Arqaam Capital

Arqaam expects inflation to rise in Egypt on FX and Fiscal Reforms

Tuesday, January 10, 2017

High annual headline inflation is expected to linger for several years, dropping to the single digit level by end 2019, early 2020 according to a research report released by Arqaam Capital, the emerging and frontier markets investment bank. This is mainly due to the recent economic reforms occurring in Q4 2016 compounding the impact of the base effect and changes in the indices in previous years, resulting now in higher changes in the overall consumer price index. Arqaam expects monthly changes in inflation, however, to decline in the months where policy changes will not result in shocks to domestic prices.

"We expect core inflation to also jump, reflecting the general acceleration in price increments, especially of the volatile food items included in the core index. This trend is expected to continue in the coming few months as importers and local vendors adjust their selling prices to the hit on costs from the floating FX rate, high energy prices and higher customs tariffs, especially on imported food and personal hygiene products, household appliances, clothing and footwear and other miscellaneous goods. The impact of the latter factor would span over the current and coming few months as imports cycles take their course,' said Reham ELDesoki, Senior Economist, Arqaam Egypt. The Central Bank of Egypt later announced that core inflation had jumped to 25.9% in December 2016, up from 20.8% the month before and 7.2% in December 2015.

Egypt now is in the eye of the policy restructuring cycle, and the price is higher inflation and an overall fiscal deficit pending a structural change in government spending and general re-pricing of goods and services. A reversal of over 50 years of comprehensive government support will take time and is a welcome change to put Egypt on a more sustainable path to growth and fiscal consolidation. A delay in implementation of the economic reforms, including VAT, energy price hikes and the EGP float, however, has significantly increased the cost of reform to the economy, compared to earlier implementation in 2015 or even the first half of 2016.

"There are two opposing factors that we will see affecting inflation in 2017, especially. The negative base effect, which will keep annual inflation high in 2017 in the 20%s range, and the counterbalancing factor of lower consumption growth, as the high inflation takes its toll on consumers. Consumers are in the midst of a consumption restructuring cycle, ranging from shedding unnecessary  items on which they spend their disbursable income, to becoming more efficient in choice of products, reducing spending on some luxury items and reducing waste in consumption, especially of energy products. The higher the income, though, the less the change in consumption patterns and vice versa. Social and cultural norms will continue to sustain higher consumption growth in the higher income groups, although we expect some luxury spending to come under pressure (second cars, second home, travel etc) until a recalibration of prices and spending happens over the course of 2017. We expect corporates' results in the coming quarters to reflect these changes in consumption patterns and the selective approach of consumers,' she said

"We expect the CBE could start cutting interest rates in late 2017, by a full magnitude of 200-300 bps gradually, as soon as inflationary pressures stabilize, which we expect will be better represented by the monthly change in inflation, rather than the annual headline figures. Next shocks for inflation are another energy price hike in Q2/Q3 17, higher pharmaceuticals prices in mid Q1 17, a possible re-pricing of fertilizer prices in mid-2017, an electricity price hike in July 2017 and a small increment in the VAT rate from the current 13% to the agreed upon 14% also in July 2017,"

'We expect FX rates to gradually decline, to around an average of EGP 16/USD in H1 17, and then to EGP 14/USD in H2 17, based on the pace of portfolio inflows and decline in pent up repat demand for FX, and then to EGP 12-13/USD in the longer term as more organically driven FDI inflows rise.' Reham ElDesoki concluded.

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