In the current economic climate, the Egyptian government has had to tone down its ambitions for the sale price of state-owned Banque du Caire (BDC), despite the attention of five rival bidders. Even so, BDC's move from the public to the private sector sends out a clear signal about the future direction of economic policy.

However, this message has been greeted with unease in Egypt, far beyond the confines of the banking market, because of the bank's distinctive history.

For more than five decades, the locally owned BDC played a vital role in sustaining economic activity and driving forward the agenda of the then-president Gamal Abdel Nasser. In 1956, it stepped into the breach when UK and French banks refused to finance the cotton crop, after the nationalisation of the Suez Canal.

The following year, it took centre stage once again, taking over the French-controlled local offshoot of Credit Lyonnais and the Comptoir National d'Escompte de Paris under the policy of 'Egyptianisation'.

Yet currently, in defiance of protests from across the political spectrum, Prime Minister Ahmed Nazif has it made it clear that traditional nationalist sentiment will not be allowed to stand in the way of modernising the banking system, even though that means transferring an institution of BDC's significance to foreign ownership.

Even the usually liberal Wafd party has come out in opposition to this particular sale. Yet Nazif is unmoved. At last month's Middle East forum in Sharm el-Sheikh, he confirmed there were five shortlisted bidders and the government wanted the sale completed in June or July. Ministers' determination to move ahead with the sale has been bolstered by the encouraging precedent set by the Bank of Alexandria (Alexbank), an 80 per cent stake of which was sold to Intesa SanPaolo, Italy's leading bank group, for $1.6bn in 2006.

The government provided a valuable dowry, recapitalising Alexbank and taking over the 80-90 per cent of its loan book that was non-performing. This allowed the Italians to take over what amounted to a skeleton institution with a low level of asset exposure and then relaunch its business with a careful approach to new lending, in line with mainstream Western standards. There has been a clear improvement in performance since becoming privatised.

This has not been the only privatisation. Misr International Bank has been sold to Societe Generale, Egyptian Commercial Bank to Piraeus Bank (Greece), Egyptian American Bank to Credit Agricole and Al-Watany Bank (AWB) to National Bank of Kuwait (NBK).

Large foreign banks are regarded by the government as a useful source of new capital and expertise for the financial sector. The Central Bank of Egypt has encouraged the process by not issuing new banking licences.

This has effectively forced international banks with ambitions to secure a percentage of the Egyptian market - with its huge potential as the most populous country in the Middle East, with 80 million people - to take over existing local banks rather than set up new operations. "The government has decided that a strong banking sector is an important parameter for the development of the economy," says one leading bank ratings analyst.

"The public banks have been performing poorly over a number of years in terms of asset quality, capitalisation, bureaucratic habits and the quality of their systems. All these issues are being addressed under the banking restructuring programme. That said, the state-owned banks are still performing less well."

Another industry source makes similar criticisms. "There are good credit people in some of the private banks such as Commercial International Bank (CIB) or Egyptian American Bank, but in the public sector that sort of expertise has never been developed."

In publicly owned banks, loans are often 'rubber stamped' without rigorous analysis, says the source. There have been scandals over businesses' use of questionable connections to obtain unjustifiably large loans from state banks.

Faced with these problems, the government has pursued a multi-pronged strategy to strengthen the industry. The key themes are consolidation, privatisation, cleaning up loan books, restructuring the publicly owned commercial banks and enhancing the capacity of the central bank to monitor the performance of financial institutions. The central bank has noticeably improved its regulatory effectiveness over the past few years.

This does not mean all state-owned institutions will be sold off. Banque Misr and National Bank of Egypt - a major player, accounting for 24.2 per cent of the deposit market and 23.3 per cent of all loans - will remain in the public sector, for now at least. But the broader direction of policy, in favour of the private sector, is clear. There is empirical evidence to support it, in the performance results from major private institutions such as CIB, which have done particularly well over the past two or three years.

However, the business conditions facing Egypt's bankers could now get tougher as inflationary pressures increase, leading to a squeeze on consumer spending and saving capacity. One year ago, the prospects for growth and earnings at Egyptian banks looked buoyant; today, the outlook is less positive.

