Egyptian banking reforms drives economic growth

07 November 2008
Egypt is not immune to the effects of the global downturn, but Cairo’s overhaul of its banking sector shows the country is well placed to weather the economic storm.

Reform has been the buzz-word in Egypt in recent years, with positive economic growth being accredited to a programme for change set in motion by Prime Minister Ahmed Nazif, in 2004.

Nazif and his reformist government oversaw real growth in gross domestic product (GDP) of 7.2 per cent last year, up from 6.8 per cent in 2006 and 4.5 per cent in 2005.

Nominal GDP grew by 21 per cent year-on-year over the nine-month period ending March 2008, to reach $117.1bn.

More than 100 state-owned firms have been earmarked for privatisation, a programme that brought in $3bn for the year 2006-07, while a rationalisation of the tax code has encouraged more foreign direct investment (FDI), with 27 tariff categories slashed to six.

Egypt attracted $13.2bn in FDI from July 2007 to July 2008, up from $11.1bn during the same period in 2006-07. A large proportion of this FDI was in the oil sector, which saw net inflows of $4.1bn in 2007-08, up from $3bn in 2006-07. Meanwhile, new investors put $6.4bn into Egypt during the same period, compared with $5.2bn a year earlier.

The recent economic reforms have also been praised for easing the regulatory burden of carrying out business in Egypt.

This year, Cairo resumed its place among the top 10 global reformers of business regulations for the third time in four years, according to Doing Business 2009, the sixth in an annual series of reports published by International Finance Corporation, a member of the World Bank.

Cairo also ranked as top regional reformer in the same report published in September this year.

With rankings based on 10 indicators of business regulation, the report states that Egypt has made improvements this year in six of the 10 assessment areas - starting a business, dealing with construction permits, registering property, obtaining credit information, protecting investors and trading across borders. However, observers on the ground say there is still much room for improvement.

“There has not been a huge change, because there is still so much bureaucracy,” says Sara Hinton, managing partner at the Cairo office of UK law firm Trowers & Hamlins.

“It is more that the reforms they have passed have removed a number of irritants that were
in the system, and they have started to introduce regulations in areas where there weren’t any before. You do still need to have access [to the authorities] at high levels, on occasion, to make things work.”

Banking consolidation

However, one area of reform that has been widely praised is the government’s dramatic overhaul of its banking sector.

The number of state-owned banks has fallen from 62 in 2000, to 41 banks today, under the government’s ambitious consolidation plan for the sector.

These reforms were kick-started by the unified banking law passed in 2003, which raised the capital adequacy ratio to 10 per cent from 8 per cent of risk-weighted assets, as well as increasing minimum paid-in capital requirements to $89.4m, from $17.8m.

Aimed at forcing consolidation in the sector, this law has helped eradicate a number of problems dogging the industry - namely, poor asset quality, inadequate capitalisation, low profitability and an unwieldy legacy of non-performing loans.

In order to meet the new requirements, small local banks and poor performers have been spurred into opting for mergers and acquisitions, which has seen the proportion of state-owned banks in the sector fall to 45 per cent from 80 per cent since 2003.

A large number of these acquisitions were by international banks whose appetite for Egyptian banks was further whetted by the new government’s moratorium on new banking licences.

The perceived growth potential of Egypt’s banking sector is illustrated by the calibre of banks that participated in the bids to acquire stakes, including BNP Paribas, Barclays and Societe Generale.

These banks also offered higher premiums in bids over local banks.

“Egypt was really beleaguered in the early years of this decade with underperforming banks,” says Simon Kitchen, vice-president of Economic Research at EFG-Hermes in Cairo.

“The government believes bringing in foreign banks is the best strategy for raising standards and it seems to be serving them well.”

The most celebrated privatisation has been the sale of an 80 per cent stake of the Bank of Alexandria in October 2006 to San Paolo IMI, the Italian bank, which went for $1.6bn - 5.5 times the book value.

The health of the banking sector is illustrated by its strong liquidity. Egyptian banks’ loans to deposit ratio is almost 50-50, according to the Central Bank of Egypt (CBE).

The consolidation trend is driving competition among banks, encouraging them to aggressively expand branch networks and roll out new financial products.

The Bank of Alexandria’s SME loan portfolio has grown by 300 per cent in the past year, while its retail business has increased by 210 per cent over the same period.

Tapping potential

With only 10 per cent of Egypt’s 76.5 million population holding bank accounts, the retail banking sector offers huge unexploited potential, especially given that 63.5 per cent
of the population falls within the working demographic of 15-64 years.

“Retail loan growth has been around 30 per cent a year for the past couple of years,” says Kitchen. “But it has grown from a low base, which explains why it only comprises about 10-20 per cent of most banks’ lending portfolio today.”

This loan growth has mostly been in the form of credit cards and car financing.

Meanwhile, the CBE’s approval of Egypt’s first credit bureau, in August 2005, is expected to boost lending to the small and medium enterprise (SME) sector in the future.

“There has been a lot of talk about the SME segment, but relatively little action up until now because of the difficulty in assessing a borrower’s credit history,” says Kitchen.

