Egypt Macro

September 29 2016

Reham ElDesoki
Reham.eldesoki@arqaamcapital.com
+002 010 11003724

Jaap Meijer, MBA, CFA

jaap.meijer@arqaamcapital.com
+97145071744

Deval balloon popping soon...

Dj vu but without the pitfalls pls
After months of preparation, the possibility of an EGP deval Avg. Official and Parallel Mkt FX Rates
is now looking like more of a reality around the IMF board 9.0 14

meeting that is scheduled to run from October 3-9. 8.8 13

We expect a hybrid new FX system, combining the traits of 8.6 12

a managed and free float to accommodate the challenges 8.4 11

EGP/USD

EGP/USD
8.2 10
facing the CBE.

8.0 9
Deval should be followed by 1-3% interest rate hike coupled
7.8 8
with the lifting of banking sector FX restrictions.
7.6 7
Past experience supports our views and highlights the 7.4 6
importance of taking bold steps, removing restrictions and

21-Dec-15
21-Oct-15
21-Aug-15

21-Aug-16
21-Apr-16
21-Nov-15

21-Jan-16
21-Sep-15

21-Feb-16

21-Sep-16
21-May-16

21-Jun-16
21-Jul-15

21-Jul-16
21-Mar-16
implementing confidence boosting measures. These factors
are key to the success of the devaluation and Egypt exiting Avg. Official Rate Avg Parallel Rate (RHS)

its state of malaise.

Source: Bloomberg, Arqaam Capital Research
We expect the CBE could implement an aggressive devaluation
soon, probably even in the coming days, to EGP 12/USD at least, 2003 devaluation
6.5
allowing minimal movements in the rate thereafter as it moves to a
free float. 6.0

A move to a free float will only be successful, in our view, if 5.5

EGP/USD

portfolio investors are granted lucrative returns on the EGP and

coordination with market players in the parallel market is achieved 5.0

to prevent an aggressive slide in the EGP. However, a higher FX rate

4.5
would heavily weigh on the budget as the government increases its
financing of basic products. 4.0
Jan 02

Jan 06
Nov 03

Jan 05

Jan 08
Nov 04

Apr 06

Apr 08
Apr 05
Sep 02

Sep 03

Feb 04
May 04

Sep 06

Sep 08
Jul 08
Mar 02
Jun 02

Jun 03

Jul 05

Jun 06

Jun 07
Mar 03

Mar 07
Dec 02

Dec 06

Dec 08
Aug 04

Oct 05

Oct 07
We believe the CBE could immediately increase interest rates by
1% to 3%, following the devaluation and not before, as evident Source: Bloomberg, Arqaam Capital Research

from the CBEs decision to hold interest rates in its September

meeting. A 1% increase in interest rates costs the budget around
EGP 18-20bn in additional financing the following fiscal year,
rendering the timing of a rate move very important. Mostly HDBK,
CIEB and COMI (after the B/S restucturing, reducing the duration of
its assets) should be well positioned. The removal of the FX overhang
will outweigh the fiscal aspects in the short term, in our view.

Lessons learnt from the previous float experience in 2003 proved

that a float scenario with no restrictions and confidence building
measures reaped better results for the economy, debt and equity
markets. So we had better look back, while moving forward. Almost Copyright 2016, Arqaam Capital Limited. All Rights Reserved.
all listed corporates did extremely well post the 2003 devaluation. See Important Notice.
 September 29 2016

The deval process

Days away from an We are finally very close to the long awaited devaluation of the EGP, the second
aggressive deval, to a such move in 2016.
hybrid system We expect the adoption of a hybrid FX exchange system that could take the EGP
to 12/USD or beyond, right around the IMF board meeting to approve Egypts
financing deal (before or after).
We expect an interest rate hike, between 1% and 3%, to further motivate
portfolio investors to invest in Egypt quickly, and a removal of the FX restrictions
in the banking sector.

We believe the success of this step would not be fully realized if the parallel market is not
absorbed, willingly, into the official system and coordination between the authorities and
different market players takes place.

