Foreign investment in Egyptian treasury bills has eclipsed US$17 billion in less than a year, a fact that the International Monetary Fund has held up as evidence that investor confidence in the country is improving.
Investment in t-bills, or foreign inflows into short term debt instruments and/or short term investments in the stock market are often labelled “hot money,” because the high, short-term interest rates are often volatile and this commonly occurs in countries that have instituted an economic liberalization program, which Egypt did when it reached an agreement with the IMF in November 2016 for a three-year, $12-billion financing program, and subsequently floated its currency on the foreign exchange market and hiked interest rates. In fact, $16 billion, the bulk of Egypt’s 2016/17 investment portfolio, which consists of foreign investments in t-bills, the stock exchange and international bonds, came after the November agreement.
However, how to read the significant influx of hot money into Egypt has grown into one of the core economic debates in the country, especially within the business community. There is an infamous history of the effects of hot money, including Egypt’s not-so-distant experience in 2011. A change in the factors that first attracted foreign investors to the short-term, high-yield debt obligations could prompt them to stop returning to the securities market, withdraw from Egypt’s economy, and wait for their securities to reach maturity, which usually takes less than a year. If Egypt had not diversified its sources of foreign currency, such a withdrawal could hurt the banking sector or deplete foreign currency reserves, moves that would weaken the Egyptian pound further in a country that depends on imports for at least half of its food consumption.
Foreign investors spot an opportunity post IMF deal
After Egypt and the IMF’s agreement to institute an economic restructuring program in November 2016, there was an influx of foreign investment in the country.
Egypt has raised interest rates by a total of 700 basis points since the loan agreement, as a self-proclaimed, if contested, effort to curb the surge in inflation caused by cutting fuel subsidies and the introduction of new taxes, such as the value-added tax. But the hike in interest rates had another consequence: attracting foreign investment in short-term government debt securities.
The associated influx of foreign currency has had a positive impact on the exchange rate and the balance of payments. However, any possible rapid fall in investment in t-bills without a concurrent rise in other sources of foreign currency would have a negative impact on the balance of payments and the exchange rate.
In FY 2016/17, the balance of payments posted a surplus, driven mainly by net investment in t-bills — which hit $10 billion — and international bonds, whereas net foreign investment in the Egyptian Exchange was a mere $497.3 million.
The economists Mada Masr spoke to classify the investment Egypt has seen since November as hot money — so named because it moves quickly between financial markets and provides the highest short-term interest rates available for foreign investors. Investors are granted a certain degree of security as well, given that the Central Bank of Egypt ensures foreign investors’ rights to repatriate their foreign currency after making profits.
“Hot money often comes when a country has higher interest rates than other countries, which is the case in Egypt now, in comparison to Europe and the US,” Noaman Khaled, an economist at the Cairo-based CI Asset Management, tells Mada Masr.
Hot money is normally facilitated through carry trade, a process where an investor borrows money from a low interest rate economy and then reinvests the money in a high interest rate economy to profit from the difference, Khaled adds.
While there may be a confluence of factors that contribute to the emergence of hot money on the state of the Egyptian economy, there are at least two primary structural features: currency devaluation and the discrepancy between long-term and short-term risk.
Investment in t-bills often targets the lowest value for a currency, according to Khaled, something he says happened in Egypt, as the influx came when the pound almost hit LE19 to US$1, and investment bankers were projecting it would strengthen to LE16 to US$1. Investors would be able to buy debt obligations cheaply and receive the maturity yield payment at a more favorable rate.
Another reason why foreign investors were attracted to Egyptian government securities is the relative low risk in the economy, especially after the IMF agreement, according to economist Mohamed Sultan.
“The idea of risk in the Egyptian financial market for most investors is not at a critical level yet, especially with the IMF loan’s backing,” says Sultan. “Egypt’s main economic problem now is the level of inflation rates, which poses no burden to foreign investors who deal in foreign currency.”
As for risks associated with the hike in government debt, Sultan argues that the “Egyptian domestic debt to GDP ratio remains smaller than that in countries such as Greece and Spain, while, at the same time, Egypt offers higher interest rates.” However, there is an increase in solvency risks in Egypt in the long term, which explains why foreign investment is targeting mostly short-term government securities, according to Sultan.
Controversy in the Business Conference
Despite the economic risks that come with a reliance on hot money as the main source of foreign currency, the recently appointed head of the Egyptian Stock Exchange, Mohamed Farid Salah, stirred controversy at the Euromoney conference in September, when he defended the positive role of hot money.
“Hot money has a role in the economy. It is money that has been — I would say — funding some purchases in the stock market; the money that has been buying the t-bills and t-bonds issued by the government. Eventually this will reduce the burden on the financial sector to pick up the budget deficit,” says Salah.
In the past few years, Egyptian banks have been the main financiers of the state budget deficit, which some observers have said crowds out the private sector for sources of finance. This can be seen in how much the government owes banks in relation to their total deposits. As of the end of June 2017, the government debt to banks was LE1.5 trillion, which constitutes half of the total deposits in banks, according to the Central Bank of Egypt’s monthly bulletin.
Salah’s comment was debated over the course of the conference, with a particular focus on whether hot money can become “sticky” — meaning it would turn into longer term investments — and whether Egypt will be able to develop more sustainable sources of foreign currency before investment in t-bills subsides, whether rapidly or gradually.
