IX Modernizing Egypt’s Financial Markets
- Howard Handy
- Published Date:
- May 1998
This section analyzes the development of Egypt’s financial system, from state control through the reforms initiated during the 1990s. The results of the reforms are described together with the continuing efforts that are under way in bank privatization, financial sector broadening, and strengthening of prudential regulation and supervision.
A Historic Overview of Egypt’s Financial System
The wave of nationalizations during 1959–61 had a dramatic impact on Egypt’s financial system. Following the confiscation and nationalization of Egypt’s 27 commercial and specialized banks, the banking system was consolidated into four noncompeting state banks, each focusing on separate economic sectors. In 1974, under the “open door policy,” Egypt authorized the establishment of “joint-venture” banks with minority foreign participation. Foreign banks were also permitted to open branches in Egypt. By 1995, the banking system had expanded to 28 commercial banks, 32 investment and merchant banks, and 7 specialized banks. Despite the emergence of new banking institutions, the “big four” state banks continued to account for over three-fourths of commercial bank deposits based on their extensive branch network, with a similar share of total lending (Table 26). The new commercial banks established under the open door policy focused on lending to private sector clients and multinationals.
|Loans and discounts||Other assets||Deposits||Capital and reserves||Provisions||Other liabilities||Provisions||Capital|
|(In billions of Egyptian pounds)||(In percent)||(In percent of assets)|
|Public commercial banks|
|Public banks as share of ail commercial banks1|
Until 1990, Egypt’s banking system was highly repressed. The CBE imposed interest rate limits on bank deposits and loans that were well below the rate of inflation. In particular, preferential interest rates were mandated for loans to public enterprises and to industrial and agricultural enterprises. At the same time, banks’ operating costs were increased by a 25 percent (unremunerated) reserve requirement on domestic currency liabilities. While overall liquidity growth was largely determined by the borrowing needs of the government, the central bank also limited credit expansion to public sector companies and the private sector using maximum loan-to-deposit ratios and bank-specific ceilings for certain classes of credits.
Highly negative rates of return on domestic currency deposits resulted in a shift to foreign currency accounts offered by domestic banks. (Such accounts benefited from a lower reserve requirement (15 percent) than domestic currency accounts.) By 1990/91, slightly over one-half of all deposits of the private sector and public sector companies were denominated in foreign currency. For the most part, banks used these deposits to finance overseas investments (capital outflows).
Although new banking institutions emerged during the 1970s and 1980s, the securities market remained underdeveloped. Public banks continued to dominate the financing of the state-owned companies, while the securities industry was hampered by the absence of a governing securities law, inadequate regulation and supervision, and weak accounting, auditing, and financial disclosure practices. Financial intermediaries such as mutual funds, finance companies, leasing companies, brokers, discount houses, money changers, and market makers were lacking. In addition, the insurance sector was underdeveloped and largely state owned.
Role of Egypt’s Banks in Intermediating Saving
Economic studies have shown that countries with “developed” financial systems tend to show stronger economic growth (see Box 4). On this basis, it would appear that the repression and distortions of Egypt’s banking system probably acted as a drag on economic growth through the 1980s.
Although it is difficult to measure the depth and efficiency of financial markets from aggregate financial data, research has commonly shown that stronger growth is linked to high ratios of broad money to GDP and high shares of bank credit channeled to the private sector. On the basis of the former indicator, Egypt’s banking system would appear to have been relatively deep. Thus, in 1980, the ratio of M2 to GDP stood at 67 percent, over twice the average of 31 percent for developing economies (Table 27). Savings were largely channeled to the government sector and public enterprises (accounting for 82 percent of banking system credit) rather than to private enterprises (with a 15 percent share of such credit). As a result, credit to the private sector represented 14 percent of GDP in 1980, well below the average of 21 percent for developing countries (Table 27).
