Emerging Market Focus

FIM RESEARCH 04 February 2011

The point of no return: Egypt’s uncertain

political future, the economy and the army
Summary
z Mubarak is set to exit sooner rather than later as popular mobilisation continues unabated.
The army will eventually safeguard the state not the regime as politics take centre stage.
z Political downside risks will remain as stability will be tenuous and uncertain. Mounting
violence is of serious concern as security forces are absent and private militias abound.
z The crisis is costing the economy at least USD310m daily. We are revising down our GDP
forecast for 2011 from 5.3% to 3.7%.

The point of no return

Political change is at the forefront of the Egyptian crisis. We expect a transition of power to take
place sooner rather than later. Popular mobilisation is bound to lead the political agenda until a
caretaker government takes over. The popular revolt we see is currently headless and the
vacuum will have to be filled soon, providing leadership and guidance but also a vision. A parallel
can be drawn with the Iranian revolution prior to the Shah’s departure in terms of events
unfolding very fast. The difference is that Mubarak does not yet seem to want to exit the country
in reasonable comfort, just like King Farouk did in 1952 after the military coup of the Free
Officers. For the time being there is no leader coming to the fore, like Ayotollah Khomeini during
the 1979 Iranian revolution. The Tahrir Square uprising of 2011 in Egypt is still a headless
populist uprising but has instituted a point of no return for the regime’s future and Egyptian polity.
There are several options available, including: Mubarak exiting soon and allowing his Vice
President, Omar Suleiman, to be a transition President, keeping his current Prime Minister,
Ahmed Shafiq, and his cabinet intact. Shafiq is respected amongst the army high command,
often fondly compared with the late Field Marshal Abu Ghazala. During his tenure as minister of
civil aviation he turned around EgyptAir and upgraded airports throughout the country. Another
option would be for both Mubarak and Suleiman to exit as well as Shafiq and his cabinet and a
new caretaker government to take over, with faces that are not affiliated with the Mubarak
regime. Alternatively, Suleiman could stay as President with Mohammed Al Baradei as the Prime
Minister, requiring a change in the members of the cabinet or keeping them unchanged until
elections take place.
Real and nominal GDP
8 250
7
200
6
5 150
4
3 100
2
50
1
0 0
2004 2005 2006 2007 2008 2009 2010 2011e
Real GDP (%chg) Nominal GDP (USDbn) rhs

Source: IMF, Central Bank of Egypt, Crédit Agricole CIB

John Sfakianakis, Chief Economist BSF Crédit Agricole Group

+966 1 276 4611, johns@alfransi.com.sa

research.ca-cib.com
Crédit Agricole Corporate and Investment Bank is authorised by the Comité des Etablissements de Crédit et des Entreprises d’Investissement (CECEI) and
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Emerging Market Focus

In both of the above scenarios, the role of the army is paramount as it will watch
the anticipated constitutional changes – a precursor to political reform. Al Baradei
does not command legitimacy and popular acclaim, although with time it can
increase. Of course, other participants could enter the political fold as transition
candidates, one of which could be Amr Moussa, current Secretary-General of the
Arab League. Moussa was dismissed by Mubarak as his foreign minister in 2001
as he was widely perceived by Mubarak and his inner circle to be a rising and
powerful contender. The army’s opinion and role in all this will be crucial and
should not be discounted. A military figure could arise as a candidate for the
transition government although a civilian that is subtly or overtly approved by the
military is a likely option. However, this will depend on the role the army plays
in the final days of Mubarak and how society views its role. At the moment,
there are differences of opinion between officers on the ground and the
high command, which will eventually converge in pushing Mubarak out. For
sure, neither Suleiman nor Shafiq have popular legitimacy as they are both
viewed as part of the regime, and it is unlikely that they would remain in power for
long although popular pressure for their immediate departure could be less
intense in the event of a Mubarak exit in the short term. Political stability will be
ensured only if the transition period is clear and presidential elections are held in
either September or at a set date thereafter.

