Reserves required: Dealing in a demand-driven market

When the Central Bank of Egypt (CBE) announced in March 2012 that it would lower the reserve requirement for local currency deposits to 12% from 14%, the market showed its approval instantly. The following day financial stocks on the Egyptian Exchange (EGX) led a 1.07% rise in the benchmark EGX30 index, on the prospect of fresh capital being made available, with the Commercial International Bank, Egypt’s largest private bank by assets, and investment bank EFG Hermes making gains of 2.99% and 3.47%, respectively. The rationale behind the CBE’s decision, according to its public announcement at the time, was to “provide permanent liquidity into the banking system and help ease credit conditions in the market”.

LIQUIDITY INJECTION: The question of liquidity had grown in importance in the weeks prior to the CBE’s move. Months of political uncertainty in the wake of the January 2011 revolution had effectively priced Egypt out of the international bond market, compelling the Ministry of Finance to turn to the domestic banking sector in order to bridge an increasingly wide funding gap vis-à-vis the state budget.

Local banks, faced with significantly reduced borrowing demand in a challenging economic environment, cooperated with enthusiasm – but at a price: as 2011 unfolded, yields on government bonds and treasury bills rose inexorably. By the close of the year, public banks increased their holdings of treasury bills by approximately 34%, according to CBE data, but by the time the CBE decided to cut local currency reserve ratios, yields had reached almost record levels. Relying on local banks to fund the national budget was turning into an expensive exercise. It also brought with it a pernicious side effect, in the eyes of some analysts, because it caused the private sector to be squeezed out of the tight liquidity market.

The government’s aim in cutting the local currency reserve in order to inject liquidity into the system was, therefore, twofold: to ease the pressure on its sovereign yields – thereby securing a cheaper means to finance the budget – and to free-up more liquidity for the private sector, which had to some extent been crowded out of the market.

YIELD CHALLENGES: The strategy met with some success, at least in the short term. During April 2012, Treasury auctions saw yields decline as the banks directed the excess liquidity produced by changes in the reserve ratio into treasury bills.

However, by the following month the liquidity injection had largely run its course, and yields began to climb once more. An auction on May 3, 2012 saw Treasury yields climb across the board: 182-day bills rose from 14.895% the previous week to reach 15.007%; while 357-day bills climbed from 15.554% to 15.748%. Missed sales targets provided another point of concern. Less than half of the 182-bills were taken up, while only two-thirds of the 357-day tranche found buyers. The period during which treasury bond sales had been both well covered and characterised by falling yields had come to an end all too quickly.

EFFECTS ON LENDING: The altered reserve rate’s effect on lending to the private sector is slightly harder to discern. According to central bank figures, lending to private businesses in Egypt by public banks fell between June 2010 and June 2011 from LE326.4bn ($54.6bn) to LE323.2bn ($54.1bn) – a drop of nearly 1% which has been attributed to the interruption to business caused by the unrest that year.

Thereafter, lending levels to the private business sector remained relatively static, showing a small increase by March 2012 at LE323.9bn ($54.2bn). This, however, contrasts with the steep rise in claims on the private business sector seen between 2007 and 2010, which saw a rise in credit extended of 21.5%. While economies across the region have seen a significant slowdown in lending in the wake of the global economic crisis and Egypt’s GDP forecast had been reduced to 1.5% for 2012 by the International Monetary Fund after the 1.8% showing of 2011, some industry observers maintain that the government’s reliance on local banks for funding continues to inhibit loan growth in the private sector.

SLOWING DEMAND: Many in the banking industry view the situation differently. Answering the charge that banks have become risk averse following the economic crisis and that the attractive yields of sovereign debt represent a safe and lucrative option at the expense of the private sector, many point to lack of demand as the reason for stagnant loan growth.

“During the second half of 2011, demand for new loans decreased dramatically on the corporate side,” Bruno Gamba, the chairman and managing director of AlexBank, told OBG. The drop-off in demand is not simply a function of the local market. “The problem at the moment is not one of liquidity, but that there is hardly any new investment coming in,” said Rashwan Hammady, head of strategic planning at Commercial International Bank. Net foreign direct investment (FDI) fell by 124% in the first quarter of 2011, according to the CBE, a net negative figure which was the result of a $1.97bn outflow following the political unrest of that period. The FDI of $218m for the nine months to March 2012 compares to $2.1bn over the same period in 2011, according to CBE data, and many of the joint ventures with international firms which accounted for a significant proportion of domestic private sector demand for credit have been put on hold. “We became one of the first players to sign a public-private partnership agreement with the government and a private firm, but this has all stopped for now,” Sameh Badry, the deputy chief financial officer of the financial division at National Société Générale Bank, told OBG. “There is an absence of big ticket lending at the moment.”

ROOT CAUSE: Those that point to a lack of demand in the market generally subscribe to the view that Egypt’s lending market is demand-driven rather than supply-driven, and that slow loan growth is the obvious corollary of flat or negative FDI and a significant reduction in domestic investment. The efficacy of further liquidity injections into the market is therefore moot. On May 22, 2012 the board of the CBE met and decided to reduce the reserve ratio for local currency deposits again, this time from the recently prescribed 12% to 10% – a reduction of 200 basis points. The rationale upon which the decision was based, “to further ease credit conditions in the market and provide additional permanent liquidity into the banking system”, was similar to that of the first ratio change.

The measure came into effect on June 26, 2012 and the third- and fourth-quarter results for the year will reveal its effect on both T-bill yields and private sector lending. However, the results of the earlier ratio adjustment suggest that a more fundamental shift in the economic environment is the real answer to rising Treasury yields and incremental loan growth.

“The fundamentals are there: a large population with a low level of banking and positive fourth-quarter GDP in 2011 – which was good, under the circumstances. International reserves can be recovered once the political situation stabilises,” said Badry.