|Number of Countries||GNP Per Capita 1990||M2/GDP Ratio||Credit to Private Sector|
|(In U.S. dollars.)||(In percent of GDP)|
|Middle Eastern and North African economies||9||2,110||47.0||65.5||24.5||31.3||36.4|
|Western Hemisphere economies||25||1,619||29.0||37.7||23.8||23.9||28.3|
The emergence of new, somewhat more independent, banking institutions during the 1980s and Fiscal adjustment in the 1990s permitted increased financing of private sector activities. By 1995, credit to the private sector had risen to 33 percent of GDP, exceeding the average of 27 percent for developing countries. The Egyptian banking system compared less favorably, however, with those of the fastest growing developing economies where credit to the private sector stood at 42 percent of GDP (Table 27).
In sum, Egypt’s banking system at the end of the 1980s was dominated by state ownership; constrained by onerous restrictions on deposit taking and lending; and subject to weak prudential regulation and supervision. At the same time, however, a number of new (typically small) banking institutions were emerging, and lending to the private sector was rising (although from low levels). It was against this background that the reforms of the 1990s were initiated.
Financial System Reforms, 1991–95
In early 1991, the Egyptian authorities initiated an important series of reforms with the goal of giving a central role to market forces in the mobilization of savings, allocation of credit, and conduct of monetary policy. The separate aspects of this reform effort are discussed below.
Banking System Reforms
In January 1991, to address the growing dollarization of the Egyptian economy, the authorities liberalized banks’ lending and deposit rates (other than for demand deposits, where a prohibition on interest payments was removed beginning in May 1993). Subsequently, ceilings on bank lending to the private sector and bank-specific ceilings on lending to public sector companies were removed in October 1992 and July 1993, respectively. Steps were also taken to reduce the competitive advantages of the public sector banks. In particular, public sector companies were authorized to deal with all banks without prior permission from a public sector bank. To streamline the public sector banks, 15 development banks were merged with the main development bank in Cairo in December 1992.
Box 4.Financial Markets and Economic Growth
Efficient capital markets can raise saving and investment (and, by implication, economic output) in a number of ways. Financial institutions, by identifying productive investment activities, offer savers a higher real rate of return than they could earn independently, thereby encouraging higher levels of saving.
Financial institutions can also foster increased and more productive investments. Uncertainties about market demand or untested technologies can deter investments in projects by single individuals (even where the potential returns are large). Financing may be available, however, where such risks are shared between investors (using financial institutions, equity markets, and so forth). Similarly, market specialization, which offers higher productivity, but also higher economic risk, may not be feasible without the use of capital markets to pool the associated risk. Capital markets also provide investors with higher liquidity than would direct investment, reducing the risks of committing a high proportion of their wealth to productive purposes. Last, the cost of gathering information on investment opportunities are high for individual investors, and without institutions to undertake this function for investors, the pattern of investment is likely to be inefficient.
Based on these arguments, a highly developed and efficient financial sector should contribute to a higher level (although not necessarily higher rate of growth) of economic activity. In practice, economists have found that countries with deep financial systems also tend to exhibit strong rates of growth.1 One possible explanation is the existence of economies of scale in the financial sector. As described above, a strong financial sector can foster increased investment and production. This, in turn, may generate demand for additional and more sophisticated financial services, which can have further beneficial effects on potential output.1 For a survey of the literature, see Berthélemy and Varoudakis (1996).
The response to liberalization was positive. By June 1992, a significant increase in returns on domestic currency bank deposits, combined with lower rates of inflation, succeeded in restoring a positive real rate of return. As a result, the share of foreign currency deposits in broad money declined from 51 percent in June 1991 to 29 percent by December 1992.
Monetary Policy Reforms
With the elimination of direct credit ceilings on the private sector and public sector companies, the CBE moved toward increased reliance on indirect monetary policy instruments. To this end, the CBE instituted from January 1991 weekly auctions of three-month treasury bills. Over time, the supply of debt to the market was increased and longer maturities were introduced–6-month treasury bills from December 1991, and 12-month bills from March 1992. The CBE has relied, in part, on the sale and redemption of treasury bills to regulate banks’ reserves, and thereby credit expansion.