The first move was a 14% devaluation on March 14, from EGP 7.78 to EGP 8.88/USD. Although
we considered it a move in the right direction, we do not think that succeeded in resolving the
FX crunch issue as it was not coupled with the injection of sufficient liquidity into the market or
lifting of all restrictions governing the FX market for corporates and individuals. In fact, the
result was a worsening of the situation by raising the cost of imports on the economy and
deepening of the confidence crisis for individuals and corporates, further fueling activity on the
parallel market.

The parallel market FX rate rose to EGP 10.96/USD in July from EGP 9.5/USD in March, after
the market deemed the devaluation insufficient and not market clearing in terms of FX
rd
availability. An interview with the Governor of the Central Bank of Egypt (CBE) on July 3
highlighted the need for a more flexible exchange rate system, as well as the cons of defending
the EGP in the past. This was coupled with investors expectations of an imminent devaluation
th
and resulted in an additional rise in the rate to EGP 12.75/USD up until September 26 . The
last push to EGP 13.0/USD followed since then after a televised speech by the President who
again alluded to a devaluation.

When?: We have been expecting a devaluation to occur soon, around the IMF Boards
approval of the financing deal with Egypt, given the importance of the devaluation in the
rd
structural reforms package and relief for the entire economy. The meetings start October 3
th
and end on the 9 with no chance of a board meeting taking place during that period. This
raises the probability of a board meeting and approval the following week. With the element
of surprise being an important factor, we have come to expect the unexpected.

How much?: We believe an aggressive devaluation is in order, to the range of EGP 11-
12/USD, at least, as the real exchange rate is not really relevant at this point, but rather the
perception of market participants of what is considered to be a market clearing rate. With the
sliding of the FX rate to EGP 13.0/USD on the parallel market over the past two days, an
aggressive devaluation is the only way to go now, in our view, to convince the massive FX
funds to shift from the parallel market to the official channels once again.

What will it be: We expect a hybrid between a managed float and a free float, based on the
funds available to the CBE, what the market will accept, and the overall cost to the economy.

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 2

Managed float curbs the
deval cost but burns
through precious FX
Estimated USD 7-9bn
needed to satisfy demand in
first month
Managed float risks
depletion of reserves before
market demand is
satisfied
Free float preserves NIR at a
potentially higher cost to
the economy
Egypt Macro
September 29 2016
A managed float scenario: would allow the CBE to control the range within which the EGP
moves, limiting the cost of the devaluation on the economy as Egypt is a net importer of
commodities and many other raw materials and equipment. This would require, however, that
the CBE injects large amounts of FX into the official market to satisfy corporate and household
demand, clear investors backlog and satisfy all the pent up demand that has been building up
for months, especially from the corporate sector. This amount would definitely exceed the USD
5-6bn that the CBE has managed to get pledges for in recent weeks, and would need extra
financing from the precariously low international reserves. There are pledges for USD 2bn from
China, USD 2bn from Saudi Arabia, USD 1bn has been received from the UAE and USD 1bn
from the World Bank. The Eurobond should yield USD 3-4bn, the IMF around USD 2.5bn and
another USD 1.5bn received from the World Bank and African Development Bank by year end.
We estimate the FX needed to satisfy the market in this first month could reach USD 7-9bn,
based on banking sector financing, basic staples financing and a rough estimate of the
magnitude of pent up demand. As the success of this scenario hinges on the satisfaction of
market demand for FX liquidity, especially with the March deval in mind, we expect that large
amounts of FX will ultimately be swallowed by the market as it tests the CBEs adherence to its
implicit pledge to satisfy demand, risking a depletion of international reserves.
An aggressive devaluation would signal to investors that the EGP is no longer overvalued and
the increased availability and clearance of the backlog would boost the investors, corporates
and household sectors confidence that this is the end of the line for the parallel market. This,
coupled with the removal of the USD 250,000 cap on corporate deposits in the banking sector,
would lure back the funds in the parallel market and in cupboards and safes back to the official
banking channels once more. Portfolio investors response would compound this effect as
investors inject funds to capitalize on the lucrative carry trade in the absence of the currency
risk. The parallel market would ultimately wither away and the FX overhang would be lifted,
while international reserves would be built up over time as FX flows rise. This is all, of course,
contingent on the CBE not running out of extra FX before the market is comfortable parting
with foreign currency savings and the portfolio investors make their grand entrance quickly
enough.
A free float scenario: would allow the CBE to preserve its precious FX and build international
reserves at a quicker pace (the CBE Governor had indicated a target of USD 25bn by end 2016),
when the transactions move to the banking sector from the parallel market and portfolio
investors return, following the float and removal of FX restrictions and repatriation delays. The
looming risk, however, would be that the FX rate stabilizes at a much higher level than the
current parallel market rate (EGP 13/USD), squeezing the governments budget to finance
basic goods while further stoking inflation.
We, therefore, believe that the upcoming devaluation will be a hybrid of both systems. The
CBE could devalue the EGP aggressively to at least EGP 12/USD, make a large FX injection in
the market, hike interest rates by 1-3%, remove the restriction on corporate USD deposits in
banks and wait for the inflows to come in. The CBE could then allow small movements in the
FX rate to signal a flexible system without leading people to wait for better rates later on.
Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 3

