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10/01/2009

Egypt Delivers Impressive Results, But with Risks


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FROM SOCIALIST TO QUASI-LIBERAL ECONOMICS | ECONOMIC STRUCTURE | EQUITY MARKETS | HIDDEN RISKS BENEATH THE SAND

Egypt—land of pyramids, sphinxes, and pharaohs—is changing with the times. Political and economic liberalization in the 1990s and 2000s has made Egypt an exceptional frontier market that is still worth investigating as part of an asset allocation. Although equity performance has been extraordinary and the chronic currency devaluations of earlier years have largely passed, investors should be aware of the political risks stemming from Egypt’s authoritarian political structure, aging president, highly unequal wealth distribution, and fundamentalist social movements.

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FROM SOCIALIST TO QUASI-LIBERAL ECONOMICS

A truly independent Egypt first emerged in 1952, when military officers overthrew the British-supported King Farouk and declared a republic. Gamal Abdel Nasser, who had been instrumental in organizing the coup, emerged as the revolution’s charismatic leader, serving first as prime minister and then as president from 1956 until his death in 1970. Nasser quickly aligned himself with the Soviet Union, primarily to counter residual British interests in Egypt and to support his nationalization plans, but also to counterbalance Israel and its close relationship with the US.

Nasser declared Egypt a socialist state, nationalized the Suez Canal and other foreign industries, and began organizing the economy along socialist lines, complete with five-year plans, large state-owned enterprises, and extensive controls on prices, international exchange, investment, and other aspects of business life. Nasserism stopped short of full Communism, however, leaving about two-thirds of the economy in private hands. In addition, the Communist Party was outlawed because it had become a focal point for political opposition.

Nasser’s successor, Anwar el-Sadat, realigned Egypt away from the Soviet Union toward the US and modestly liberalized the economy, while maintaining its overall socialist character. Sadat signed a peace treaty with Israel in 1979 as part of this political-economic shift and as a result was assassinated two years later. The assassination brought current president Hosni Mubarak to office, and the immediate result was a series of emergency measures primarily aimed at restricting political activities and the opposition, but these controls also spilled over to affect businesses. Many of those emergency measures remain in effect today.

In the 1990s external pressures resulted in some economic liberalization, and relaxing restrictions in the economic sphere was also seen as a way to disempower the fundamentalist Muslim Brotherhood and offer society a nonreligious vision for national prosperity. In 2004, in response to slowing growth and rising inflation, the government ratcheted up its economic liberalization program substantially, dramatically reducing red tape, allowing a more freely floating currency, and greatly reducing the tax burden on businesses. These changes succeeded in increasing GDP (gross domestic product) growth and had a dramatic effect on the Egyptian stock market, but, as shown in Figure 1, the changes only lowered inflation rates temporarily.

Figure 1: Egypt’s Annual GDP Growth and Inflation (1981–2008).

Egypt’s Annual GDP Growth and Inflation (1981–2008)

Source: Economist Intelligence Unit (accessed August 10, 2009).

Figure 2 details the evolution of the Egyptian GDP over the last three decades and shows the dramatic effect of the reforms starting in 2005. Foreign trade, both imports and exports, increased substantially and business investment also grew markedly. Egyptian consumption has remained relatively constant over time, suggesting that GDP growth is being used primarily to improve productivity rather than to simply fuel consumption, which bodes well for Egypt’s future growth.

Figure 2: Evolution of the Egyptian GDP by Category (1980–2008).

Evolution of the Egyptian GDP by Category (1980–2008)

Source: Economist Intelligence Unit (accessed August 10, 2009).

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ECONOMIC STRUCTURE

The CIA World Factbook lists Egypt’s 2008 GDP at US$442.6 billion, the second largest in the Arab world, and the fourth largest in the region, after Turkey, Iran, and Saudi Arabia. Due to its large and densely packed population, however, Egypt has a per capita GDP of about $5,400 that puts it closer to countries like Guatemala, Bhutan, and China than to the other large Middle Eastern economies. The per capita figure also disguises large disparities of wealth and income. A substantial minority enjoys lifestyles comparable to those in industrialized countries, while a considerably larger segment lives in conditions much poorer than the $5,400 figure would suggest. Table 1 compares Egypt to some other countries.

Table 1: Egypt in Comparative Perspective.

Egypt in Comparative Perspective

Sources: GDP, GDP/capita, population, age, literacy, and public equity capitalization estimates from the CIA World Factbook; corruption data from Transparency International’s 2008 Corruption Perceptions Index; economic freedom scores from the Heritage Foundation’s 2009 Index of Economic Freedom.

According to the Economist Intelligence Unit data (accessed August 10, 2009), about 48% of Egypt’s recent GDP originates in the service sector, 38% from industry, and 14% from agriculture. In comparison, employment breaks down into roughly 51% in services, 17% in industry, and 32% in agriculture (see Figure 3). The sectoral compositions of both GDP and labor have been relatively stable over the last 30 years, although agriculture’s contribution to the GDP is slowly declining, with industry taking up most of the balance.

Figure 3: Sectoral Composition of Egyptian GDP and Labor Force (2008).

Sectoral Composition of Egyptian GDP and Labor Force (2008)

Source: Economist Intelligence Unit (accessed August 10, 2009).

Egypt lacks the massive oil fields that distinguish Saudi Arabia, Iran, Iraq, and the other Gulf states, but there is crude oil around the Sinai Peninsula and the Eastern Desert. New discoveries of oil have been made in the Western Desert near Libya, and the Nile Delta has natural gas fields. Egyptian hydrocarbon production has been declining slowly over time, but hydrocarbons are, nonetheless, an important part of the economy, constituting about 8% of the GDP and about 40% of exports (see www.medibtikar.eu/hydrocarbons.html).

