In spite of 4.7 percent growth in Egypt’s GDP last year and near-unanimous approval for how the government handled the financial crisis, the nation is still an emerging economy. And though the fixed income – debt – market is a pillar of developed economies like those in the US or UK, this market has been overshadowed in Egypt by the more speculative stock market. Accordingly, the debt market has much room to grow given its low penetration, the government’s need to stimulate the economy, and corporations’ desire to capitalize on opportunities in developing countries.
But taking on more debt could be a risky decision, especially considering that Egypt has a large subsidies account, low single-tier taxes (20 percent) and an appetite for long-term, low-profit infrastructure projects.
In general, bonds are used when a government or company wants to borrow at a lower interest rate than banks charge; the bigger the difference, the more eager corporations are to issue bonds. Also, bonds are not subject to bank requirements and restrictions. “Ideally, the capital market decides which bonds to accept based on their rating. This helps protect individuals investing in bonds,” says Amr Hassanein, chairman of FINBI (Finance & Banking Consultants International), who has specialized in the capital market for 15 years.
Bond prices are based on default-risk ratings by Standard & Poor’s (S&P), Fitch, Moody’s and other agencies. Egypt’s sovereign rating of credit worthiness is BBB-, according to S&P, which is the lowest investment grade rating. It is used as a benchmark for corporations and other entities that want to issue bonds. “Ideally, a corporation would benchmark its bond against an active government [bond] with similar maturity and interest payment,” says Hany Genena, chief economist at Pharos Investment.
Like stocks, bonds can be traded in the open market, and transactions are registered in the Central Bank of Egypt (CBE) and Egyptian Exchange (EGX) clearances. “Investors don’t need to speculate about price. The rating does this for them. Investors will [mathematically] know how much risk they are incurring,” Hassanein says. In general, as interest rates increase, the price of the bond decreases because investors prefer to put their money in the more secure banking system.
Capital markets in stable economies consist of about 70 percent fixed income instruments (bonds and treasury bills in Egypt) and 30 percent stocks. “[Corporate] bonds account for less than 10 percent of the money market,” Hassanein says. “This is not a healthy sign.” Government bonds are not much better, accounting for about 10 percent of money market capitalization.
Treasury bill transactions traded in the over-the-counter market must be registered in the clearance department of the CBE. Experts say the transactions are relatively efficient since they are subject to open market dynamics. T-bills with maturities of three, six, nine and 12 months are issued weekly by the government.
The bond market is generally seen as more important because of its higher capital inflows, longer maturities and greater potential returns. Overall, the bond market is divided into corporate, government and quasi-government, which represents entities established and guaranteed by the government but operating independently. In Egypt, the government issues three- and five-year bonds monthly, while seven- and 10-year bonds are issued twice a year, each auction raising about LE 10 billion, according to Mostafa Assal, head of fixed income trading at Beltone Financial. There’s no set schedule for corporate quasi-government bonds.
So far in 2010, Mobinil has issued bonds to raise LE 340 million, while GB Auto bonds are expected to raise LE 1 billion. The quasi-governmental New Urban Community Authority plans its first bond auction, worth LE 5 billion, also this year.
Despite its importance for financing issuers’ projects, the bond market is opaque since primary dealers, rather than the open market, control pricing, Assal says. “The secondary market in bonds is a dead market,” he says.
Part of the problem could be that there are 15 banks in Egypt authorized as primary dealers, meaning they are obliged by contract to cover all government issues. “It is a primitive and closed market,” Assal says. “Only six or seven banks are active... trading among themselves with no volumes available to the secondary market.” Because money market funds are prohibited from holding bond portfolios whose overall average length of maturity exceeds six months, the funds typically hold bonds for no more than a year or two. That can significantly limit demand for corporate bonds.
This was not always the case. Hayssam Shaaban, head of the money market and GDR desk at Prime Holding, recalls that “10 or 12 years ago, bonds and bills were given to brokerages. And brokerages would trade in them to make money; we sold everything and anything. Now these bonds sit in the bank’s dealing room earning fixed income... To sell them, banks ask for a huge spread.”
Interest rate structure is another problem. “In Egypt, the difference between bank interest rates and bond interest rates is very small, so there is no incentive to issue due to the extensive paperwork needed,” Hassanein says. This puts the CBE under pressure not to adjust the interest rate because doing so would force the government to raise interest payments. “Fixing the term structure of interest rates [used to assess bonds based on prevailing interest rates defined by the CBE] will require investment bankers and buyers – individuals, financial institutions and banks – to work together to ensure suitable bank loan and bond interest rates.” Bank loan interest rates need to be stable and known for bond rates to be set at appropriate levels.
To encourage a secondary market for bonds, Shaaban suggests an interbank system to force banks to accept a “buy request,” even if it meant accessing bonds from another bank. “An interbank system for currencies was created a while back, and now the currency market is transparent and efficient,” Shaaban says. “In the currency market, main dealers are still the banks, but individuals are able to enter and exit more freely. I don’t think that an interbank bond system would be any different.”