Success of a free float linked
to working with and
absorbing the parallel
market
Reviving the FX interbank
mkt is key to floats
success
Egypt Macro
September 29 2016
The success of this step, however, stipulates cooperation with the market players controlling
the parallel market to curb an acceleration of the EGP/USD slide and implementation of
creative measures to convince Egyptians transferring their remittances to do so through the
official system. Remittances are the second largest FX source for Egypt after exports, ahead of
tourism and foreign investments. In FY 2014/2015 remittances registered USD 19.2bn, tourism
USD 7.4bn, exports USD 22.0bn and foreign investments USD 5.9bn.
Once inflows have risen enough, we emphasize the importance of resuming the operations
of the FX interbank market to facilitate the replenishment of banks FX resources from within
the system and not from the CBE directly to reduce pressure on reserves.
Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 4
 September 29 2016

History supports our scenario

We note some blasts from the past supporting our view:

i) A one-step aggressive devaluation is more likely to unlock investments and FX flows from
the parallel to the official system. Data on FX sources (Exhibit 3) shows a rise in inflows
following the float and the implementation of banking sector reforms, starting late 2003, with
the new monetary policy framework, the FX interbank and ultimate absorption of the parallel
market into the official market. History has proven that including exchange bureaus in the
official system has created positive synergies.

ii) Restrictions have a negative impact on confidence: In spite of the float implemented in
February 2003, a foreign exchange surrender requirement was imposed in March 2003
stipulating that exporters, tourism companies and any companies earning in FX would
surrender 75% of their proceeds to banks. This decree was later canceled in December 2003
restoring the confidence that had been lost following implementation of this restriction.

iii) An aggressive interest rate hike occurred following the float, raising the overnight
interbank rate and the 6-month T-bill rate by 8-9%. The volatility in rates dropped following
establishment of the corridor system, but rates were still significantly higher in 2004/2005
compared to 2003 and portfolio investments flowed aggressively to Egypt after the 2007-2008
global financial crisis subsided.

iv) Confidence boosting measures are key to reviving the economy: Most indicators reacted
favorably to the floating of the EGP, and more so when the banking sector reform was
underway and the new corridor interest rate system and FX interbank market were
operational after 2004. The banking sector is currently well regulated and achieving solid
growth and the macro-fiscal management has significantly improved. Better confidence led to
the build-up of net international reserves and higher GDP growth overall.

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 5
 September 29 2016

Exhibit 1: Looking into the 2013 devaluation

6.5

6.0

5.5
EGP/USD

5.0

4.5

4.0
Jan 02

Jan 06
Jan 05

Jan 08
Nov 03

Nov 04

Apr 06

Apr 08
Apr 05
Sep 02

Sep 03

Feb 04
May 04

Sep 06

Sep 08
Jul 08
Jun 03
Mar 02
Jun 02

Jul 05

Jun 06

Jun 07
Mar 03

Mar 07
Dec 02

Dec 06

Dec 08
Aug 04

Oct 05

Oct 07
Source: Bloomberg, Arqaam Capital Research

In the 2001 to 2002 period the CBE used a step approach to changing the EGP/USD rate,
moving the rate from EGP3.85/USD to EGP4.51/USD, while widening the trading band from 1%
to 3%. The parallel market showed its ugly face, and the corporate sector suffered from the FX
crunch leading the government to finally float the EGP on January 28 2003.

