The economy received a double blow last week, with the US rating agency Moody's lowering the country's credit worthiness, thus making it even more expensive to get foreign financing, just a few hours after a decision to increase the cost of borrowing, threatening a further growth slowdown. While the ailing economic fundamentals played a role in the two developments, a statement issued by the Central Bank of Egypt explaining the interest rate hike and a commentary by Moody's on the reasons behind the downgrade revealed that worries of social and political unrest were the main drivers behind the changes. Egypt has been in a state of political turmoil since the toppling of former president Hosni Mubarak in the 25 January Revolution. But events have been escalating since November last year when street protests turned to violence between supporters of the Islamist ruling Muslim Brotherhood and activists belonging to the secularist opposition. Moody's cut Egypt's sovereign rating to Caa1, seven levels below investment grade, saying that the current political stalemate was hindering economic recovery. This is the sixth downgrade in Moody's rating since the 2011 revolution, putting Egypt on an equal footing to Pakistan and one level below Argentina. The cut reflects the “deep polarisation” of the country's politics, with “repeated episodes of violent civil unrest”, Thomas Byrne, a Moody's analyst, said in his report. “This polarisation is in turn impeding the government's ability to govern effectively, restore social stability, and avert a worsening of the already severe disruption to the economy,” he added. In addition to the political factors, Moody's downgrade and the negative outlook for the economy stemmed from a deterioration in the country's balance of payments and uncertainty surrounding the projected IMF loan. At this rating level, the probability of Egypt's defaulting on its debt is close to 10 per cent over one year and 40 per cent over a five-year period. Hany Genena, head of research at Pharos securities, expected the move to raise the cost of foreign currency debt. It is also likely to put further pressure on firms that import raw materials, given that suppliers will likely request cash payments to secure against delinquencies, according to Genena in the Pharos commentary on Sunday. Concerns about rising social unrest stemming from a spiraling increase in prices were the main reason behind the Central Bank of Egypt's Monetary Policy Committee (MPC) deciding to increase interest rates during its meeting on 21 March, a move that came for the first time since November 2011. The decision, according to which both the overnight deposit and the lending rates increased by 0.5 per cent to reach 9.75 and 10.75 per cent, aimed to cap increases in inflation rates. Egypt's inflation rate reached 8.2 per cent in the year to February, compared to 6.3 per cent in January. The CBE attributed this hike to the shortage of diesel oil, as well as to “broad-based increases in food and non-food prices on the back of the recent movements in the exchange rate.” The increases in prices have been eating away at the purchasing power of the Egyptian pound, which has lost nine per cent of its value against the dollar since the end of December, inflating the country's imports bill. The CBE made the move after trading off the expected slowdown in economic growth due to the increase in borrowing costs with the adverse effects of keeping inflation rates that high. The CBE statement said that while the growth outlook was weak, a decision to keep interest rates as they were would not stimulate the economy given the “political stalemate and social unrest and the continued feeble demand for credit.” “The possibility of a reemergence of local supply bottlenecks and distortions in the distribution channels poses upside risks to the inflation outlook,” the statement said. The government is aiming at a growth rate of three per cent during the year ending in June. “Inflationary risks currently take a higher priority given the continued currency depreciation, expected fiscal reforms, and local market supply shortages, which could ignite significant social unrest,” the Beltone financial research team commented in a note on the CBE move. Pharos Holding also shed light on the implications of the move, starting with tightening demands on new bank credit and an expected re-pricing of outstanding corporate credit that is usually higher by a spread over the overnight lending rate. Pushing the overnight lending rate up might also result in a parallel increase in yields on government securities, Pharos said. The yield on bonds has been on the rise during the last couple of months to reach 14.25 per cent. One positive outcome for Egyptian families depending on yields on their bank deposits for living expenses is that the move will encourage an interest rate hike on deposits. According to Pharos last month, the country's top three banks had raised rates on their three-year deposits by 1.5-2 per cent.