CPI and food inflation

25

20

15

10

0
2004 2005 2006 2007 2008 2009 2010 2011e
CPI Inflation (YoY % Chg) Food Inflation (YoY % Chg)

Source: IMF, Central Bank of Egypt, Crédit Agricole CIB

The Muslim Brotherhood and the army

The likely scenario after the elections is complex, and investors will be watching
as another test case for assessing Egypt’s political risk. Formal opposition in
Egypt has been co-opted and infiltrated for the past three decades. If elections
are held immediately the likelihood of most opposition parties mobilising
effectively over the short term is less plausible. In the event of elections in
September or thereafter, the chance of the Muslim Brotherhood having a
role as the most important political broker is not an improbable outcome.
The Muslim Brotherhood is not a unified and homogenous political force and
there will be ‘pull and push’ political and ideological fights that ensue within its
ranks. Relations with the US and Israel and the Camp David peace accords
will be issues with which it will have to reckon. It could be that the Muslim
Brotherhood is put to the test as an effective ruler, addressing deep structural
problems in the Egyptian economy. Liberal economics are expected to be
reviewed and it remains to be seen whether a different approach can be taken
that is more welfare-oriented.
It is not improbable to expect the army play a seminal role in accepting a possible
majority-held parliament. The resolve of the army to determine the final
political and parliamentary outlook will have to be tested. Certainties have
been dismissed so far in the Egyptian political sphere and all is possible. The
only way the economic agenda of any party can be discounted would be by
effective proof of its rulership and deliverables. Egypt witnessed parliamentary
government in the 1920s and 1930s. The role of the army at this point is again
paramount as it would always safeguard the state, not the regime. It could
be that the army will not allow a Muslim Brotherhood majority-led government.

04 February 2011 2
Emerging Market Focus

The role of the security forces should not be discounted as they could make last-
ditch efforts to support Mubarak and the regime. Its unexpected withdrawal from
the streets is of concern, and violence could erupt among protestors.
Neutralising these forces would be the job of the army.

The Turkish reference and the US initiative

Moreover, as Egypt’s economic problems are not easily solved despite some
short-term ‘carrots’ given to the people by any future government, the foreign
policy agenda could become an attractive stage on which the Muslim
Brotherhood could operate. The role of the US and Israel is crucial although it
also remains to be tested whether the former would be willing to play an active
role and what the role of the latter would be upon accepting a Muslim
Brotherhood dominated government. The Turkish model of an army in the
barracks (but with a watchful eye on the political situation) under a
moderate Islamic government has been seen as a likely option. A military
caretaker government that would oversee a transition to civilian rule based on a
new constitution was proposed by the liberal Wafd Party in Egypt in 1984, which
was based on the post-1980 Turkish military coup political process and its
subsequent transition to democracy. The willingness to test this model is as much
in the hands of the domestic political process of Egypt as much as it is in the
hands of the US and Israel. For many years now the US has been calling for
democracy in the Middle East – now it is confronted with just that in a pivotal
country such as Egypt.
The role of the US is pivotal, although we cannot predict the ability and
willingness of the Obama administration to be proactive. The US, and
Europe as well, has to strengthen its ability to address deep-seated economic
problems which impact the wider populations of Egypt rather than simply
maintain the status quo. Supporting Mubarak ultimately contradicts an assurance
of political stability. Regime perseverance is also to be discounted. The next
solution is to work to bring a safe transition and a new political order that is
inclusive of all the opposition forces, which at the moment appear immobilised
and mummified by a long process of regime co-optation and exclusion. A level
playing field has to be created for all opposition forces as the Muslim
Brotherhood has a head start over everyone else. The US could opt to
support some politicians and army officers who are willing to support the regime.
This scenario would be disastrous for the US as it would enhance the prospects
of an ‘Iran scenario’. Another scenario would be to bring together different reform
agents that would be able to bring political reformers and the army together. A
group that unites the army and political reformers is an optimal strategy so as
appropriately to silence any residual force and violence from the security forces’
apparatus. The US would be able to provide assistance despite the Obama
administration’s disengagement from many parts of the Middle East. Domestic
American politics could also play a major part in Obama’s proactive stance in
Egypt, which would safeguard a smooth and a level playing field for the
opposition. The gradual but effective rise of the Muslim Brotherhood in
Egypt would not be welcomed by the American Israel Lobby (AIPAC) – one
of the most effective lobbies in US politics – and without their swing vote
Obama’s re-election would be very difficult.

