EGX correction may be a function of crowded out private sector borrowing, portfolio flow contraction

Though still up by over 40 percent YTD, Egypt’s benchmark equity index looks ripe for a near-term correction—a thesis we’ve put forth in recent weeks primarily on the back of the country’s wobbly and inadequate external financing state which we estimate should continue to strain borrowing costs, adding stress to the country’s terms of trade while  further crowding out private borrowers before it is resolved.  Adding to our concern are possible negative feedback loops emanating from the country’s financial sector and its repercussions on growth and fiscal performance.  A newly released working paper from the IMF[i], for instance, details “significant links between emerging market banks’ asset quality, credit and macroeconomic aggregates” while specifically pinpointing a reversal in [gross rather than net] bank related and foreign portfolio and bank flows [and not FDI] as the most statistically relevant (i.e. highest R-squared correlation) independent variable considered upon which asset quality (NPL/total loans) depends.  Ensuing growth contraction, weaker terms of trade and depreciating nominal exchange rates ultimately can negatively impact balance of payments (as well as possibly the feedback channel on investment, per the authors, given “new orders for capital equipment [would be] more expensive in an environment of deteriorating private sector balance sheets”).

The IMF’s findings echo a rather ominous assessment of the Egyptian bank sector from Moody’s last November wherein analysts noted in the midst of various downgrades that “although data published by the Central Bank of Egypt (CBE) points to lower non-performing loans for the system as of June 2011 . . . these figures benefit from the CBE’s directive allowing different NPL classification rules for retail and tourism loans for three and six months, respectively, after the January 2011 revolution . . . [and we] expect that the full extent of asset-quality issues will begin to emerge in the next few quarters…”  To wit Commercial International Bank (CIB), Egypt’s largest private creditor by assets (third overall) and one of five institutions whose local and foreign-currency deposit ratings were slashed last fall, disclosed in its recent full-year 2011 earnings report that while its NPL ratio stood at 2.8 percent (up slightly from 2.7 in 2010 but in line with historical averages and well under the GCC mean since Egyptian bank loan books are underexposed to the riskier retail sector in comparison to GCC peers) the absolute number rose by over 20 percent y/y.  Taken in tandem with the fact that foreign currency deposits across Egypt rose by 14 percent (an implicit red flag on future asset growth given said deposits must be channeled to foreign currency loans per law) while provisions leapt from LE6mn to 321mn over that same period and one may reason that NPL ratios could indeed be under some strain in future quarters given that net capital flows (as discussed last week) slackened considerably since last July (and are estimated to reach nearly USD6bn FY11/12) while the aforementioned dollar deposit figure grew—suggesting a similar trend for gross flows.  Moreover, per the IMF’s capex hypothesis, investment has been a detracting headwind on GDP since early 2011 as real GDP, which averaged ~4 percent annually in the years pre-revolt now struggles to remain above flat.

Note: Where might the EGX be headed?  Simple Fibonacci analysis would indicate that because the index failed to retrace even past its .5 retracement (vis a vis the three-year, 2010 high versus the December 2011 low) a broader, secular downtrend remains in tact.  Moreover in the short term a weekly close <4300 would indicate that a lower-low from December is likely impending.  We expect, however, that a 10 percent correction from today’s levels (~5080), particularly if combined with positive macro and/or geopolitical developments will be well received by investors and offer an impetus for strategic longs to gain traction). 

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[i]  De Bock, Reinout and Demyanets, Alexander.  Bank Asset Quality in Emerging Markets: Determinants and Spillovers.  IMF WP/12/71.

This piece as well as past Maghreb commentaries (as well as weekly sub-Saharan Africa analysis) can be found at: www.alterioresearch.com

Technically weak currencies may keep certain SSA central banks hawkish

From Alterio’s SSA report last week:

Countering relative disinflationary trends across SSA are diverging currency dynamics which can be swayed by both fundamental and technical reasons.  The Central Bank of Kenya’s somewhat surprising decision this week to keep its policy rate unchanged at 18 percent, for instance, is otherwise shilling supportive in both the near and medium-term as it comes despite higher-than-anticipated declines in both headline CPI (16.7 percent y/y in February from an 18.6 annual average over the preceding two months) as well as private sector credit growth (28% y/y in January versus 30.9% in December 2011) and against a backdrop of lower food inflation and impending base effects which should further reduce price pressures despite hitherto sticky core inflation (ex food and fuel) that detracts from the country’s balance of payments.  Technically the shilling has returned to levels not realized since last April at which point it began a fairly hasty plummet of over 20 percent against the dollar (characterized by a nasty feedback loop whereby negative real rates on short term [91/182-day] debt—which ultimately rose over seven-fold over the course of just a few months—initiated ever strident dollar demand as the central bank furiously tried to maintain its import cover ratio) while finally peaking in October.  Given our subdued outlook for inflation as well as the central bank’s hitherto ‘ahead of the curve’ hawkishness over the past year (+1200bp overall since January 2011) other things being equal (they never are) present levels (i.e. 82-84 consolidation) should support a USD/KES bottom and ultimately provide an impetus to the upside past 83.6 and through the 84 level.  That said even if the shilling ultimately retraces some of its near-term rally, macro conditions are such that 2011’s volatility can be comfortably set aside for the appreciable future, a plus for both public and private equity risk sentiment.

