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Mass Protests in Egypt Challenge the Regime and Shake Markets
By Ayah El Said and Rachel Ziemba
Editor's note: RGE's latest coverage and views on the unfolding Egyptian crisis are available in the RGE Critical Issues: Mubarak Appoints a New Cabinet: Is His Resignation Only a Matter of Time? and Tunisian and Egyptian Ripple Effects Felt Across the Middle East Governments and Markets?
On January 25, 2011, demonstrators took to the streets of Cairo, Alexandria, Suez, and throughout the Nile Delta governorates, protesting against their economic problems and calling for the ouster of Egyptian President Hosni Mubarak. The riots were not a complete surprise, as Egypt has seen protests before, mostly triggered by rising food prices, but the scale and coordination of the current street actions has been much greater than in the past. They were inspired by the popular uprising in Tunisia that eventually ended the reign of President Zine El Abidine Ben Ali earlier this month. As we noted in a recent MENA focus, Egypt faces a volatile mixture of high inflation, flat wages, lack of economic and political reforms and an already wide fiscal deficit. Foreign investors had already showed their concerns about regional unrest in the Middle East through the Egyptian markets at the time of the Tunisian uprising, and the unrest in Egypt itself has extended losses in equity markets—which are down 16% over two days and 21% from the beginning of the year. Further political uncertainty could add pressure to existing economic and financing strains. However, we expect that the regime to survive, but it may need to make some significant concessions over the long term, including allowing more openness and competition in presidential elections later this year.
Mounting Challenges to the Ruling Party
January has been a tough month for Egypt’s government, as it has been for many governments in the MENA region. The year started with a New Year’s Eve bombing of a Coptic Christian church in Alexandria among other incidents, which exacerbated previously existing interfaith tensions. Despite food subsidies, protests against soaring food prices have been occurring on a regular basis since 2006, and public sector workers were increasingly strident in their demands for improvement in their economic conditions. The January 25 protests, concentrated in the delta region and Cairo, clearly took inspiration from the events in Tunisia and similarly leveraged social networks, the internet and texting to coordinate actions and wrongfoot government clampdowns. The delta region not only has a less extensive security presence than Upper Egypt or Cairo but also a greater concentration of publicly owned factories and low wages. Suez in particular, centered on the Canal that provides a key government revenue source, has experienced some of the strongest protests. Additional protests scheduled in the country, as well as across Europe and in the U.S., could keep asset markets volatile in the short term. In fact, as we have suggested for some time, new long-term investment could be delayed until after the election as key policies remain on hold. RGE expects that the regime will be able to retain power, given its ties with the military.
Although the political situation remains uncertain, further clouded by the lack of official statement from Mubarak and his key ministers, the domestic economy should be resilient as it was during the financial crisis. (We still expect 5.9% growth this year.) Foreign financing for Egyptian entities will likely become more scarce and costly as political uncertainty exacerbates the effects of high food prices on the fiscal and external accounts, as is occurring also in other large, commodity-importing MENA countries.
Additionally, President Barack Obama’s recent State of Union address hinted that U.S. priorities for Egypt—until now a staunch regional ally and a recipient of U.S. military aid—may be shifting following Ben Ali’s ouster from Tunisia: “And tonight, let us be clear,” said the president, “the United States of America stands with the people of Tunisia, and supports the democratic aspirations of all people.” This was a surprising line that may be disconcerting to Egypt’s governing elites. It remains to be seen how the U.S. will respond, as signs of realignment could be destabilizing.
Bear Market Territory
The market’s reaction on January 26 and 27 was sharp and severe. Markets were closed on the “Day of Wrath”—the protestors’ name for the mass action—as it was a public holiday, Police Day. Markets, however, responded the next day, and Egypt’s main stock index lost almost 6% on January 26 and 10% on January 27 amid near-record trading volumes. Although foreign investors, including other Arab investors, were net sellers, a small number of local investors seemed to be buying on the big dip. Some investors could decide to re-enter the market if the political situation stabilizes.
An initial shock to the stock market came after the ouster of the Tunisian president, in what was thought to be contagion effect. However, once the demonstrations began in Egypt and showed themselves to be persistent, the outflow of hot money began in what may be the worst incident of capital flight since the 2008-09 height of the global financial crisis.
Figure 1: Sharp Equity Market Declines
Note: Tunisia's exchange has remained closed since January 13.
Figure 2: Latest Selloff Led by Foreign Investors (net flows, EGP millions)
Source: Egyptian Exchange
Along with the fall in the equity market, the Egyptian pound (EGP) fell to a six-year low, suggesting that there may have also been a flight from bond markets, which could account for some of the recent capital inflows. Unlike the equity action, the additional depreciation of the EGP was relatively small, as policy makers had already been weakening the currency to maintain competitiveness. Further or sustained weakening of the EGP, as noted in the Emerging Markets Quarterly, is but one of the conditions contributing to the current expansionary policy stance and could exacerbate existing inflationary pressures. Despite inflationary pressures, the political uncertainties may make the Central Bank of Egypt even more hesitant to hike interest rates, which along with the likely fiscal expansion to soothe the population, could leave the country behind the curve.