Hazem Badran, the managing director of one of Egypt’s leading investment banks CI Capital, also struck a positive note on hot money, seeing it as a type of seismograph for investor confidence.
“I am trying to look at the good side, that investors are testing the system. They are testing the FX market. They are testing repatriation. I think it is working,” says Badran.
However, this has raised two main critical responses from international private equity investors, though at different levels. The investors stressed that the “positive role” of hot money ultimately depends on the exchange rate and the maintenance of high interest rates, in addition to whether hot money phases out gradually or suddenly.
“I think another point of interest is where the exchange rate sits today. We are of the view that the Egyptian pound is probably one of the most attractive currencies across the spectrum at the moment. It is arguably oversold and it is underpriced. That is why we had this great influx of money into carry trade,” says Sherif al-Khouly, Actis’ North Africa and the Middle East regional manager.
Ahmed Badreldin, one of the heads of the private equity firm Abraaj Capital, echoes Khouly’s sentiment, warning of the impact of the anticipated cut in interest rates. “I guess the biggest fear concerning the foreign currency market is if the downturn in carry trade happens too quickly, as we just heard that interest rates might come down 400 to 600 basis points over the next year.”
Badreldin and Khouly’s concerns are tied to the appreciation in the value of pound in the foreign exchange market, as well as cuts in interest rates that are expected in 2018, in addition to the IMF’s projections for net portfolio investment in Egypt. In the IMF’s first review of the restructuring program, which was made available to the public in October, net portfolio investment peaked in the fiscal year that ended in June 2017 at $12 billion, and was projected to fall to $5 billion each year thereafter. In the meantime, projections for long-term foreign direct investment was cut to $9.4 billion for FY 2017/18, down from the $10.4 billion estimated at the beginning of the program.
Slowly returning to a pre-2011 scenario
Whether hot money is a momentary upswing or a real source of financial strength for a more robust economy ultimately depends on how it is used, and this use has only been recently hinted at in government statements.
Khaled points to two scenarios that would have drastically different effects in answering this question. In the first, if the Central Bank were to offer foreign currency at the interbank, or use it to build up foreign currency reserves, Egypt’s vulnerability to external shock would increase. In the second, the Central Bank could take an inefficient path and keep the money in a separate bank account, thereby mitigating solvency risks in the long term.
“Some portfolio investments that were absorbed by the CBE through the repatriation mechanism did not flow into the FX market,” according to the IMF report on the first review of Egypt’s economic restructuring program. However, it remains unclear whether this remained the case after the review that was held in June or not, especially given that some statements by Central Bank officials hinted at the possibility that the money was offered at the interbank.
This can be seen in a report by the state-owned Al-Ahram newspaper on October 15, which cites deputy CBE governor Rami Abul Naga as saying that foreign currency circulating in Egyptian banks increased by $52 billion since the flotation of the pound, including portfolio investments and people’s exchange of US dollars to Egyptian pounds.
If the Central Bank did pour hot money into the banking system, it would raise concerns over the extent of exposure to external vulnerabilities, exposure that came to fruition in the aftermath of the 2011 revolution, when political turmoil and sporadic violence deterred foreign investors from returning to the Egyptian debt market, contributing eventually to a plunge in reserves to near dangerous levels. And the memory of the events of 2011 persisted throughout the debate in the Euromoney conference and interviews with economists Sultan and Khaled, as they spoke about the current t-bill surge.
The real threat when it comes to foreign investments in t-bills is when new investors stop coming and the Central Bank has to repatriate matured investments with its own resources, says Sultan.
In 2011, the Central Bank offered investments in t-bills at the interbank, according to Khaled, who says that these investments were repatriated using reserves, because the banks could provide the needed sum at once. Foreign currency reserves plunged from $36 billion to around $17 billion in the first few months after the uprising erupted.
“Reserves plummeted because of portfolio investment, including investments in t-bills and the stock exchange,” Sultan explains.
“Ultimately, it is a question of balancing the balance of payments,” says Khaled. “If other sources of foreign currency — whether from tourism or foreign direct investments — did not improve enough to replace portfolio investments, then a fall in foreign investments in t-bills would have a negative impact on the exchange rate and ultimately lead to another wave of inflation.”
The Egyptian balance of payments for the Fiscal Year 2016/17 shows that an improvement in FDI and tourism — both of which fell drastically following 2011 — remains limited. Tourism revenues were recorded at $4.4 billion, compared to $11.6 billion in FY 2009/2010, while FDI reached $7.9 billion, a figure that owes half its value to the petroleum sector. And Khaled does not believe that investments in the petroleum sector are an indicator of foreign investors’ tendency to enter the Egyptian market, as they are not linked to the political and economic context.
For Sultan, the main factor that could lead to a reprise of the 2011 scenario is political risk. “The implications would not just be that of the size of the event, but also ones position at the time of the event,” says Sultan. “Egypt is currently in a worse position than that of 2010, in terms of the size of debt, growth, unemployment and inflation.”
In laying out the main risks that Egypt faces in its report on the first review, the IMF stated that the “risks to the program arise from still fragile stability, the difficult reform agenda, and possible deterioration of security conditions […] opposition by vested interests, corruption, and fear of escalating social tensions could derail structural reforms and hurt medium-term growth prospects.”