The behaviour of the Middle East countries

The Middle East is changing in the way we view it and the changes that have
been brought in over the past few weeks. ‘Status quo politics’ between rulers and
ruled is no longer obvious in many parts of the Middle East as the pacts are
neither clear nor obvious. Governments in the Middle East will have to become
more attentive and address fundamental and basic needs such as jobs,
affordable food, more equitable distribution, governance and voice. The Gulf
countries are better placed to adjust macroeconomic necessities in a far
more resilient way than oil importers and the republics due to their smaller
populations, foreign assets and rising oil revenues. The Gulf countries have
far deeper pockets to tap into without disturbing their fiscal and macroeconomic
prudence. Moreover, Gulf monarchs are far less distant from society than the
republics due to size but also style. Some Gulf countries would be able and
willing to provide fiscal support and economic assistance to safeguard the

04 February 2011 3
Emerging Market Focus

economic stability of Egypt. There are historical links between Egypt and the
Gulf as well as business and familial ties.

The economy, stupid!

The economy is at the heart of Egypt’s problems. Mubarak’s regime fell due to
the lack of economic trickle-down, rising inequality, high incidence of (near)
poverty, high unemployment, and underemployment, and very high and sticky
inflation. The current political crisis is costing Egypt at least USD310m a
day. Tourism is the first industry that is being impacted. Prolonged political
uncertainty and perceived violence could have a destructive impact on tourism
earnings this year. Tourism accounted for 6% of GDP in 2010 and accounts for
one out of eight jobs in Egypt with important multipliers for the economy as a
whole. Tourism receipts could easily retract to pre-2004 levels of less than
USD5.5bn. The extent of political unrest will have an impact on tourism arrivals
as well as the amount of time tourists spend in Egypt. A shortfall in tourism
receipts will have to be addressed by additional budgetary support.
Remittance inflows should not suffer a setback since there are no systemic
crises abroad and the Gulf economies are returning to growth. This is a very
different picture from the early 1990s when remittances dropped after the
departure of Egyptians from Kuwait and Iraq. The crisis in Egypt will compel the
diaspora not to remit as much as anticipated. However, we do expect that
remittances will drop from an expected USD7.7bn to a little over 2005 levels at an
estimated USD5.4bn. The shortfall in remittances will have to be addressed and
that is a risk factor. However, what is more worrisome is the danger of capital
outflows, which are likely to spike in the short term. The rapid capital outflow in
late 2008 was countered with a drawdown in official reserves and the central
bank’s foreign currency deposits with local banks declining. Local as well as
international investors will demand an early exit as political instability and lack of
clarity looms. Those that have not opted for capital outflow strategies over the
past few years will do it now, particularly among the business community and
minorities.

Remittances & FDI

14
12
10
8
6
4
2
0
2004 2005 2006 2007 2008 2009 2010 2011e
FDI (USDbn) Private Remittances (USDbn)

Source: IMF, Central Bank of Egypt, Crédit Agricole CIB

For any government, addressing capital imbalances will be a crucial matter.

Public finances will no longer be contained this year after some years of hard
work. Any government which comes to power will have to revert to some form of
additional short-term subsidies. More importantly, Egypt’s budget deficit is bound
to increase as the cost of borrowing rises and the government embarks on
additional distribution tactics. Our base-case scenario for the next three years
was for Egypt’s gross public debt to GDP to remain around 70%. We now think
this scenario is no longer viable and we expect that public debt will revert to 85%
this year and 97% by 2014. Fiscal policy will be another major challenge for the
government. In all likelihood there will be no rationalisation of fuel subsidies and
improving tax-evasion mechanisms will not be carried through this year.
Replacing the sales tax by a comprehensive VAT is expected to be postponed
and measures to close loopholes in the income tax system will not be addressed
this year. The proposed property tax will also not be enacted, restraining the
revenue options of the state. We expect that the budget deficit this year could