To strengthen the CBE’s control over monetary conditions, changes were introduced to the reserve requirement policy. In particular, the coverage of the reserve requirement was extended to deposits of all maturities. In addition, to limit reserve creation through refinancing facilities, the CBE raised the rediscount rate to 2 percentage points above the most recent treasury bill auction rate.
Prudential Supervision and Regulation
Prudential supervision and regulation were generally inadequate during the 1970s and 1980s. For example, banks were not subject to guidelines for capital adequacy or foreign currency exposure (except as required at start-up). As a result, by late 1990, the foreign currency liabilities of the four public sector commercial banks had risen to about $2.1 billion (or 7 percent of total assets), a level viewed as a risk to the banking system. This exposure, and the associated undercapitalization was addressed in May 1991, through a $1.8 billion (LE 6.1 billion) recapitalization financed through the sale of bonds denominated in foreign currency.
To strengthen the banking system, new prudential guidelines were introduced in 1991 for foreign currency exposure, capital adequacy, asset classification and provisioning, bank liquidity, and auditing. This was followed in 1992 by guidelines covering investment concentration abroad, and in 1993 by regulations on credit concentration (Appendix II).
Securities Industry Reforms
In 1992. with a view to revitalizing the stock and bond markets as well as assisting investment and privatization, the government adopted a new Capital Market Law (Law 95) streamlining all preexisting capital market regulations. The provisions (Box 5), including the legal framework, facilitated a marked expansion in the size of the securities industry. The number of securities intermediary firms, which stood at 48 in 1993/94, increased by over 150 during 1994–96 (Figure 21). Stock market activity increased correspondingly, with turnover rising from an annual average of LE 531 million during 1991–93 to over LE 10 billion in 1996. New issues through the stock market rose from LE 2.1 billion in 1993 to over LE 16 billion in 1996. During this period, the stock market began to rival the banking system as a means of financial intermediation: new issues as a percentage of new bank credit rose from 18 percent in 1993 to about 80 percent in early 1997 (Table 28).
Figure 21.Cumulative Number of Securities Intermediaries Licensed
Source: Capital Markets Authority.
|Trading value (In millions of Egyptian pounds)||179||531||2,557||3,849||10,968||25,995|
|Trading volume (in millions)||8.6||23.3||59.8||72.2||207.8||350.7|
|Number of traded companies||157||240||300||352||354|
|Market capitalization (in billions of Egyptian pounds)||3.6||10.8||14.5||27.4||48.1||…|
|New issues2(in billions of Egyptian pounds)||2.13||4.9||8.3||16.5||19.9|
|New issues as percentage of new banking system credit4||18.33||31.2||38.5||69.9||80.2|
The market for public and corporate bonds has also seen rapid expansion in the past few years: while placements of corporate bonds on the domestic market were limited to $30 million for the three-year period 1993–95, new corporate issues totaled $270 million in 1996 and were expected to rise further in 1997. In addition, two tranches of treasury bonds were issued in 1995 and 1996. valued at LE 3 billion and LE 4 billion, respectively (about $0.9 billion and $1.2 billion). To date, secondary trading in these treasury bonds has been limited.
Box 5.The Capital Market Law of 1992
The core provisions of Egypt’s 1992 Capital Market Law are summarized below:
The law established an independent Capital Market Authority (CMA) charged with supervising and regulating the securities industry.
A legal framework was established governing specialized capital markets companies. Minimum capital requirements were established ranging from LE 250,000 for brokerage firms to LE 10 million for venture capital companies.
Corporate bonds were authorized to be officially listed, and the previous 7 percent interest ceiling was eliminated. Bearer shares were also authorized.
Taxes on the income from most stocks and bonds were eliminated.
Recourse to arbitration was established for resolving legal disputes.
Investors’ rights were strengthened by provisions prohibiting unfair market practices. At the same time, foreign investors (institutional and individual) were given full access to the market.