Figure 3: Egyptian Pound Continues a Steady Depreciation (EGP/USD)
Despite these acute effects, RGE and many commentators continue to foresee strong Egyptian economic growth momentum as global conditions stabilize, strong oil prices support regional liquidity and domestic demand continues to expand. Our base scenario continues to be the maintenance of the political regime and its expansionary policy stance, but the situation is far from certain. These events highlight the vulnerability of the Egyptian economy to political uncertainty and political unrest, and we expect the government may need to make some meaningful gesture toward reform. The risk is that the government playbook seems to contain one major play: more subsidies. Already subsidies eat up about 20% of government spending. The Egyptian government’s wheat wheat bill in particular, is set to soar, as it joins other regional players (Algeria, Saudi Arabia) in adding to its stocks.
Egypt, compared to Tunisia, has been described as a more robust regime. While we believe that political tumult will have no major impact on the country’s growth rate in the short-term, we expect that social and political unrest will remain frequent until the November 2011 presidential elections unless the government announces a significant structural change. President Mubarak could well try to give the appearance of a more open election, as some close to him may be encouraging. We think the chance that he will simply resign is low.
So far, the Muslim Brotherhood—an officially banned Islamist party that functions as the main opposition—has not been directly connected to the protests. However, many of the Friday (January 28) planned protests are based out of mosques and garner the participation of brotherhood members. Al Azhar, the Islamic university based in Cairo and normally supportive of the regime, also issued a fatwa supporting the protests. In Egypt, as in elsewhere in the region, the decision to ban and generally undermine non-Islamist parties leaves the country with little official outlet for legitimate opposition to the regime. Even the Muslim Brotherhood, whose representatives have tended to hold seats as independents, was left out of the most recent parliamentary elections in a surprising first round decision.
Reports have been mixed as to the response from security services across different regions. Should the regime lose its command over security forces, this could have a significant spillover effect, as it did in Tunisia, where an unwillingness on the part of the police to attack crowds contributed to Ben Ali’s overthrow. We do not foresee this happening in Egypt at present.
Resilient Domestic Demand?
Unlike Tunisia, Egypt’s economy is largely driven by domestic demand. However, high and rising inflation though could have a significant effect on consumption of nonfood goods and overall consumer confidence. Should protests continue and culminate in extensive work stoppages, then there could be a more noticeable effect, but this is not yet RGE’s central scenario.
The strength of the domestic demand—the main driver of growth for the last six quarters—should be resilient in the face of policy uncertainty. The increase in subsidies on basic food items—announced in mid-January—could restrain inflationary pressures, maintaining the purchasing power of the Egyptian consumer. Additional EGP depreciation should be slight, having only a modest inflationary effect. While increasing subsidies may delay needed fiscal consolidation, social unrest is currently a more pressing threat. Government investment—and infrastructure investment in particular—should stay on track. However, public-private partnership opportunities that were announced for investors in Egypt's infrastructure sector may take a hit from the nervousness of foreign investors. Private sector activity, including the needed support for infrastructure, may be adversely affected, especially if the losses in the equity markets continue. Stronger economic trends globally, including in global trade, are supportive for Egypt, particularly through the channel of Suez Canal revenues, which will temper the current account and fiscal deficits. Tourism revenues could suffer in the short term, however, as might those in other seemingly vulnerable regimes, such as Jordan or even Morocco.
In the longer term, failing to respond to the economic grievances and to create sufficient jobs would weigh on Egypt’s growth prospects, dampening its long-term growth to the 5-6% range. Major investment and productivity-enhancing gains are needed to employ the new entrants into the workforce. Major economic reforms could be politically and socially difficult but are necessary for Egypt to increase its potential output growth, and take advantage of its demographic dividend.
Even if growth is relatively resilient, prospects for foreign investment might be more vulnerable, particularly the long-term foreign direct investment (FDI) Egypt’s government is struggling to attract. Like many emerging markets, FDI has lagged shorter term portfolio flows, and the latter seem to have fled with the first whiff of political uncertainty and inflation. Along with the currency and equity markets, the cost of insuring Egyptian sovereign debt spiked to over 346 basis points, and the cost is currently converging to the levels of Dubai and Lebanese debt. While we do not expect any defaults on either Egypt’s domestic or foreign debt, continued political uncertainty could, along with the accompanying fiscal deterioration, contribute to worsen the ratings outlook. A large fiscal deficit of close to 8% of GDP was already priced in by ratings agencies, but the political pressures could lead to increased expansiveness. The latest rating by Fitch early in January maintained a stable outlook on its BB+ ratings and on January 27. Fitch expressed concerns about the developments in Egypt but suggested it was premature to downgrade the country’s debt. However, prolonged uncertainty could result in a negative outlook/watch or less likely a downgrade.
Figure 4: Spike in CDS
Source: Bloomberg, all CDS on five-year sovereign debt
Corporations, even large internationally focused ones, could face some pressures raising funds, particularly on the equity market. International investors may consider investing elsewhere in the region, in places where there is less political uncertainty and strong growth. International investors interested in investing more heavily in Egypt—perhaps in FDI—may postpone any short-term plans until the public private partnerships law is implemented or privatization plans resume after the election. We believe, however, that Egypt will maintain its investor-friendly policies and broad policy stance, given its need to attract foreign investment. The hefty subsidy bill has limited government space to support infrastructure, requiring foreign capital as well as expertise.