Global research firm IHS downgrades Egypt’s banking sector to ‘Significant Risk’ on sovereign concerns.
Sovereign risk constraint is ‘significant’ given the banking sector’s substantial holding of sovereign debt, which stands at 40% of GDP.
Outlook and implications.
Bank-supplied credit to the economy is moderate at less than 40 percent of GDP and credit growth has been restrained – averaging just 6 percent per year between 2010 and 2012 – and the sector’s banks maintain well-diversified loan portfolios. Although these factors alone would indicate a low level of intrinsic credit risk in the sector, the country’s recent political turmoil has raised the credit risk factor significantly.
Ongoing political uncertainty in Egypt, with its negative impact on government finances and the country’s external balance of trade, will continue to influence banking-sector risks in the near term. These broad macroeconomic-level events could negatively impact the ability of all borrowers to service their debts, while the deteriorating financial position of the government raises repayment risk on sovereign debt (of which the banking sector holds substantial amounts). In addition, existential risks include the high level of foreign exchange lending, which presents sizeable indirect foreign exchange risk for the banking sector in light of depreciation pressure on the Egyptian pound.
Sovereign-level risk factors heavily influence banking-sector risks.
We use the sovereign risk constraint to take into account economic and political risks affecting the broader sector in which commercial banks operate. As uncertainty surrounding Egypt’s political transition continues, macroeconomic-level concerns could lead to stress in the banking sector via three main channels: banks substantial holding of sovereign debt, sizeable lending to vulnerable economic sectors, and the elevated level of foreign currency lending on bank balance sheets.
Egyptian banks currently hold around 40 percent of their assets as government-backed securities and the sector remains dominated by state-owned banks. The vast majority of these assets are short-term Egyptian Treasury bills. As a result, banks are not required to write down the value of these assets as yields rise and, in fact, the replacement of old bills with a larger quantity of higher-yielding bills over the past several quarters has served to boost profitability.
Nonetheless, pressure on government finances and external balances is elevated and the sector thus remains heavily exposed to a potential default on sovereign debt. Furthermore, the substantial holding of government debt on bank balance sheets distorts sector-level liquidity ratios, given the zero risk-weight on sovereign debt holdings under Basel capital rules. Given the ongoing political uncertainty in the country, banks could find that their government securities are not liquid in the event of future distress, effectively raising what would otherwise be a low structural liquidity risk profile, in our opinion.
Overall, economic growth is expected to remain low over the next 12 months.
The sector carries a sizeable amount of lending to government-related entities (20%) and the service sector (25%), areas that will continue to be affected by deflated foreign exchange earnings and economic growth in the near term. A growing twin deficit on the fiscal and current-account balances is likely to decrease the debt-servicing capacity of state-owned enterprises, while slumping tourism revenues (entries were already down 10% from pre-crisis levels before the events in July) may erode asset quality in the service sector loan book.
A sizeable amount of the sector’s lending (29%) is conducted in foreign exchange, which increases the sector’s vulnerability to losses given the elevated risk of further currency depreciation in the near term. Between the end of 2010 and June 2013, the Egyptian pound depreciated nearly 20 percent against the U.S. dollar. Although markets initially reacted positively to the army’s ousting of President Mohammed Morsi, the political situation remains fluid, and in early July, the parallel market rate for the pound was trading at up to a 25 percent discount to the official pound/U.S. dollar exchange rate, suggesting that the currency has additional room to fall in the near term.
Services and industry-related businesses, which account for nearly 75 percent of lending in foreign currency to non-government entities, have seen foreign exchange earnings eroded by the slowdown in tourist activity and trade more generally, which may further constrain their ability to repay foreign currency-denominated loans in the event of additional pound depreciation.