Last Thursday, the Central Bank of Egypt (CBE) announced that it would liberalize its exchange rate regime and move to a free float of the Egyptian pound. The central bank's decision is credit positive for Egyptian banks because it will likely increase the availability of US dollars in the economy, supporting economic activity and the banks' business, Moody's Investors Service said. Concurrently, the CBE raised benchmark rates by 300 basis points, with the main policy operation rate increasing to 15.25%. The increase in the benchmark rates will support the banks' profitability given their large exposure to short-term government securities. These positives offset the negative effect that the currency devaluation will have on the banks' capital adequacy ratios and the negative pressures that banks will face on asset quality owing to rising inflation and higher interest rates, which weaken debt affordability. The CBE announced a nonbinding foreign-exchange rate of EGP13.0 per US dollar to serve as soft guidance for the market, which reflects a 46.5% devaluation of the currency from the current EGP8.875 per dollar. A flexible exchange-rate regime will support the Egyptian government's efforts to attract foreign direct investment and improve trade competitiveness, which, in turn, will fuel economic expansion and support banks' business. The increase in foreign investment also will stave off the existing liquidity pressures in foreign currencies that Egyptian banks currently face. The interest rate increase will support banks' profitability. Banks' high exposure to government bonds and treasury bills reached EGP1.24 trillion ($140 billion) as of July 2016, accounting for around 43% of total assets. According to our estimates, around half of banks' exposure to government securities are short-term treasury bills that the banks will reinvest at higher rates. At the same time, the increase in the banks' funding costs will fall, given that the bulk of the banks' funding comprises of low-cost current and savings deposits. Egyptian banks are vulnerable to currency depreciation because it exposes them to higher credit risk in their loan book and erodes their capital adequacy. A weaker currency will exert mild pressure on banks' already-low capital buffers because US dollar-denominated banking assets will appreciate relative to the banks' Egyptian pound-denominated capital, although the higher profits that banks will make on their foreign currency assets will partially offset this effect. We estimate that a 50% devaluation would lower the banks' reported Tier 1 capital ratio by 150 basis points to 10.8%. Rising inflation and higher interest rates likely also will reduce debt affordability and loan performance, particularly in the more vulnerable small and midsize enterprise sector that banks are targeting as a growth segment. However, the low leverage levels in the private sector, combined with central bank regulations aimed at ensuring debt affordability, partly mitigate the risk of worsening asset quality. Loans to households account for a low 7% of GDP and are mainly salary secured or collateralized by deposits. In addition, the central bank introduced a 35% payment-to-income cap in January this year. Borrowing by local corporates is also low at 30% of GDP. The amount of loans in foreign currencies is low (see Exhibit 2) since borrowers are not allowed to take loans in foreign currencies unless they have revenues in the same currency, thereby limiting difficulties with loan repayment owing to currency depreciation. — SG
