Foreign currency liquidity returns to bolster Egyptian banking sector

Having come through Egypt’s worst economic crisis in decades relatively unscathed, its banks are ready to reap the medium- and long-term benefits accruing from the country’s dramatic rescue by Abu Dhabi’s sovereign wealth fund, ADQ, and the IMF.

Long-standing concerns over the mechanisms of a long-anticipated, further devaluation of the Egyptian pound — seen as a necessary step to attract sorely needed foreign currency investment — were dramatically put to bed in late February with ADQ’s announcement of a $35bn investment in the coastal real estate project of Ras al-Hekma.

The additional investment enabled the Central Bank of Egypt on March 6 to let the currency devalue by 40 per cent, closing the gap between official and black market foreign exchange rates, while raising interest rates by 600 basis points in a bolder-than-expected move against the country’s soaring inflation.

These moves, in turn, triggered a fresh $8bn deal with the IMF — the country’s fifth in 10 years — with Egyptian authorities agreeing to let the pound float freely, cut back on wasteful projects and reduce government involvement in the economy in favour of the private sector.

While the government’s commitment to reform remains to be seen over the medium term, recent events have already seen foreign currency liquidity return to the market, to the immediate benefit of the banking sector.

“Over the past 18 months, the sector didn’t have sustainable [foreign currency] flows, leading to significant issues when it came to trade finance,” says Monsef Morsy, co-head of research at CI Capital in Cairo.

“There’s already been a pick-up in interbank foreign currency liquidity, which is positive for the sector as a whole.”

Dollars retreat

Egypt’s economic crisis began with Russia’s invasion of Ukraine in February 2022, nearly two years to the day before the announcement of the Ras al-Hekma development. Having relied heavily on hot money inflows from international portfolio investors for its foreign currency needs — lured by the country’s attractively priced short-term debt — the conflict prompted the withdrawal of more than $20bn in the following months.

Three devaluations of the Egyptian pound and six interest rate rises over the following 18 months had little impact on either foreign currency reserves or inflation, which peaked at 37.9 per cent in September 2023.

Despite severe restrictions on trade finance and government controls on foreign currency dealings — the CBE last year introduced restrictions on hard currency withdrawals and foreign credit card purchases — Egyptian lenders’ finances have remained in a healthy state.

“As elsewhere, banks in Egypt have benefited from the higher interest rate environment, with most lenders reporting record earnings for 2023, thanks to higher yields on government securities,” says Elena Sanchez-Cabezudo, head of financials equity research at EFG-Hermes.

The country’s two largest banks, state-owned National Bank of Egypt and Banque Misr, both saw profits rise by around 120 per cent in the nine months to end-September 2023, with net interest income increasing by 13 per cent and 120 per cent, respectively, during the period. Commercial International Bank, the country’s largest private lender, reported a 78 per cent rise in profits for 2023, with net interest income rising 65 per cent.

On the eve of the devaluation on March 6, most bank ratios were in decent shape, according to Sanchez-Cabezudo.

“The amount of deposits utilised as loans is quite low compared with other markets, with the loan-to-deposit rate standing at about 40 per cent for the sector. Net interest margins are at an all-time high, and solvency and capital adequacy ratio are also pretty strong,” she adds.

“Throughout all the devaluations of the past 10 years, banks’ asset quality has not been adversely impacted, so there is unlikely to be a significant deterioration this year, given that banks’ corporate customers have been using parallel rates that have been much higher than official rates for some time now.”

Capital concerns

Capital adequacy remains a slight concern following the March 6 devaluation, given banks’ high exposure to sovereign debt. In a mid-March note, Fitch Ratings highlighted that the banking sector’s common equity Tier 1 ratio declined by 140bp, partly driven by currency depreciation, when the Egyptian pound weakened by around 40 per cent against the US dollar in 2022.

“We estimate a 10 per cent move in the exchange rate (to US dollar) results in about a 30bp change in Fitch-rated banks’ average capital ratios,” the agency said.

The devaluation’s impact on capitalisation is set to be limited, especially for private sector lenders, argues Morsy.

“Most banks have been very active in raising Tier 2 capital denominated in foreign currency to hedge against any future local currency devaluation,” he tells The Banker.

“What’s more, the positive impact on profitability from higher interest rates will help banks absorb any negative impact on their capitalisation levels.”

Fitch noted that while National Bank of Egypt and Banque Misr’s capital ratios “have been hurt” by the devaluation, they likely remain in compliance with minimum regulatory capital requirements set by the CBE, with the improved profitability at the two lenders last year supporting core capital build up. The government is likely to step in and bolster capital buffers if necessary, the agency said.

Foreign liquidity returns

Crucially for the country’s economic development, the Ras al-Hekma investment, the first tranche of which arrived in mid-March, has paved the way for the return of foreign currency liquidity to the country’s banking system, which has already begun to positively impact banks’ operations.

“The foreign currency orders that had accumulated at our end for weeks have now been mostly cleared,” Mohamed Abdel Kader, country head for Citi in Egypt, tells The Banker, referring to the situation in mid-March.

“This is good news for the market in that we’ll see pricing of foreign currency based purely on supply and demand.”

While a key condition of the IMF’s most recent programme is for Egypt to move towards “a credible flexible exchange rate regime”, similar promises made by authorities during previous IMF deals have not been kept, with the government being reluctant to withdraw support for the pound.

As The Banker went to press, however, the CBE’s floatation of the pound appears to be genuine.

“Ahead of the Ras al-Hekma deal, the CBE didn’t have the financial firepower to comfortably move to a new floating [foreign exchange] regime,” Morsy explains. “Now that they have that firepower, I think the authorities will be more inclined to stick to the plan that was agreed with the IMF, to let the pound float freely.