From the government’s side, economic stimulation is based on increasing the supply of bonds with various maturities to encourage registered primary dealers to open the secondary market to individuals and financial institutions. To stimulate corporate bonds, Minister of Investment Mahmoud Mohieldin announced that regulations will be implemented to expedite processes, and standardize application and disclosure forms.
The Islamic financial system survived the crisis well. Faisal Islamic Bank of Egypt recorded a net profit of LE 123.8 million in 2009, a 45 percent increase from 2008, while Egyptian Saudi Finance Bank made LE 54 million after reporting zero net profit in 2008.
Recently, several experts have urged the government to issue bonds known as sukuk. These are securities governed by Sharia law, which can be interpreted as forbidding investors from profiting by the exchange of money, such as interest payments on traditional bonds. Unlike traditional bonds, sukuk have variable interest rates.
Given the stability of the Egyptian economic and financial structure, “introducing such instruments will not increase market risk,” Shaaban says. But Hassanein would rather “develop and advance the simple vanilla bond market first.”
“You can’t be optimistic about taking more debt, and the Ministry of Finance has been issuing a lot of bonds in 2010,” says Genena. One reason the government is issuing bonds instead of T-bills is to shift its debt maturity structure to the long term.
Economists generally see it as a sign of serious problems when a country’s interest payments exceed 10 percent of GDP. Egypt “is paying between LE 70 billion and LE 80 billion in interest [annually], which is roughly 6 to 7 percent of GDP,” Genena says. Debt to GDP stood at almost 60 percent in 2009.
Government bonds have an interest rate between 12 and 12.5 percent. Apply the 2008-imposed 20 percent tax and the figure falls to about 10 percent. Meanwhile, the country recorded its highest-ever GDP growth, 7.2 percent, in 2007; in 2009 it was 4.7 percent. So the interest-to-GDP ratio will continue to increase until GDP growth reaches 10 percent. One reason for high interest rates on bonds is inflation. “No investor will pay for a bond that has an interest payment significantly lower than the inflation rate,” Genena says.
As a result, Genena says, “the government has been cutting costs by reducing subsidies and private-public partnership (PPP) budgets,” which focus on big-project cooperation. It also is increasing revenue by introducing a revised property tax and transfer pricing, and moving from sales tax to value-added tax. “Such changes could increase net GDP by 1.5 to 2 percent,” he says.
Such problems are limited to internal debt. Genena says external debt servicing – interest and principle payments – costs Egypt nearly LE 5 billion annually, “not a tremendous amount.” An important factor has been the pound’s strength against the euro and the dollar.
Nonetheless, Genena worries about how the government will handle issues that may arise when it reduces spending and attempts to increase cash inflow to hold internal debt interest payments below 10 percent of GDP.
Foreign investors have long been a force in the domestic money market. Before the 2008 crisis, foreign investment in T-bills exceeded LE 30 billion. “Give foreign investors easy entrance and exit procedures, and they will invest,” Assal says. After the crisis, however, Genena says, foreigners sold about LE 30 billion worth of T-bills, leaving only LE 2.5 billion invested. “This massive exit in 2009 was not because the government was not performing,” he says, but rather to mitigate losses in other markets.
Many experts agree the domestic bond market has potential, citing Egypt’s stable economy, an advantageous foreign exchange rate and GDP approaching $200 billion. “This is when foreign bond investors start putting you on their radar,” Assal says.
The lack of a secondary bond market makes entry and exit both difficult and risky for foreigners. Another major problem is in traded volumes and values. The domestic bond market in Egypt considers LE 50 million to be a large portfolio, Assal says, while small to medium-size international bond portfolios are about LE 550 million. “The big players have bond portfolios of LE 11 billion to LE 16.5 billion,” he says.
Hassanein says foreigners are not absolutely necessary, noting that “investment banks need to target individuals or financial entities, and they will stimulate a suitable secondary bond market.” In the case of the A-rated Mobinil bonds, he says, the portion directed toward individuals was covered 11 times, meaning that each bond had 11 potential buyers.
One reason Egypt was not hit badly by the global crisis was because it lends 51 percent of deposits to investors or corporations, while the remaining 49 percent covers government issues of bonds and bills, according to Assal. The remainder goes to corporate bonds and other investment instruments. “Corporate bond investments amount to LE 10 billion out of LE 800 billion in cash deposits,” Hassanein says. “So there is still a lot of potential for corporate bonds to be issued and covered.”
Assal also is optimistic. “The bond market is executing transactions valued at LE 5 billion a month,” he says. “I think this figure can easily reach LE 15 billion. T-bills execute LE 40 billion to LE 50 billion a month... Ideally, the bond market should execute LE 30 billion to LE 50 billion a month.”
Assal and Shaaban agree that investors from abroad are necessary for the market to thrive. “Foreigners come with massive budgets and trading tools... We need to open the door for them to enter and take a little more risk in order to grow,” says Assal.
Shaaban believes the bond market should be subject to open market dynamics: “The nation’s needs are for sure important, but these needs should not influence open market dynamics or global context.”
If the bond market doesn’t expand, Hassanein says, it will be a lost opportunity but “things would not be worse.” Assal says, “as an economy, Egypt will never be able to play with the big boys without a powerful fixed income [debt] market with high-volume trading, transparency, stable interest rates and known players.”
