Middle East Dilemma over Subsidies Unnerves Investors

By Shadia Nasralla

LONDON, Nov 8 (Reuters) – Egypt’s proposal to cut subsidies as part of a loan deal with the IMF highlights a far broader fiscal and social conundrum for the region, raising the stakes for investors.
Countries need support, but getting it can have side effects.

Egyptian stocks have rallied 50 percent this year on greater political stability and hopes for a deal with the International Monetary Fund, after shedding half their value in 2011 after the ousting of Hosni Mubarak. http://link.reuters.com/weh36s

For many investors, securing a $4.8 billion IMF deal will be the catalyst for a much-needed rebound in private-sector investment.

“If the IMF gives Egypt a loan, that would supersede everything else,” said Sergei Strigo, head of emerging debt management at French asset manager Amundi.

But taking cost-cutting steps to gain a deal could also pose risks: A reform of Egypt’s hefty subsidies, for example, c ould hurt foreign investment in supported sectors such as energy as well as prompt renewed social unrest.

“In a time of political transition and a fragile rebuilding of the social fabric, a brutal cut in the subsidy system could prove very sensitive,” said Philippe Dauba-Pantanacce, economist at Standard Chartered.

It’s a dilemma that extends across the Middle East and North Africa as lenders and ratings agencies demand that governments cut budget deficits, at a time when authorities are reluctant to reduce handouts for fear of aggravating the social turmoil that has gripped the region.

Standard & Poor’s downgraded Morocco’s outlook in October to ‘negative’ and warned the country could lose its investment grade rating if it does not significantly narrow its fiscal and current account deficits.

Morocco’s subsidy bill reached 6 percent of GDP in 2011. Its fiscal deficit soared 462 percent in the first seven months of this year as subsidies increased by 58 percent, according to Standard Chartered.
In Jordan, a $2 billion stand-by arrangement secured with the IMF in August has provided a lifeline after foreign direct investment slumped 31 percent in the first quarter of 2012 from a year earlier and government subsidies rose 41 percent in the first half of this year.

That has pushed public debt to above 72 percent of GDP, according to Standard Chartered.

But worries about social tension have already prompted King Abdullah in September to intervene and block a fuel price hike recommended by the IMF, in order to quell street protests that erupted on news of higher prices.

Jordan spends $2.3 billion on subsidies, almost a quarter of its annual budget, and is trying to gradually force businesses to pay higher fuel and electricity prices.
“Jordan is essentially on the brink of financial collapse without IMF help,” said Said Hirsh, economist at Capital Economics.

Eaton Vance’s Parametric Structured Emerging Markets fund has trimmed its 0.8 percent allocation in Jordan slightly, while Templeton’s frontier fund has reduced its Jordan weighting to 0.8 percent from 1.18, according to data from Lipper.

Across the Middle East and North Africa, dedicated MENA funds tracked by Lipper, and with a little over $1.3 billion in assets, have seen net outflows of just over $200 million this year. Funds covering only Arab nations in the Gulf Cooperation Council, with about $1.8 billion in assets, have seen net outflows of just over $100 million.

Oil importers Egypt and Jordan in particular need to address their balance of payments to attract loans and investment, analysts say.

Egypt spent $15.7 billion, or 20 percent of government spending, on subsidising petroleum products, including cooking gas, in the financial year that ended on June 30.

Under the current system, a canister of butane cooking gas, or “butagas”, sells for around 5 Egyptian pounds, while it costs almost 70 pounds to produce.

“There is still a lot to do for Egypt to avoid a big financial crisis in the immediate term,” Hirsh said.

“People are buying into Egypt’s medium- to long-term story rather than what’s going to happen next year.” Egypt’s finance minister said this week that the government hoped to reach a deal with the IMF in the middle of next month, but some investors are not so optimistic and it is unclear what commitments Cairo will make to secure a financial backstop. “It would appear that markets have taken an IMF deal as a given … It’s probably a bit of an overreaction on the part of investors,” Hirsh said.

Templeton’s Frontier Markets Fund has cut its Egypt allocation to 4.6 percent of its portfolio from 6.2 percent at the end of 2011, according to Lipper, while Morgan Stanley’s Emerging EMEA fund more than halved its holding to just over 2 percent, signalling caution.

Egypt’s new leadership under President Mohamed Mursi seems more willing to reduce its subsidies bill than Hosni Mubarak’s administration. But the government has been moving carefully to sell austerity measures to a public whose economic expectations have risen since last year’s popular revolt.

Many investors have yet to be convinced that Cairo, and other governments in the region, will be able to manage the delicate balancing act of slashing subsidies and other needed fiscal reforms, without arousing the ire of their restless citizens. An IMF deal for Egypt would be only a first step.

“We don’t think of the IMF as the gospel. For the time being we’re in wait and see mode.” said Slim Feriani, Chief Executive Officer of UK-based Advance Emerging Capital.

“Talk is cheap, the proof is in the pudding.” (Additional reporting by Joel Dimmock; Editing by Susan Fenton)

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