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Al-Ahram Weekly 27 Jan. - 2 Feb. 2000 Issue No. 466 
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Published in Cairo by AL-AHRAM established in 1875 |
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Al-Ahram Weekly 27 Jan. - 2 Feb. 2000 Issue No. 466
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| Published in Cairo by AL-AHRAM established in 1875 |
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Egypt Region International Economy Opinion Culture Features Profile Travel Living Sports People Time Out Chronicles Cartoons Letters To kick-start the financial sector
By Mohamed Metwalli *
The investment climate in Egypt is very attractive right now. Macro-economic indicators are quite healthy compared to other emerging markets. GDP is growing at five per cent, inflation is at 3.5 per cent and the budget deficit is below one per cent.
Right now Egypt is emerging on international investors' radar screens. It is almost certain to be included on the MSCI index and when that happens capital will flow to Egyptian equities from funds tracking the index.
Telecommunications, utilities and the banking sector tend to attract international investors, due in part to their high market capitalisation and liquidity. The telecommunications sector in Egypt is particularly attractive because of the high growth rate of its earnings, the electricity sector is attractive because of the stability of its earnings and its relatively high dividend while the banking sector is attractive because it is a proxy to the economy.
The government of Egypt is currently using financial and legal consultants to establish a regulatory body and framework for the telecommunications and electric utility sector. This work will take some time to be completed but it is moving on the right track.
As for the financial sector, the Central Bank is the regulator. And the investment community would certainly like to know more about the government's plans to privatise the four public sector banks. Investors would also like to see the Central Bank providing incentives for smaller banks to merge in order to kick off consolidation within the financial sector. Economies of scale will be crucial in the future of financial institutions -- the high cost of technology will squeeze out the smaller players.
The Egyptian equity market remains quite cheap relative to similar emerging markets though in terms of liquidity it has some way to go. Apart from two or three stocks, liquidity in the Egyptian capital market is rather limited.
Compared with the Czech Republic, Hungary, Poland, Greece, Israel and Turkey, Egypt has a lower average daily trading volume in dollar terms relative to the size of its market capitalisation. The reason is that the privatisation programme has yet to be completed and as such the free float -- shares owned and traded by the public -- on several stocks is rather limited. Also, the Cairo Stock Exchange has yet to list the large utilities (telecoms and electricity companies) which have relatively high market capitalisation and as such would be highly liquid, assuming there is a decent free float.
The reason the Egyptian stock market slumped in the first half of 1999 was the convertibility crisis of the Egyptian pound. This is an issue that is taken very seriously by investors. While investors do not mind if they get into a market when the exchange rate is at X and exit when the exchange rate is at X plus five per cent for example, they very much mind not being able to convert their investments into dollars when they want it back.
Pegging the Egyptian pound to the dollar is still at the back of the minds of investors. And the pound has come under pressure over the last 18 months for several reasons.
Many countries devalued their currencies after 1997 while the Egyptian pound, being pegged to the dollar, retained a relatively high purchase power that was very well exploited by importers. This resulted in a higher trade deficit and negative pressure on the Egyptian pound from the significant increase in demand on the dollar.
When this happens there are only two choices available: the exchange rate floats to reflect supply and demand or else the central bank supports the currency using its foreign reserves. The Central Bank of Egypt opted for the latter course, but reluctantly. The reluctance resulted in a severe liquidity crisis in the dollar, which affected the repatriation of foreign investments in Egypt and shook investors' confidence in the convertibility of the Egyptian pound.
Some international funds made a global decision, after the economic crises in South East Asia and Russia kicked off, to pull out of any market where the local currency is pegged to the dollar. Egypt was one of the countries that suffered from this decision. As investors pulled out, demand on the dollar surged.
This, combined with a very low oil price (almost $8 per barrel) and low receipts from tourism, exacerbated the pressure on the pound.