Egypt’s ancient investment in pyramids and temples is paying off well. Tourism generates 11.1% of the GDP and ready access to hard currency. Tourism receipts are vulnerable to political instability, terrorism, and spillovers from conflicts in the region. Egypt had more than one case of massacres targeting foreign tourists in the 1990s, and the terrorist attacks of September 11, 2001, also created a noticeable drop in receipts. The industry has improved its resilience, however, and recovers from such events with increasing speed. More recently, the global financial crisis has cut into tourism, but Egypt benefits from being a relatively inexpensive destination.

Despite liberalization, the public sector is still very large—roughly one-third of the total GDP—and privatization of state-owned enterprises has not proceeded far. The government traditionally maintained a policy guaranteeing work for all university graduates. Although recently abandoned, this policy filled government bureaucracies with large numbers of poorly paid graduates, and public-sector labor laws make it difficult to downsize. The low pay also results in opportunistic graft and corruption, contributing to Egypt’s low rank on Transparency International’s Corruption Perceptions Index.

Other noteworthy sources of GDP include Suez Canal revenue (1%) and remittances from Egyptians abroad (2.1%), especially those working in the Gulf countries. In early 2008 high oil prices boosted remittances and increased canal revenue to its highest levels ever, as shipping around the Cape of Good Hope became so expensive that the canal became an attractive alternative. The rise of Somali pirates may have put a dent in canal revenues, but the Egyptian government claims that the piracy threat is overstated.

Egyptian industrial policy has targeted ICT (information and communications technologies) as a strategic national industry, and the sector has been growing substantially. High population densities in Cairo and Alexandria help create critical masses of human capital. Low wage rates combined with more liberal regulations for new technologies make this a small but rapidly growing sector.

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EQUITY MARKETS

The modern Egyptian stock market, formed by merging the Cairo and Alexandria exchanges, is actually one of the oldest stock markets in the world. The Alexandria exchange dates from 1888, Cairo from 1903, and both were actively traded up to the 1950s. Nevertheless, the reemergence of the Egyptian stock market in the 1990s and 2000s is remarkable, even by emerging-market standards. Figure 4 shows that from January 2004 to the peak in May 2008 an investor would have seen their investment grow to roughly 13 times the initial outlay. Of course, the nearly 70% drawdown from the 2008 peak requires a tough stomach too, but even the recovery since the March low added nearly 80% by the end of July 2009.

Figure 4: MSCI Cap-Weighted Equity Indexes (Total Return in USD).

MSCI Cap-Weighted Equity Indexes (Total Return in USD)

Source: Bloomberg (accessed August 11, 2009); weekly data (January 4, 1999–July 27, 2009). Note: Base of 100 set at December 1, 2003, due to availability of BRIC data from that date. Weekly indices are indexed to Monday levels because the Egyptian stock markets are closed on Fridays (Muslim holy day).

One might think that Egypt simply represents a high-beta market, because the shape of Egypt’s historical performance resembles other indices on the chart, but a closer look at the quantitative characteristics of weekly returns in Table 2 shows that Egypt has a remarkably low correlation with developed and even other emerging markets. Indeed, the low correlation results in low world beta—to ACWI (All Country World Index)—despite volatility levels comparable to the high-beta BRIC index. This suggests that Egypt offers diversification benefits, and its outperformance originates in country-specific factors such as the business reforms discussed above.

Table 2: Quantitative Comparison of MSCI Total Return Indices.

Quantitative Comparison of MSCI Total Return Indices

Source: Bloomberg (accessed August 11, 2009); weekly data (January 4, 1999–July 27, 2009). Note: Risk-free rate for computations of Sharpe ratio and Jensen alpha assumed to be 2%.

Egypt’s position on the risk-return chart (Figure 5) shows attractive total risk characteristics, placing it in the same approximate region as the BRIC indices, but with lower correlation and lower total risk. This is impressive given that the BRIC index is actually more diversified. It would require a risk-free rate of more than 10% before the BRIC Sharpe ratio starts to look more attractive, and substantially negative risk-free rates would be necessary for other indices to outperform.

Figure 5: Risk-Return Chart Comparing Egypt versus Other MSCI Indices (Total Return in USD)

Risk-Return Chart Comparing Egypt versus Other MSCI Indices

Source: Bloomberg (accessed August 11, 2009); weekly data (January 4, 1999–July 27, 2009). *MSCI EM (Emerging Markets) Europe, Middle East, and Africa Index.

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HIDDEN RISKS BENEATH THE SAND

Egypt’s attractive risk, return, and correlation features make it a sensible allocation to emerging-market portfolios, but there are important risks to consider that do not show up in the volatility of returns. Egypt’s government is essentially authoritarian. It holds elections, but political expression is constrained to a few legalized opposition parties that capture only a small percentage of votes. The Muslim Brotherhood, although ostensibly dedicated to nonviolent reform, is illegal, and thus its candidates run as independents. Nonetheless, it is the most successful and organized opposition force.

Compounding these factors is an aging president, who at 81 has held power for most of the last three decades. Although there has been limited political liberalization in recent years, the fact that the president’s son, Gamal Mubarak, is generally considered his likely successor indicates that little political competition is actually permitted. When Hosni Mubarak steps down or dies, there is no guarantee that the current market liberalizations will continue or that his successors will be able to contain opposition forces.

Conditions look favorable for Egyptian markets as long as the current government remains in power and continues its liberalization policies; however, when political transition comes, there could be severe liquidity problems as investors attempt to readjust to a potentially volatile situation. Thus, although much of Egypt’s recent outperformance comes as the fruits of liberalization, some of this return premium may represent compensation for the hidden risks lurking beneath Egyptian sands.

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Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.

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