“It’s something that everyone will be monitoring in the coming weeks, but so far it seems as if the authorities have learned their lesson and have let the exchange rate be dictated solely by market forces.”

Portfolio investors are back

Significantly, the combination of the Ras al-Hekma deal and the events of March 6 have thus far proved a virtuous circle in terms of foreign currency liquidity for the banking sector, with ADQ’s investment monies likely to be supplemented by the return of both foreign portfolio investors and overseas remittances.

After taking flight at the start of 2022, portfolio flows have begun to flow back into Egyptian debt following the March 6 devaluation. Morsy notes that a treasury bills auction in mid-March recorded a significant increase in interest from foreign portfolio investors, leading to a 2 per cent fall in yields.

Two years on, such flows play a very different role in terms of government finances.

“The situation is very different compared with 2021/22, in that the portfolio funds this time act as a supplement to the CBE’s [foreign currency] reserves rather than their main source,” says Citi’s Abdel Kader.

“There isn’t the same dependence on such flows as there was previously; instead they give the CBE more muscle to act.”

Another net positive for the banking sector would be the resumption of growth in inward remittances, which fell 30 per cent in 2023, according to Fitch.

“If recent developments increase confidence that further large-scale devaluations are unlikely in the near term, as we expect, remittance inflows could rise, further supporting banks’ foreign currency liquidity,” the agency said.

“Accordingly, we believe the banking sector’s net foreign liability position of $17.6bn at end-January 2024 represents a trough and that the position will narrow significantly in 2024.”

Lending outlook

While increased foreign exchange liquidity will provide a boon for lending, credit growth is set to be constrained by higher interest rates, which, while likely to fall from 2025 onwards, are set to remain at elevated levels for some time to come.

Abdel Kader notes that three-year certificates of deposit issued by state banks in recent weeks, which are geared towards retail investors, pay out interest rates of 30 per cent for the first year, followed by 25 per cent in the second year, dropping to 20 per cent in the third year.

“Such pricing indicates how the central bank sees the interest rate trajectory,” he says.

“We see the high interest rate as a temporary phase to tackle inflation. There will be pressure on businesses in 2024, but the outlook for 2025 is more positive.”

Loan volume growth is set to slow in 2024, with retail lending set to be most impacted, Morsy notes.

“Of course, higher interest rates will see NIMs rise, which will boost profitability, but at the same time, lending growth will inevitably slow across the board,” he says.

The outlook for corporate lending is less pessimistic, however.

“In spite of higher borrowing costs, the greater availability of foreign exchange at the inter-bank level, at a cheaper rate than was previously available on the parallel market, may well boost corporate lending,” Morsy adds.

Such a trend may well become more pronounced in 2025 for private banks if Egypt’s positive economic trajectory continues.

“Beyond 2024, lower inflation and rates, a functioning [foreign currency] interbank market and stronger corporate confidence will bode well for a pickup in investment loans and for changes in CIB’s asset mix,” Sanchez said in a mid-March note to clients.

Even for the small and medium-sized enterprise market, the picture is not unreservedly bleak, according to Morsy.

“SMEs are always most vulnerable to major macro events, so are likely to be among the worst affected in the short term,” he says.

“Until recently SMEs have had to rely on the parallel market to source [foreign currency] at higher rates. The availability of [foreign currency] should have an overall positive impact on the market, including SMEs.”

Beyond the increased foreign currency liquidity it brings, hopes are high that Ras al-Hekma and other similar projects will further stimulate activity in Egypt’s private sector, which has been subdued for several years in the face of weak growth in the wider economy, and the increased crowding out of private sector operators by a growing number of state-affiliated companies.

“Banks stand to benefit from any increase in private sector investment within the wider economy these deals unlock, which has been quite subdued for a number of years,” says Sanchez.

“They also stand to benefit from financing contractors that are going to work on the Ras al-Hekma project, although this may have more of an impact in 2025 than 2024.”

Privatisation reborn?

Also back on the agenda following Ras al-Hekma is the prospect of the restarting of the government’s long-mooted privatisation programme, which has once again been listed as a priority by the IMF, with banks near the top of prospective investors’ shopping lists.

Egypt’s finance minister said in February that the country is planning to raise $6.5bn from the sale of stakes in up to 35 state-owned firms in 2024, after having raised $5.6bn via the sale of stakes in 14 companies last year.

As part of $1.85bn worth of investments across a series of companies announced in April 2022, ADQ acquired a 17 per cent stake in CIB for $910mn, the largest merger and acquisition transaction in the financial services space in Africa of the year.

Yet the sale of stakes in other lenders, including Union Bank, Banque du Caire and Arab African International Bank, has not yet materialised, in no small part due to past concerns over the value of the Egyptian pound and wider economic uncertainty.

News reports in February 2023 suggested that Saudi Arabia’s Public Investment Fund was on the brink of acquiring Union Bank, formed by the CBE in 2006 from the merger of three lenders facing bankruptcy. Yet the deal fell through over disagreements on price.

The more secure economic outlook makes such sales far more likely in the near future.

“It should be much easier now for the government to proceed with their asset sale programme across the board,” Morsy adds.

“The banking sector is one of the most attractive sectors for regional and international investors, so we may start to see transactions in this space quite soon.”

Bloomberg reported in late-February that Qatar Islamic Bank and Kuwait Finance House had both completed due diligence on United Bank, with sources suggesting the value of the acquisition could reach approximately E£22bn ($467.5mn).

QIB and KFH were approached for comment.