Financial disclosure was strengthened. Publicly traded companies and their auditors were required to follow international accounting and auditing standards, and companies were required to issue semiannual financial statements. The stock exchange and CMA have also published periodic reports regarding trading and market conditions.
Exchange System Reforms
In the late 1980s, Egypt operated a segmented exchange regime with three different exchange rates (broadly applicable to official transactions conducted by the central bank; the operations of the commercial banks; and transactions outside the banking system). From February 1991. this was replaced by a transitional two-rate system, and in November 1991, the regime was fully unified with a single, market-determined rate of exchange. Additional elements of the reform of the exchange regime included the abolition of exchange rate guarantees formerly provided by the central bank; elimination of limits on exchange rate spreads for banks’ customers; and the authorization of nonbank foreign exchange dealers.
Reinvigorating the Reform Process, 1996–97
Launching a new phase of adjustment and reform by the Government of Egypt in 1996 included elements designed to broaden and deepen the financial liberalization initiated in the first half of the decade. Key elements are summarized below.
Financial Sector Privatization
Joint-venture banks. Although the liberalization of entry to the banking system during the 1970s resulted in the establishment of 26 joint-venture banks, these institutions were subject to equity holdings by the state banks, the NIB, and the state insurance companies. In 1993/94, the government decided to initiate a divestiture of public holdings in these banks, and the public banks totally or partially divested their holdings in eight joint-venture banks by the end of 1995. Notwithstanding this, eight joint-venture banks continued to be majority owned by state banks 51 and were held in other joint-venture minority holdings of over 20 percent. Furthermore, the NIB and insurance companies had holdings of between 20 percent and 40 percent in five institutions.
The process of divestiture was revitalized in 1996 and 1997, and by the end of September 1997, the state banks had limited their majority holdings to three joint-venture banks, and reduced their holdings to below 20 percent in all but two other banks. In addition, the state insurance companies had reduced their holdings to below 20 percent for all but three institutions. The government anticipates further progress in divesting the remaining state holdings in the months ahead.
Public commercial banks. As a further element of its financial liberalization program, the government decided in 1996 to privatize one of the four public commercial banks. Progress has been made in auditing the balance sheets of the candidate institution, and draft legislation is being submitted to parliament. Privatization is envisaged within six months of the enabling legislation.
Insurance companies. The government is committed to increasing private participation in the insurance industry, and public holdings were recently divested in two joint-venture insurance companies, leaving all four such institutions under majority private ownership by June 1997. As a further measure, the government intends to privatize one of the three state insurance companies. Audits are under way, and draft legislation is to be presented to parliament shortly. As with the state bank, privatization is envisaged within six months of the enabling legislation.
Prudential Regulation and Supervision
Banking system. By 1996, the regulatory framework for the Egyptian banking system was broadly in line with international practice, but improvements were still needed in the quality and quantity of financial data reported by banks. Accordingly, in mid-1997, the authorities required banks to prepare and publish financial reports on the basis of international accounting standards (IAS). The first such reports will be for the final quarter of calendar 1997. To further improve transparency, the central bank also intends to publish from early 1998 aggregate data on key performance ratios for the banking system. With a view to strengthening banking supervision, on-and off-site supervision manuals have been revised, with technical assistance from U.S. Agency for International Development (USAID), and an early-warning system is being developed in conjunction with technical assistance from USAID and the EU.
Securities markets. For the securities markets, parallel steps have been taken to improve the quality of financial data. In October 1997, the government published corporate guidelines on IAS, and required joint-stock companies to prepare future accounts based on IAS. Steps have also been taken to strengthen rules for corporate disclosure. To protect investors, the stock market intends to establish in the next few months a compensation fund to cover potential settlement losses arising from defaults by capital market institutions. Priority is also being given to upgrading the prudential rules governing the activities of securities intermediary firms including in regard to their capital adequacy and code of conduct.