Economic uncertainty

All the evidence suggests it is the established private sector institutions that will withstand the present conditions best.

Combined with the longstanding challenges of operating in an economy as complex as Egypt, the new climate of economic uncertainty may induce caution among the local offshoots of US and European institutions, says one analyst. Some may conclude that this is the time to consolidate rather than seek to further expand their product range or their customer base.

Citibank was caught out after vigorously promoting credit cards on competitively fine margins. Since then, like HSBC, it has been growing organically and continuing to develop card services and consumer finance, but at a careful pace.

"For the Egyptian market, you have to have a long-term view," says one industry observer. "If you try to get in and make a killing, you will burn your fingers. I cannot really think of a Western bank that is desperate to get a share of the market."

But Arab banks, with abundant revenues from the oil boom, may well feel they can still continue to look for growth opportunities. In particular, for banks based in Arab countries with much smaller populations such as Jordan, the Gulf states or even Saudi Arabia, the opportunity to market their consumer finance products to Egypt's large audience remains a powerful incentive.

Regional interest

That explains why Emirati, Saudi and Jordanian institutions are all competing to acquire BDC, and why NBK has already entered the market with the acquisition of AWB, confirmed in April.

"Egypt is the largest market in the Arab world, with great growth and investment opportunities in all sectors, and I am glad to see Egypt accelerating the pace of its privatisation programme," said Ibrahim Dabdoub, chief executive officer of NBK, at the time of the deal. "We in the GCC should seize this opportunity. It is also the time for Egypt to be closer to the Gulf."

Moreover, this is not just about moving into a new market. The takeover will also allow NBK to service the already large market of bilateral business and personal connections. More than 400 Kuwaiti companies and organisations, many of them existing clients of NBK, have investment and business activities in Egypt, while more than 400,000 Egyptians live as expatriates in Kuwait and need to remit money to their families or use other financial service links to their home country.

For NBK, the acquisition of AWB provides a significant entry into Egypt. The bank has 26 branches and £E12.4bn ($2.32bn) in assets.

But according to one industry observer, investment in the Egyptian banking market is not without risks for newcomers.

The Egyptian business and consumer-lending environment is more complex and, to a large extent, less affluent than Gulf States. "When you are a financial institution with shareholders, you are under pressure to start lending and make money," argues the industry observer.

However, he adds a note of caution. "Foreign banks don't understand that Egypt is different and needs patience. The risks are large and it is a complex market. Egypt is much more difficult and complex than less populous Arab countries - which means that credit skills need to be doubly efficient and strong.

"There are niche areas where foreign banks can carve out a role, such as trade finance, and mergers and acquisitions. But these are not sufficient to sustain a business. They are not reliably there. The only niche is what private sector banks do, focusing on the upper-middle class where the risks are lower."

But to attract such desirable customers, banks must offer what they need. For incoming investors, that should mean emulating the example set by Egypt's most successful private sector banking companies.

CIB is one example of a well-targeted private sector bank. Over the past few years, it has gradually developed in the personal and corporate markets, says the international ratings agency analyst. "It truly understands the risk," he adds.

One area that offers great but challenging potential, considering Egypt's social structure, is the development of services catering for less affluent people. Traditional ideology assumed that state-owned banks would meet the needs of poorer people but they have not been that effective, preferring to rely mainly on the captive market provided by public agencies and parastatal companies for their earnings flow .

Economic uncertainty

Indeed, despite its vast national population, personal lending accounts for only 10-15 per cent of the publicly owned banks' business. This leaves room for newcomers to develop a well-run basic banking and micro-credit operation for the many Egyptians who live effectively at subsistence level. This has been done in other economies with large low-income populations such as K-Rep in Kenya and, most famously, by Grameen Bank in Bangladesh.

This area of business is starting to develop in Egypt. But there is clearly more room for growth in this area. On the other hand, there are also risks and banking for the less affluent has to be carefully managed.

In current conditions, the many households who must spend half their total income on food are under pressure because of price rises. Their ability to save or to service loans is desperately constrained and despite the will to grow business in this sector, it will remain difficult in the current climate.