Egypt - External soars

Strong external performance
Egypt's external performance remains strong despite the current account surplus falling to 1.6% of GDP in FY2005/06 (July 2005-Jun 2006), from 3.1% in the previous year. This figure masks the robust performance of exports, which increased by 33% y/y, with export growth accelerating to 52.5% y/y in H2. Imports also increased strongly (by 25.8% y/y in the FY) driven by the buoyant demand in the economy. Given that imports are over double the value of exports, this resulted in the trade deficit widening. Positively, imports of investment and intermediate goods represented 53.6% of total imports, which bodes well for Egypt's economic outlook.

There were also strong performances in the invisible components of the current account, as tourism, remittances and Suez Canal earnings continued to increase. Although tourism revenues grew by 12.5% y/y in FY 2006/07, the sector was negatively impacted by the terrorist attacks in April. Visitor numbers into Egypt fell by 5.5% y/y in July, the third consecutive monthly drop. However, we are forecasting a strong recovery in the tourism sector and expect the figures to start improving from August as the conflict in Lebanon resulted in many regional tourists changing their holiday plans to other regional countries, such as Egypt.

Reform driving capital and financial inflows
There have also been positive developments on the capital and financial accounts. The progress on the reform front has raised and improved Egypt's profile in international capital markets. Foreign direct investment and inward portfolio flows have risen sharply. FDI into Egypt increased by 56.4% y/y to USD 6.1bn in FY 2005/06, equivalent to over 5.5% of GDP; this is up from under 3.0% of GDP in FY 2003/04. Importantly, non-energy investments accounted for around 70% of FDI, compared with just 33% in FY 2004/05. Meanwhile, portfolio inflows increased to USD 2.8bn in FY 2005/06, up from USD 800m. The strong external performance has resulted in the continued build up of FX reserves, which reached USD 24.1bn in September 2006, a 14.1% y/y increase.

Importantly, FDI inflows into Egypt are continuing to increase in the current fiscal year, supported by the government's privatisation program, including the sale of Egypt's third mobile network to Etisalat for around USD 2.9bn. Furthermore, 80% of Bank of Alexandria was sold to Italian bank Sanpaolo IMI for USD 1.6bn. For both these sales, the prices were at the higher end of analysts' expectations.

Strong growth… but increasing inflationary pressure
The external sector remains a strong engine of economic expansion, although growth remains broad-based with expansion in private consumption and investments (as reflected in the increase in imports). Preliminary government data places real GDP growth at 6.9% in FY 2005/06; however, this is above our and the IMF's estimates of 6.0% and 5.6%, respectively.

Robust economic activity is resulting in a pickup in inflationary pressure and CPI jumped 9.5% y/y in September. After moderate growth rates in the CPI at the beginning of the year, inflationary pressure has been accelerating since June, with the year-on-year CPI increasing by over 7.0%. Along with the strong demand in the economy, other factors driving inflationary pressure are the outbreak of avian influenza which has been placing upward pressure on food prices and the reduction in fuel subsidies. While the central bank kept interest rates on hold in October, we are forecasting a 50bps increase by year-end. Nevertheless, growth will remain strong driven by private consumption and investment.

Progress expected on the fiscal reform front
Continuation of the reform program is a key factor that will support sentiment. Auspiciously, the government is forging ahead with its financial reform plans. The majority sale of Bank of Alexandria was crucial for banking sector reform, including reducing the role of the government in the sector.

In other developments, the government has concluded an agreement with the World Bank for a USD 1bn loan to support the financial positions of two state-owned banks (National Bank of Egypt and Banque Misr) through capital increases. Moreover, the merger of Banque Misr and Banque du Caire is slated by the end of the year. The merger is aimed to create fewer and bigger banks that could compete better domestically and expand regionally, while also tackling non-performing loans. Banque Misr has restructured debts worth around EGP 15bn and thus, could help reduce the problem of Banque du Caire's bad debts. However, further delays to the merger cannot be ruled out. Egypt is also making progress with its pension reform.

Previous reform already having positive impact
Importantly, there are indications that the previous reforms are starting to bear fruit including on the fiscal front, although the budget continues to be the main area of concern and further reforms are required. The government figures indicate that the fiscal deficit narrowed to 8.6% of GDP in 2005/06 from 9.6% in the previous year, despite increases in expenditure. The government figure
is close to the IMF's estimate of 8.3%.

Previous tax reforms, which involved tax cuts and the widening of the tax base, are resulting in increased revenues. The reduction in tax level is spurring growth which is resulting in higher tax receipts, while more individuals are filing returns. Consequently, the preliminary data indicates that tax revenues increased by 28% y/y in 2005/06. The fall in the fiscal deficit also reflects receipts related to: (i) the partial sale of Egypt Telecom (0.8% of GDP), and (ii) the payment of tax arrears by Egyptian General Petroleum Corp (EGPC). In a further positive development, the government has reclassification budget accounting procedures to bring them into international standards.

Continuation of reform vital
These positive developments have improved our confidence of the government reducing its budget deficit going forward, although reaching the government's target of reducing the budget deficit by 1% of GDP a year will require sustained fiscal reform and strong growth to boost tax revenue. Crucially in July, the government reduced fuel subsidies by around 30%. This increase in fuel prices is an indication that the government is willing to tackle the huge subsidy burden. The privatisation program will continue to support government revenues.

Furthermore, the government is continuing to promote wider reform. Cairo and Beijing recently signed contracts to jointly build cement, glass, cable, chemical, petrochemical and aluminium plants on Egyptian soil, with Chinese investment of around USD 2.7bn. In addition, an accord for China to develop railways, and textiles and metal industries in Egypt has been tentatively agreed. Positively, these measures will help to promote the growth potential of the country.