“Therefore banks had been deterred from entering this sector because of the expense involved in doing all the detective work necessary for approving loans.”

The Egyptian Credit Bureau, which began operating earlier this year, is also helping to provide broader access to credit that has historically been a problem. In December 2005, figures showed that just 0.19 per cent of banking clients received more than 52 per cent of bank credit.

Another conspicuous area of the banking market that is still in a nascent stage is Islamic finance - currently accounting for only five per cent of the Egyptian banking market.

This is surprising, given that Egypt was the first Middle Eastern country to experiment with this form of financing in the 1960s, and is home to one of the largest Muslim populations in the world - 76.5 million people.

By contrast, Islamic finance is booming in the GCC - despite having a Muslim population of some 34 million people.

Listed Islamic banks in the GCC represent 23 per cent of banks’ total assets.

However, promoting Islamic finance has not been on the Egyptian government’s agenda. With retail banking flourishing in the wake of banking consolidation, the institutions are wholly preoccupied with getting staple products, such as personal loans and credit cards, out into the market.

But many believe that an appetite for Islamic products will increase, once the banking industry has matured. For the medium term, analysts agree that retail banking, SME loans and mortgage lending are going to be the key growth engines for Egyptian banks.

The value of mortgage loans increased from to E£2,087bn in September 2008, from E£1,610bn in September 2007.

While no date has been confirmed for the lifting of the ban on bank licences, it is believed that it will not be revoked until the current banks have been adequately recapitalised.

“It could be a decade, maybe longer,” says Kitchen. “There are still banks they want to sell. Most notably Banque du Caire, as well as a handful of joint venture banks they want to sort out, such as the Arab African International Bank, which is a joint venture between the CBE and the Kuwait Central Bank.”

Egypt’s external economic growth also continued to improve during the 2007-08 financial year. Its balance of payments ran an overall surplus of $5.4bn during this period, up from $5.3bn in the 2006-07 financial year.

The services balance also achieved a surplus of $15bn during 2007-08, compared with $11.5bn a year earlier. This was attributable to a 32.3 per cent increase in tourist revenues to $10.8bn, and Suez Canal proceeds picking up by 23.6 per cent to $5.2bn.

The canal has benefited from a surge in global trade powered by China and India, capacity problems with the Panama Canal and higher oil prices and global shipping costs, which are forcing shippers to take shorter routes.

Rising inflation

Such positive growth across a wide range of sectors has translated into a better quality of life for Egyptians as the per capita GDP rose at 16.8 per cent cent year-on-year to $1,706 in 2006-07, from $1,460 in 2005-06.

However, soaring inflation has diluted the benefits of this growth. Inflation peaked in August at 23.6 per cent, and was running at 21.5 per cent in urban areas in the year to September - food riots have been just one visible result of the effects of high inflation on Egypt’s consumers.

However, it seems unlikely that such high rates of inflation will be sustained beyond the end of this year.

“I expect inflation to average out to 15-17 per cent for 2009,” says Ahmed Kamal Selim, managing director of Delta Rasmala Investments.

“The Consumer Prices Index (CPI) was very low in 2007, so when this rose sharply on the back of higher prices in different sectors in 2008, inflation became very high. But because the index was very high in 2008, the CPI change in 2009 is going to be a lot smaller, which will lead to a decline in inflation.”

Financial problems were further stoked by the government’s decision to pass a bill on 5 May, stating that companies operating in the country’s free zones would no longer be exempt from corporation tax, and that it was cutting subsidies on fuel used by energy-intensive industries, has also been widely criticised for undermining investor confidence.

The laws were introduced with immediate effect, which meant that overnight foreign investors were stripped of their tax holidays and saddled with an increase in fuel price.

The negative implications of these announcements were further compounded by the unravelling global financial crisis, forcing foreign investors to sell their shares on the Cairo and Alexandria Stock Exchange (Case), in order to cover their losses elsewhere.

This unnerved local retail investors who, accustomed to consecutive years of positive growth reaching levels of 100 per cent some years, started panic selling, sending the Case into freefall.
By September this year, the Case 30 index, comprising the 30 largest listed companies on the exchange, had fallen by 42 per cent since its peak in early May.

“That was an extremely troubling decision and I do not think we have fully seen all the ramifications,” says Hinton. “A lot of the companies in the free zones have megaprojects under way that could run as long as 20 years, so the tax breaks were an integral part of their business model. Not only that, but they weren’t even given any notice to prepare and hedge against any possible negative impact these changes would have.”

Others have been more sympathetic to the government’s announcements in May, which were part of a government bill that aims to raise $3.6bn, in order to help finance the 30 per cent public sector salary increases it has had to make as a result of soaring inflation.

“Commodity prices have gone up by 200 per cent, and Egypt is a heavily subsidised country with about 17-20 million of Egypt’s population living at the subsistence level,” says Selim.

“Increasing corporate taxes was not an option, nor was reducing subsidies, which would have led to social unrest. The easiest of [all] the options was to hit the big corporate guys, who were enjoying huge profit margins, without killing the whole economy.”

Key fact:

210% - The growth in the Bank of Alexandria's retial business in the past 12 months

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