma and other mooted investments on paper reduces the need for IMF assistance, the latter remains important for the country’s image among the overseas investors it is seeking to attract.

“The Ras al-Hekma deal provides comfort for existing bondholders, but not for would-be foreign investors,” says Hisham Ezz Al-Arab, non-executive chairman of Commercial International Bank, Egypt’s largest private lender.

“The IMF deal by contrast is a stamp of approval in the eyes of the rest of the world.”

To free, or not to free (float)

Thus far, the CBE move to weaken the pound has been enough to satisfy the initial demands from the IMF to strike an agreement. The fund on Wednesday welcomed the “decisive steps” by the authorities “to move toward a credible flexible exchange rate regime”, with agreement “that a flexible exchange rate regime would help Egypt manage external shocks and would support the authorities’ decision to move toward a full-fledged inflation-targeting regime over time.”

Swanston notes that communications from the CBE around interest rate rises and the float have been more transparent than usual, with the bank holding a press conference on Wednesday evening.

“The central bank is also acting fast to unwind foreign currency restrictions,” he says, noting that local banks had already been directed to lift limits on FX transactions on credit cards put in place in December.

Yet doubts are already emerging about the CBE’s commitment on Wednesday to “allow the exchange rate to be determined by market forces”.

After dropping from its supported rate of E£30.90 to the dollar on Wednesday, the pound has stabilised at around E£49.10 to the dollar at time of writing, with Ürmössy expressing scepticism that the bank “played no role” in maintaining the orderly function of the market on the day.

The CBE was approached for comment.

“The IMF board still has to vote on the loan; if there’s a perception in the coming weeks that the exchange rate has been re-pegged, it would be in the fund’s power to refuse to increase the size of the loan,” says Kaldas.

Keeping New Administrative Capital spending in check

While the reduced role of the state in the domestic economy is at best a medium-term proposition, fiscal discipline and the use of funds to steady government finances is seen as crucial in the coming months.

“The first priority needs to be a reduction in the budget deficit and the government’s overdraft with the central bank, in order to reduce public debt and servicing costs,” says Ezz Al-Arab.

“It’s only once such steps have been taken that you can start to think about major projects and other spending priorities.”

Past megaprojects, particularly the NAC, have burdened Egypt with heavy external debt, while negatively impacting both the fiscal and current account balances, notes the Institute of International Finance.

The IIF notes that large FDI promises were made around the NAC project, but that many of the pledges have never materialised, leaving the project to become a significant drag on the country’s finances.

In an ominous sign, the project’s CEO Khaled Abbas announced within hours of the new IMF deal that the second phase of the NAC would commence construction early next year at the cost of E£240bn ($4.9bn), according to the Sharq newspaper.

“We hope that Egypt has learned from these past mistakes and is able to take full advantage of this opportunity, while continuing with the IMF-backed structural reforms focused on macroeconomic stability, restoring reserve buffers, shifting towards a market-determined exchange rate, and enabling private-sector-led growth,” says the IIF.