As the crisis was brewing, the Central Bank seems to have concluded that the liquidity squeeze would be temporary and thus decided to support the pound using its foreign reserves. Right or wrong at the time, as the crisis peaked it would have been unwise to make any adjustment to the exchange rate as the market would have amplified the adjustment and the situation could have got out of control. Now tourism receipts are at a peak, oil prices are up by 150 per cent for the year and Egypt is witnessing the beginning of a positive flow of capital, and as such it may be worth reconsidering the rigid pegging of the pound to the dollar.
A modernised stock market, the main catalyst for Egypt's economic growth
There are several ways to introduce some flexibility to the foreign exchange system to accommodate changes in the forces of supply and demand. One of the options the Central Bank may have is to peg the Egyptian pound to a basket of currencies -- let's say 50 per cent US dollars and 50 per cent Euro, and create a band with a floor and a ceiling beyond which the Central Bank would intervene. Implementing measures of this kind in response to the severe liquidity crisis Egypt went through recently would signal to investors increased sophistication in the management of the foreign exchange rate and would act to restore confidence in the government's free market policy.
It is worth noting here that there is nothing wrong with fluctuations in currencies to accommodate forces of supply and demand. The Euro has lost 15 per cent of its value against the dollar since the beginning of 1999. Similarly, the dollar lost almost 10 per cent of its value against the yen since the beginning of 1999. There is nothing wrong with some fluctuation in the Egyptian pound's exchange rate, as long as convertibility is sound and investors' confidence is maintained.
Normally, one would expect the bond market to be twice the size of the equity capital market, which is clearly not the case in Egypt. To have a successful bond market the government must establish a yield curve, which does not really exist right now. The government may want to consider having a pre-announced calendar of issuance of paper with different maturities -- five, 10 and 30 years -- and in sizes that would provide enough liquidity to act as a true benchmark. Financial institutions would price new bond issues off the liquid government benchmarks. Currently, bills or bonds -- other than three month t-bills -- are tightly held by financial institutions, mainly public sector banks, which results in one point on the yield curve, and a rather fake flat yield curve. In the absence of liquid benchmarks financial institutions would be very reluctant to price longer term paper and investors would demand a high premium for the uncertainty which turns off issuers.
The other issue impeding the development of a corporate bond market is that the three months t-bill rate yields almost 8.8% when inflation is around 3.5%. In the presence of a liquid and efficient bond market the rate of the government's short term borrowing -- taking into account the stable economy and good macro economic indicators -- should be much lower, reflecting a real rate of one or two per cent above inflation.
The mechanisms and policies governing Egyptian stock exchanges are clearly not yet up to par with more developed exchanges that allow option trading. However, to the best of my knowledge, these issues are being addressed by the Cairo Stock Exchange chairman and executive committee, and by the regulator, the Capital Markets Authority (CMA). Cairo Stock Exchange has an international advisory committee which meets quarterly to discuss how to develop trading on the exchange. The exchange is also working on issues crucial for its future development, such as surveillance, securities law and enforcement. The Ministry of Economy and the CMA have also retained law firms to review and further develop the securities laws in Egypt to bring them to par with securities laws in more developed markets.
Derivatives trading is still too ambitious for the Egyptian capital markets at this stage -- the reason being that with the exception of two or three stocks traded on the Cairo Stock Exchange liquidity is limited. Several steps will need to be taken to develop the market before it can allow options and futures to trade.
The prospects for growth in Egypt's financial sector are huge. However, the sector is hindered by the government's ownership of the four public sector banks that control almost 65 per cent of the industry.
Yet the employees' compensation system in the four public sector banks, particularly at entry level jobs, does not allow public sector banks to attract the best qualified candidates. High quality school graduates are attracted to private sector banks and investment banks that pay multiples of what they would earn in a public sector bank. Twenty-five years ago this was not the case since anyone who wanted to work in the financial industry had no where to go other than the public sector banks. However, today the competitive landscape is completely different.
Banking is all about human capital. The best financial institutions are the ones which can hire and retain the best talents. In my opinion the inability to hire the best candidates is not only hindering the four public sector banks but the development of the entire banking system, since the four banks control the bulk of financial services in Egypt.
