Fitch changes Egypt's LTFC outlook to stable; affirmed at 'BB+'; downgrades LTLC to 'BBB-'

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The agency has also downgraded the long-term local currency IDR to 'BBB-' (BBB minus) from 'BBB'. The outlook remains stable. The short-term foreign currency IDR and Country Ceiling are affirmed at 'B' and 'BB+', respectively.

'This year's surge in global food and fuel prices has increased the challenges facing Egypt's policymakers,'

says Richard Fox, Head of Middle East and Africa Sovereign Ratings at Fitch.

Fox added, 'The power of Egypt's monetary tools to curb inflation is still quite weak, raising the prospect of double-digit inflation continuing well into next year. And no reduction in the very high budget deficit is planned this year, with the timing of critical fiscal measures - subsidy reductions and the introduction of VAT - sensitive to their impact on inflation.'

The change in the FC rating outlook to stable reflects the more challenging policy environment as demonstrated by the slowdown in deficit reduction compared to what Fitch expected a year ago. The general government deficit remained at 7.7% of GDP in FY08 (fiscal year ended June 2008) - amongst the highest of any Fitch-rated sovereign, with other high-deficit countries rated lower. Nevertheless, the authorities did well to contain the narrower 'budget sector' deficit to a less-than-budgeted 6.7% of GDP, including measures to offset the rising cost of energy subsidies, but this was still higher than Fitch had expected. Substantive deficit reduction is now unlikely until FY10. The introduction of VAT, legislation for which is expected to be introduced to the People's Assembly in November, will inevitably raise prices so its timing will be sensitive to inflation dynamics. Despite increased interest rates and stronger sterilisation efforts, double-digit inflation is likely to continue well into next year.

The downgrade in the LC rating reflects several factors. Public finances are much weaker than external finances: although gross and net debt ratios continue to fall, at 70% and 56% of GDP, respectively, they are still more than twice the 'BB' and 'BBB' median of under 30%. Egypt's inflation in recent years has also been higher and more volatile than its 'BB' peers, which exacts a higher interest risk premium and can be associated with increased macro-economic instability. And while Egypt's ability to fund itself domestically is an important strength, high inflation is a factor in the predominantly short-term nature of that funding: two thirds of marketable debt and the bulk of this year's issuance comprise short-term treasury bills. Finally, with foreigners now holding almost a quarter of treasury bills, the distinction between domestic and external debt is narrowing.

External finances are a key rating strength. Egypt is a solid net external creditor and although the current account is likely to move into deficit in the coming year, it will remain well covered by increasing FDI, which is itself a testament to the credibility of the reform programme and the improved business climate. An overall investment rate of approaching 25% of GDP is encouraging as it will help sustain economic growth in the 6% to 7% range, notwithstanding current more difficult global conditions.

The success of Egypt's reform programme and the government's commitment to advance it provides crucial support to the ratings. The stable outlook on both ratings reflects Fitch's expectation that reform momentum will continue in the medium-term and that as inflation subsides, deficit reduction will resume. Future positive rating action will require appreciable progress towards the FY11 3% 'budget sector' deficit target and reduction in debt ratios closer to peer group medians; a strengthened monetary policy framework and further progress of banking sector reform; and sustained growth in per capita incomes, supported by further improvement in the business climate. A stalling of reforms or an ineffectual policy response to future shocks would prompt negative rating action.