04 February 2011 4
Emerging Market Focus

reach 12.3% from an estimated 8.2%. Infrastructure expenditure by the

government to help kick-start the economy, hinted at by the new minister of
finance, would place an additional burden on the budget and fiscal consolidation.
Banks will be under pressure to finance the budget, but risk – due to private
sector output falling due to a decline in investments – will create unavoidable
short-term challenges.

Current account balance and fiscal balance

6
4
2
0
-2
-4
-6
-8
-10
-12
-14
2004 2005 2006 2007 2008 2009 2010 2011e
Current Acount Balance (% GDP) Fiscal Balance (% GDP)

Source: IMF, Central Bank of Egypt, Crédit Agricole CIB

Over the short term we expect the EGP to fall by 20%, which would require
the central bank to intervene on several occasions. The main instigator of the fall
will be the decline in capital inflows and rise in outflows. The forecast decline is
more than the 6% the EGP depreciated between September 2008 and March
2009. It subsequently appreciated due to resumed capital inflows. The drawdown
in reserves would be a crucial factor in supporting the EGP, but increased
political tensions, a run on local banks as well as expected dollarisation of some
of the deposits will impact the short-term currency outlook. The government will
be caught ‘between a rock and a hard place’ as it could fast exhaust its foreign
currency reserves to pre-2002 levels.

Gross public debt

(% GDP)
120

100

80

60

40

20

0
2005 2006 2007 2008 2009 2010 2011e

Source: IMF, Central Bank of Egypt, Crédit Agricole CIB

A significant depreciation of the EGP and falling service receipts, tourism and
remittances would expose current account risks over the short to medium term as
growth is expected to fall. A small decline in demand-driven imports could
offset some of the current account pressures but it will not be enough. FDI,
which reached more than USD13bn in 2008 from below USD1bn pre-2004, would
be impacted given that investor confidence is expected to fall precipitously.
Additional pressure on the EGP could arise due to a possible reintroduction of a
parallel market in USD. A parallel market rate, which had a premium of 15% in
late 2003-04, could return as confidence declines and trust in the EGP falls. This
could be a major macroeconomic disturbance to our short- and medium-term
scenario. A liquidity crisis is not implausible. We do not expect the Suez Canal to
cease operating as the army will safeguard its smooth functioning. Any doubt
about safe passage through the Suez Canal would be a significant

04 February 2011 5
Emerging Market Focus

destabilising event for Egypt and would open the door to outside military
intervention.
A depreciating currency would lead to higher import costs, especially food
imports such as wheat. Global food commodity prices are on the rise and that is
likely to translate into additional burdens for the local economy. Inflation will
continue to be the ‘untameable beast’ that the government failed to stabilise
despite concerted efforts. Food inflation of around 17% – which accounts for 44%
of the inflation basket – is a major issue for the government. The 1977 bread riots
that broke out in Cairo when the government tried to stop subsidising it led to the
army’s intervention. The government refrained from instituting a cut to the
subsidy. Food riots broke out yet again in Cairo in 2008 and the army once again
played a crucial role in reinstating order. The government would not be able to
combat inflationary pressures effectively as high fiscal deficits would only
add fuel to an existing fire. Food inflation will remain a considerable worry as
supply shocks could occur in several food categories due to the ensuing crisis.
The government will have to address inflation, which remains at elevated levels.
In view of the political and economic conditions currently prevailing, we are
lowering our real GDP outlook for 2011 from 5.3% to 3.7% with additional
downside risks lingering in the short term.

04 February 2011 6
Emerging Market Focus

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Certification
The views expressed in this report accurately reflect the personal views of the undersigned analyst(s). In addition, the undersigned analyst(s) has not and will not receive
any compensation for providing a specific recommendation or view in this report.
John Sfakianakis

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