Deutsche Bank has provided a macro update on Egypt, highlighting emerging dynamics that have made them more optimistic on the country's fiscal and external dynamics. It noted that, despite the slippage in debt to GDP ratio due to the shock of the novel coronavirus (COVID-19) pandemic, the twin deficits could improve compared to their pre-pandemic levels in the upcoming fiscal year (FY). The bank believes that the improving macro fundamentals are not fully priced in by the market and that there is room for further spread compression, especially in the long end of the curve. Based on this, they express a bullish view on Egypt credit by recommending a DV01-neutral flattener via 47s vs the green 25Ns. They see room for spread compression of 30bp (entry: 332bp; target: 300bp; stop: 345bp). Background In May, the International Monetary Fund (IMF) and Egypt reached a staff-level agreement on the second review of Egypt's economic programme supported by the IMF's $5.2bn Stand-by Arrangement. On the back of the agreement, an additional $1.6bn will be made available to the Egyptian government in the coming weeks. An important point worth highlighting is that net international reserve accumulation and the primary balance exceeded the IMF's targets. Furthermore, according to the IMF, all structural benchmarks were met, including further advancing reforms. Fiscal dynamics would see structural improvements from the upcoming FY. First, the country is expected to continue to post a primary surplus of 1% of GDP in FY 2020/21, and 2% in FY 2021/22 and 2022/23. Second, authorities have indicated that they plan to cut subsidies further next year, while also planning to cut the deficit aggressively. Third, inclusion in the JPM EMBI index, Euroclearability of the local debt market, and institutional reforms that would allow the Central Bank of Egypt (CBE) to accept bonds for collateralised lending to banks will all add to further liquidity, yield compression, and eventually lower fiscal costs of servicing debt. All of the above will make Egypt less vulnerable to the stress scenario of a shock to refinancing costs. External financing needs will become more manageable, with the current account deficit expected to shrink to lower levels compared to the pre-pandemic era. The foreign trade deficit continues to narrow as it did in February, narrowing by 1.2% year-on-year (y-o-y) following an 18.2% y-o-y fall in January. While commodity prices should exert some pressure in the near term, the persistence of weak household demand until at least early 2022 will continue to weigh on the import bill. Meanwhile, a stronger than-expected European rebound, as well as robust growth in the UAE and Saudi Arabia, will likely translate into better-than-expected exports. Furthermore, the government has upgraded its tourism revenue target for 2021 up to $9bn, on the back of increased rising arrivals from Eastern European and Gulf tourists. Colliers International has also recently upgraded its forecast for hotel occupancy rates, expecting 66% and 34% increases in occupancy rates in Cairo and Alexandria, respectively. Overall, Deutsche Bank expects the CAD to narrow to between 2-2.5% of GDP in the next FY, from an expected 4.1% during this FY (ending in June), and 3.1% and 3.6% in the last two FYs. Finally, Deutsche Bank expects further portfolio inflows on the back of high real rates, benign inflation dynamics and a credible central bank. More importantly these inflows have proved to be resilient to the recent core rates repricing. The latest data on foreign holdings of Egyptian bonds show that the spike in rates volume in March led to a small outflow of investments from the local debt market. This is quite positive for the country's financial stability, given the rising weight of portfolio investments compared to foreign direct investment (FDI) inflows as a source of external financing needs. Trade recommendation The Egyptian sovereign has outperformed during the past few weeks, but the rally has mostly been in the short end of the curve ( 10Y), while the long end has not moved much. Based on the above background, the bank expresses its bullish view on Egypt credit by recommending a DV01-neutral flattener via 47s vs the green 25Ns. The bank sees room for spread compression of 30bp (entry: 332bp; target: 300bp; stop: 345bp). Valuation-wise, the green 25Ns are trading very rich, as the old 25s are trading 20bp wider. Meanwhile, the 47s are the relatively cheap bonds in the 30Y sector. Medium to long-term (MLT) risk to the credit profile is lower given the above-mentioned dynamics. This will enable Egypt to get back on track of lowering its debt to GDP ratio soon while a strong economic rebound would provide extra support. Moreover, liquidity risks are also lower with MLT external debt accounting for 91% of gross external debt while short-term external debt as a portion of gross external debt has fallen below end-2019 levels by less than a 1%. Commercial banks have diversified their FX liabilities while increasing their debt maturity profile in response to the COVID-19 shock. Deutsche Bank expects lower supply risks especially in the long-end in the coming FY. The bank thinks that the sovereign will rely more on Sukuk issuance during the upcoming FY, as the Senate recently approved in principle the draft law on sovereign Sukuk. The government's official projection for international bond issuance is lower, at EGP 66bn in FY 2021/22 compared to EGP 72bn in the current FY. A good portion of this is expected to be in the form of sovereign sukuks.
