Credit downgrades: Compounding the challenges, international ratings are lowered

In November 2011 Moody’s ratings agency downgraded five of Egypt’s largest banks, attributing its decision to concerns surrounding their exposure to sovereign debt and the ability of the transitional government to support the banking system in the event of a significant deterioration of their position. The development came as a reminder that, despite relatively robust performances in the wake of the political turmoil which began in January of that year, Egypt’s banks are subject to economic forces and political currents beyond their control, both of which are likely to influence the sector in the medium term.

ECONOMIC INTERRUPTION: On the economic side, the uprising of January 2011 significantly altered the debt structure of the Egyptian banking sector. According to Akram Tinawi, the CEO and managing director of the Arab Banking Corporation, “Egyptian banks have large exposure to the tourism industry, which is suffering now, and the industry focus will shift to sectors that are doing well, such as oil and gas, health care, or infrastructure.” This impairment of some of the nation’s most important revenue streams and an interruption of what had been a rising trend of foreign investment in the years prior to 2011, resulted in a budget deficit for the 2011/12 fiscal year equivalent to some 10% of GDP. The country’s foreign reserves, while providing a useful buffer during the crisis, had fallen to around half their pre-revolution levels by the end of 2011, and by the end of May 2012 stood at just $15.2bn. The transitional government, therefore, has turned to the domestic sector in its attempt to meet the shortfall.

As a result of the government’s efforts, Egyptian banks’ sovereign debt holdings increased to 550% of equity over 2011, from the 430% recorded at the close of 2010. Moreover, this trend continued into 2012, with Central Bank of Egypt (CBE) data showing that aggregate net claims on the government for the sector climbed from LE534bn ($89.4bn) during January 2012 to LE553bn ($91.6bn) later that March.

The most obvious effect of this trend was to link the credit profiles of some of Egypt’s best-known lenders directly to the credit risk of the sovereign, and it therefore came as little surprise that the downgrade of both the local currency and foreign exchange deposits of the National Bank of Egypt, Banque Misr, Banque du Caire, Commercial International Bank and Bank of Alexandria followed the decision a week earlier by both Moody’s and Standard & Poor’s to downgrade the debt of the Egyptian government. Similarly, the decision in January 2012 by Fitch to downgrade the long-term foreign currency ratings for the National Bank of Egypt, its subsidiary National Bank of Egypt (UK), and Commercial International Bank followed its reduction of Egypt’s foreign and local sovereign ratings the previous month. The downgrade of the banks, as the ratings agencies pointed out at the time, was an automatic result of the downgrade of the sovereign.

“Banks are increasing their risk as they lend to the government – often at high interest rates – because the government’s creditworthiness has been downgraded,” Jean-Philippe Coulier, the managing director of National Société Générale Bank, told OBG.

PLAYING POLITICS: On the political side, downward rating pressure has resulted from the political turbulence, which has delayed the economic recovery. Despite budgetary challenges before the revolution, many in the sector told OBG that the current economic crisis is purely political in nature. “The financial sectors have been suffering from a political situation, not an economic one. Egypt does not have major fundamental macroeconomic issues like Greece does,” Maged Fahmy, the chairman of Export Development Bank, told OBG.

A transitional government installed after the departure of former President Hosni Mubarak faced difficulties securing international funding. Most notably, a $3.2bn facility offered by the IMF in the weeks after the uprising did not receive broad political backing in the domestic sphere. The clarity brought by parliamentary and presidential elections, meanwhile, has been undermined by an opaque process of constitutional reform, which has raised questions surrounding the authority of both institutions.

To many in the sector, the transitional government, which was in place for much of 2011, was distracted by the unfolding political situation at the expense of the nation’s balance of payments. “The budget deficit is particularly worrying because there are only two and half months of reserves, yet the politicians seemed more focused on burning social issues than both the strategic and immediate needs of the economy,” Hatem Sadek, the chairman and managing director of Bank Audi in Egypt, told OBG.

Those banks which have escaped ratings downgrades have done so for a number of reasons, most notably a higher cross-border operational diversification and low balance sheet exposures to government debt. Banks operating in Egypt as part of multinational groups frequently follow group policies on sovereign debt exposures. While these banks saw the performance of their Egyptian units adversely affected in 2011 by an elevated cost of risk, increased taxes and charges, and a challenging economic environment, their credit profiles have not become a cause for concern for the ratings agencies.

LOOKING AHEAD: Given the uncertainties that attend Egypt’s political and economic transition, the actions of the three ratings agencies are unlikely to be reversed in the short term. In early 2012, the ratings agency Moody’s extended the review for a possible downgrade of Egypt’s B2 sovereign debt ratings. The anticipated follow-on regarding those Egyptian banks with credit profiles closely linked to the sovereign came in April, with the ratings agency extending the review for downgrade of the local currency and foreign currency deposit ratings of the five banks it downgraded in 2011. Then in May Moody’s announced that its outlook for Egypt’s banking system remained negative, in part due to their high and increasing exposure to Egyptian government securities and government-related instruments.

In September 2012 Moody’s announced that it was confirming its B2 government bond rating and maintaining its rating outlook at negative. At the same time, the ratings agency confirmed its country ceilings for foreign and local currency deposits, at B3 and Ba1, respectively. According to Moody’s, the key drivers in its decision were reduced political uncertainty, stabilisation of the country’s external payments position, progress in the stabilisation of government financing and macroeconomic conditions, and a formal request by the government for IMF support. Indeed, optimism seems to be growing regarding a deal with the IMF, with yields on short-term government debt falling in September 2012.

A DEBATABLE OFFER: A successful conclusion to the protracted negotiations over the IMF’s offer of funding would represent a significant step forward in terms of improving Egypt’s balance of payments, which would reduce the government’s need to generate financial backing from the domestic banking sector. While the most recent $4.8bn offer is dwarfed by the $22.5bn required to finance the fiscal deficit in the 2012/13 state budget, the imprimatur of the IMF will have a positive effect on the perception of Egypt as a borrower nation and open the door to yet more funding from international organisations such as the African Development Bank and the GCC. “The biggest concerns of the banking sector and the general economy are the sovereign risk and declining reserves. The IMF loan is expected to set a solid standard for international investors to enter the market and boost confidence,” Francois Edouard Drion, the managing director and senior country officer at Crédit Agricole Egypt, told OBG.

OPTIMISTIC PROSPECTS: While some banks in the sector remain at risk of further downgrades until a reduction of their exposure to government securities is brought about, they are sanguine about their prospects in the potentially turbulent short term. “Compared to other countries in the region, Egypt’s revolution concluded with minimal damage to infrastructure and other key segments of the economy. The fundamentals of the banking sector remain strong and will be able to rebound from any shocks to the system,” Mohamed Abbas Fayed, the vice-chairman of Banque Misr, told OBG.

In the meantime, banks awaiting a review of their credit ratings remain upbeat about their positions. “We view this time as an opportunity for growth, especially compared to multinationals that are constrained by their head offices. The government is crowding out corporates with T-Bill sales to some extent, but not completely. If there are good private sector propositions out there we will still service them,” said Rashwan Hammady, the head of strategic planning at Commercial International Bank. The trade-off for some banks may be depressed ratings for more freedom of movement within the market.