International experience is increasingly clear on the central importance of a sound financial system. Systemic weaknesses can contribute to the onset and depth of macroeconomic crises. In Egypt, considerable progress has been made in reestablishing a sound banking system during the current decade, as summarized below.52
Capital adequacy. Banking losses in the late 1980s contributed to a sharp deterioration in the capital-asset ratio of the banking system, from 3.5 percent in 1985 to 2.4 percent in 1990 (unadjusted for risk basis). A publicly financed capital injection in 1991 produced a sharp recovery in capitalization (to 4.3 percent). Subsequently, through the end of 1996, the capitalization ratio has been broadly constant (Tables 26 and 29). On a risk-adjusted basis, the average capital adequacy ratio for the banking system was 10.6 percent at the end of 1996, up from 10.0 percent a year earlier. All four public sector banks and all but three joint-venture and private banks met the Basle 8 percent minimum capital adequacy ratio at the end of June 1997. The latter three banks are small (accounting for less than 3 percent of banking assets) and capital increases are envisaged in the near term.
|Capital and reserves as a ratio of risk-weighted assets|
|Public commercial banks||…||…||…||9.1||9.5|
|Capital and reserves as a ratio of assets (non-risk-weighted)|
|Public commercial banks||3.8||3.7||3.5||3.6||4.1|
|Provisioning as a share of lending and discounts|
|Public commercial banks||16.6||17.6||17.8||19.4||17.4|
|Profitability ratio as share of assets|
|Big four state banks||0.17||0.18||0.20||0.23||0.39|
|Profitability ratio as share of equity|
|Big four state banks||4.45||4.83||5.53||6.37||9.60|
|(in millions of Egyptian pounds)|
|Assets per employee|
|Big four state banks||…||…||3.1||…||…|
|Selected joint-venture banks||…||…||5.8||…||…|
|Selected foreign banks||…||…||13.5||…||…|
Loan losses and provisioning. Commercial banks entered the 1990s with substantial nonperforming loans, and provisioning for such loans exceeded 18 percent of the total loan booked at the end of 1992 (Table 26). Subsequently, a gradual decline in provisioning appears to have signaled a parallel decline in nonperforming loans. Thus, on official estimates, nonperforming loans declined from 14.7 percent of total loans in June 1996 to 13.4 percent in June 1997.53 Banks reportedly comply with all provisioning guidelines, and total provisions are equivalent to about 80 percent of nonperforming loans at the end of June 1997.
Banking profitability. Based on published financial statements, a number of Egypt’s joint-venture banks are highly profitable, with rates of return on equity of 20 percent or more. By contrast, the state commercial banks have been much less profitable, with returns averaging less than 5 percent in the three years to June 1995, rising to a little under 10 percent in 1996/97 (Table 29). The growing profitability of the state banks appears to reflect, in part, lower provisioning expenses, as provisions declined as a share of the loan book.
Efficiency, Based on a limited sample of banks’ asset-employee ratios, the joint-venture banks and branches of foreign banks appear more efficient than the state commercial banks. Thus, for every LE 15 million of assets, the state commercial banks have about five employees, compared with three for the joint-venture banks, and one for branches of foreign banks (Table 29). This difference is probably related, in part, to the more extensive branch networks of the state banks.
Recent Banking Sector Developments
Egypt’s adjustment and reform efforts during the 1990s, including steps toward financial liberalization, have led to changes in the pattern of banking sector activity. Two aspects of these changes are discussed in the paragraphs below: the evolution of deposits and banking credit denominated in foreign currencies, and the changing pattern of credit allocation.