Exhibit 2: Interest, Inflation and T-bill Rates

15 25

13 20

11 15

9 10
%
%

7 5

5 0

3 -5
Jul-02

Jul-04

Jul-06
Jul-01

Jul-03

Jul-05
Jan-01

Jan-03

Jan-04

Jan-06
Jan-02

Jan-05

Overnight IB 6M T-bill ODFR OLFR WPI (RHS)

Source: CAPMAS, Central Bank of Egypt, Arqaam Capital Research

* ODFR and OLFR: Overnight deposit facility rate, overnight lending facility rate, the lower and upper bounds of the
corridor system. ** WPI: Wholesale price index

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 6
 September 29 2016

Exhibit 3: Egypts FX Sources in BOP

10,000 8,000

8,000 6,000

4,000
6,000
2,000
USDm

USDm
4,000
0
2,000
-2,000

0 -4,000

-2,000 -6,000
Q1 03
Q3 03
Q1 04
Q3 04
Q1 05

Q1 07
Q3 07
Q1 08
Q3 08

Q3 10
Q1 11
Q3 11
Q1 12
Q3 12
Q1 02
Q3 02

Q3 05
Q1 06
Q3 06

Q1 09
Q3 09
Q1 10
Direct Investment In Egypt (net) Exports
Travel Private Transfers
Portfolio Investment in Egypt (RHS)

Source: Central Bank of Egypt, Arqaam Capital Research

Exhibit 4: Banking System NFA and NIR

35

30

25

20

15
USDbn

10

0
Sep-01

Sep-02

Sep-03

Sep-06
Sep-04

Sep-05
Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06
Mar-01

Mar-02

Mar-03

Mar-06
Mar-04

Mar-05
Jul-01

Jul-02

Jul-03

Jul-06
Jul-04

Jul-05
May-01

May-02

May-03

May-06
May-04

May-05
Nov-01

Nov-02

Nov-03

Nov-06
Nov-04

Nov-05

NFA (CBE) NFA (Banks) Net International Reserves

Source: Central Bank of Egypt, Arqaam Capital Research

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 7
 September 29 2016

Exhibit 5: Real GDP Growth

12%

10%

8%

6%

4%

2%

0%

-2%

-4%
01/02 02/03 03/04 04/05 05/06 06/07
Private Consumption Government Consumption
Total Investment Net Exports
Real GDP Growth (RHS)

Source: Ministry of Planning, Arqaam Capital Research

Exhibit 6: Revenues by company

80,000

70,000

60,000

50,000
EGPm

40,000

30,000

20,000

10,000

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

MNHD EY ESRS EY MCQE EY SCEM EY SUCE EY TORA EY

COMI EY CIEB EY QNBA EY HRHO EY HDBK EY NBKE EY

Source: Company Data, Arqaam Capital Research

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 8
 September 29 2016

Exhibit 7: Gross profit by company

25,000

20,000

15,000

EGPm
10,000

5,000

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

MNHD EY ESRS EY MCQE EY SCEM EY SUCE EY TORA EY

COMI EY CIEB EY QNBA EY HRHO EY HDBK EY NBKE EY

Source: Company Data, Arqaam Capital Research

Exhibit 8: Indexed EPS growth by company

3,000

2,500

2,000

1,500

1,000

500

-500

-1,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
MNHD EY ESRS EY MCQE EY SCEM EY
SUCE EY TORA EY COMI EY CIEB EY
QNBA EY HRHO EY HDBK EY

Source: Company Data, Arqaam Capital Research

Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 9
 September 29 2016

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Egypt Macro Copyright 2016, Arqaam Capital Limited. All Rights Reserved. See Important Notice. 10