The opportunity for growth in the financial sector is large. Egypt is one of the most underbanked societies. It has the lowest banking density among its Mediterranean peers. There is one branch in Egypt for approximately every 45,000 people versus one branch for every 10,000 in Turkey, 5,200 in Greece and 1,100 in Spain. In addition, the retail banking services available for the Egyptian consumer are very limited when compared with services commercial banks offer in Europe and the US.
The financial industry is a service industry. It is a labour intensive industry, and it has one of the highest compensation packages in any economy. So far, the government of Egypt has given high priority to the development of manufacturing enterprises through tax incentives, soft loans etc. I am not aware of any such incentives that exist for financial institutions to develop the financial service industry and convert Egypt into the financial capital of the region.
Financial institutions are actually among the largest employers in most of the countries where they have a strong presence. International financial institutions are attracted to markets with large populations and high quality infrastructure: telephony (voice and data), mail, airports, hotels and roads. For Egypt, it may be worth offering some financial incentives such as tax breaks to financial institutions, encouraging them to select Cairo as their regional headquarters.
Compare the situation with Beirut. There corporate and personal tax rates are 15 per cent, way below the current tax rate in Egypt. Solidere right now is developing a state-of-the art central business district. We also have to keep in mind that it is only 45 minutes from Beirut to Cairo by plane. An ideal environment for the service sector is now being developed in Beirut to position it as a regional service hub similar to New York or London. International firms will be able to attract high international talents to Beirut (personal tax rate at 15 per cent) who in turn will provide the proper training to generations of young, well-educated Lebanese. It is Egypt's challenge to develop the right environment to encourage the financial service industry to establish a regional presence in Egypt and create job opportunities for tens of thousands of young Egyptians.
There is, I think, a misconception about the ownership of the assets of public sector banks. The assets of a financial institution are not the property of the owner. The financial assets are offset against the liabilities of the bank which are predominantly customers' deposits and interbank or long term borrowings. Banks, unlike most companies, are highly leveraged entities and as such their equity base is usually very small. When this issue is taken into account, state ownership of financial institutions is not the ideal tool for governments to develop an economy.
In general, one of the first indicators of a liberalised economy is the ownership of its financial institutions. Investors verify the ownership of the key financial institutions in any market, and their confidence in the market and the political system increases significantly when they realise that the banking industry is mainly controlled by the private sector.
You will not find banks owned by the governments of the US or the United Kingdom. However, financial institutions in both countries drive their economies. If we try to compare how easy it is to obtain credit for the consumer in the US versus Egypt, it is very clear that private ownership actually works to the best interest of the economy and the end consumer.
Private ownership will not be satisfied by a three to five per cent return on equity. They will require returns on equity in the high teens, which will mean more efficient operations driven by high quality employees, and a well incentivised visionary management team. This is in line with what is being achieved by the private sector banks in Egypt.
As far as the government is concerned, the higher returns a publicly traded private financial institution can earn on its equity will be through higher earnings, which means that the government will collect higher tax revenues. It should be a win-win situation for the government and the public.
Without being privatised the public sector banks will be unable to attract the right talents. To expect public sector banks to deliver high returns on their equity and high quality service, they ought to be able to attract and retain the best talents out there. Governments in general are interested in stimulating the economic development and protecting consumer rights by imposing regulations and employing fiscal and monetary policies. For example, the Central Bank may consider requiring financial institutions operating in Egypt to establish an insurance fund to protect customers' deposits up to a certain amount -- let's say LE50,000 -- should one of the financial institutions fail. A step of this sort would increase confidence in the Egyptian financial system and encourage depositors, whether local or international, to keep their deposits in financial institutions in Egypt.
In addition, the government may have to spend more time in presenting case studies to the public on how other countries successfully implemented their liberalisation programmes which are currently driving their economies. The press will have a crucial role to play on this front as well.
* The writer is director of investment banking at Merrill Lynch