Banking System Dollarization
Foreign currency deposits, Egypt’s successful stabilization efforts during the early 1990s, combined with high domestic interest rates, contributed to a rapid unwinding of banks’ foreign currency deposits. For the private sector and public sector companies, the share of deposits held in foreign currencies fell by more than half in the three years to 1993/94 (declining from 50.4 percent to 23.4 percent). After a small increase in 1994/95 (associated with uncertainty about the exchange regime), this trend continued in subsequent years, falling to a low of 18 percent in September 1997 (Table 30).
|(In percent of total foreign currency assets and liabilities)|
|Foreign currency assets||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0|
|Credit to residents||26.6||25.3||29.5||30.4||37.0||40.9||40.3||46.4||51.8||55.5|
|Deposits at central bank||15.5||14.9||15.7||10.3||6.6||6.2||6.7||6.8||5.9||5.8|
|Foreign currency liabilities||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0||100.0|
|Deposits by residents||76.3||76.7||82.8||79.3||72.2||73.4||74.2||75.4||69.9||68.2|
|Liabilities to central bank||2.7||3.2||4.7||4.9||14.1||14.3||14.9||14.9||15.4||16.1|
|Foreign currency deposits||43.4||44.8||50.7||37.3||26.7||23.4||25.1||22.9||19.4||18.3|
|Foreign currency loans||23.6||21.7||19.5||22.0||25.3||26.9||23.3||23.6||25.3||26.5|
|(In millions of U.S. dollars)|
|Private external proceeds3||…||…||…||8,242||3,177||7,180||9,004||9,305||9,927||10,526|
|Foreign currency credit4||…||…||…||2,844||4,014||4,952||5,370||6,687||8,946||9,531|
|Ratio of foreign currency credit to private external proceeds||…||…||…||34.5||49.1||69.0||59.6||71.9||90.1||90.5|
Foreign currency credit. The share of bank credit denominated in foreign currencies has been relatively stable over the past ten years, in the range of 20 percent to 27 percent (Table 30), with temporary shifts toward the top of this range during periods of sustained capital inflows and confidence in the exchange regime (e.g., 1993/94 and 1996/97). Over the period since 1991, foreign currency credit has risen significantly faster than foreign currency deposits. As a result, banks have restructured their foreign currency balance sheets, drawing down investments abroad and expanding domestic foreign currency credit. Thus, in the five years to 1996/97, the share of overseas investments in total foreign currency assets fell from 59 percent to 42 percent, while foreign currency credit rose from 30 percent to 51 percent.
Although recent developments arc consistent with banks limiting their overall foreign currency exposure, there may be an increase in credit risk, to the extent that foreign currency credit is less secure than investments abroad. Concerns would relate, in particular, to the risks of loan default in the event of depreciation of the Egyptian pound. In this connection, it is noteworthy that while foreign currency credit to the private sector represented some 35 percent of private commercial foreign currency earnings in 1991/92, this figure rose to about 90 percent by 1996/97 (Table 30). The challenge to banking supervision that these trends represent is recognized by the authorities, who maintain a close watch on banks’ foreign currency lending.
Patterns of Lending
The evolution of the banking system during the past decade has been associated with a changing pattern of credit allocation, both in terms of economic sector and type of borrower. Data on the composition of new credit to the private sector for the eight-year period 1989/90–1996/97 is summarized in Table 31. Although the data are partial, representing about two-thirds of total new credit to the private sector, certain features can be determined. Prior to the financial liberalization (1989/90–1990/91), credit was focused on the industrial and services sectors (representing 53 percent and 23 percent of net credit growth, respectively). In 1991/92, however, a sharp contraction of credit growth at the outset of the stabilization exercise was focused on these two sectors, along with agriculture; instead, the bulk of the new credit was extended to the trade sector and households.
|(In millions of Egyptian pounds)|
|By economic sector|
|By institutional classification|
|Corporate business sector||1,349||85||3,144||5,917|
|(In percent of new credit extended)|
|By economic sector|
|By institutional classification|
|Corporate business sector||53.6||8.8||36.8||44.6|
As credit growth recovered its pace in the 1990s, two trends are noteworthy. First, while the share of industrial credit recovered sharply after the 1991/92 contraction, it remained substantially lower than in the late 1980s. The counterpart was a sustained higher allocation of new credit to the trade and (to a lesser extent) household sectors. It is also noteworthy that the most recent period of intensified economic reform has been associated with a decline in the share of new credit going to the household sector, contrary to experience in many reforming countries.