That said, though credit growth has subsided Kenya’s MPC remains unsatisfied, we feel, by demand-related pressures on both imports and consumer goods.  As a percentage of output Kenya’s private sector lending still outpaces M2 money supply, a relationship authorities would prefer to invert.  Therefore KES weakness may also be dependent on the pace of further private sector deleveraging.  Looking to Nigeria, on the other hand, one may find a potential USD/NGN bottoming that could signal perceived transitory inflation dynamics are extensively capped to the downside as well given an ongoing secular trend of dollar demand for imports continuously exceeding supply.  Fundamentally the currency has deteriorated for over a year as dollar demand for imports generally exceeded supply while last fall the central bank, failing to meet demand at the official market, lowered the midpoint of its exchange-rate band to 155/dollar from 150.  Concurrently, however, from a technical level the pair also looks problematic; indeed a glance at the weekly chart since Q42010 shows both strong support and resistance at 155, while recent hammer patterns indicate that a move back towards 160 is increasingly likely.

Maghreb: Discretion better part of Valor

Last week’s Alterio report initiated Maghreb as well as SSA-focused analysis:

Our initial report on Mashrek Maghreb macro conditions comes at an increasingly sensitive time for the region’s economies as roughly one year following a seismic ‘Arab Spring’ lead shift within the culture’s broader civic paradigm the need for political and economic synergy remains as critical as ever to achieving lasting, viable stability and growth given a stark dichotomy between the need to address high unemployment, social inequality, tax reform and subsidies versus the need to maintain fiscal discipline as well as secure financing against a dim backdrop of ever-deteriorating EU demand (EU imports of Moroccan goods grew 7.8 percent in 2011, for instance, down from 19.8 percent growth in 2010), largely uncompetitive export baskets and food/fuel dominated (i.e. price taking) import ones.  As we touch upon in this initial commentary, however, there exists within the region—and moreover the broader Middle East at large—a convoluted catch-22 whereby, as described in a recent research note (see citation) the “need for regional economic linkages across the Arab world” sits in direct contrast with “political incentives of Arab elites [that] are not fully aligned with opening regional markets” and by extension helps nurture a fragmented economic model which seems to particularly effect [in terms of total share of merchandise exports as % of GDP] resource-poor, labor abundant countries such as Morocco, Tunisia and Egypt.[i]

The resulting chill on private investment further exacerbates the aforementioned EU macro squeeze and places a greater premium on [and cost to] external financing.  The latter element refers to an ongoing [region wide] balance of payments dilemma which will demand continued attention from investors in the coming year given trending declines since 2009 in respective capital accounts (admittedly most acute in Egypt where FDI fell by over 50 percent in 2011 to just over $USD2bn and portfolio flows saw a similarly marked collapse) and weakening trade balances intensified by subsidized, sticky domestic demand (most notably the oil import bill which at ~9 and 7 percent  of GDP in Morocco and Tunisia, respectively, is uncomfortably high), a strong correlation to Eurozone growth (more than 88 and 80 percent of Moroccan and Tunisian exports, respectively, go to the EU) and in Egypt’s case a projected gradual depreciation of the EGP (though we do expect the CBE to exert a generally tightening monetary bias over the course of the year while also promoting repatriation of foreign assets and generally tightening liquidity in the domestic banking system to retain deposits) given a dangerously low import cover that has fallen from 6.2 months to 3.7 months since last summer and threatens to further chill capital flows given omnipresent domestic political uncertainty, highlighted most recently by the High Administrative Court’s declaration that the voting system used to elect a new parliament last winter was unconstitutional—a decision that in turn could derail not only a new constitution, but May’s planned elections and an ultimate transition from military-to-civilian rule by year’s end (not to mention potentially jeopardize roughly $4.2bn aggregate in aid requested from the IMF and World Bank)

To this end Egypt’s funding predicament gives us the most pause given the ramifications on the state’s cost of borrowing (evidenced by recent 3-year debt auction yield widening), even though [considering in part how important its export market is for a number of countries] the country scores comparatively higher per both our Contagion Score and Original Sin metrics and also saw a healthy rise in both remittances and Suez Canal receipts during the latest quarterly report which is reserve positive.  In light of said ambiguity we plan to continue to monitor official donor’s medium-and long-term lending figures as a proxy to gauge any secular turnaround in creditor sentiment.  We also remain cautious about equity valuations at current levels; despite a near 46 percent rebound in 2012, we fear the state’s crowding out of private sector borrowing and the ramifications on growth leave future cash flows vulnerable.

[i]  “The economics of the Arab Spring”, OxCarre Research Paper 79, Department of Economics, Oxford University, December 2011.