Gov’t cancels 3 T-bond sales, banks increase yield: Beyond blaming it on the EM crisis

Offered yields went over 19 percent, as opposed to 16-17 percent in previous auctions (Photo courtesy of CBE website)

On Monday, media outlet Bloomberg dropped a headline sending waves through Egypt’s business community: “Gap grows between what investors want, and what Egypt offers”. The article referred to the government’s cancellation of three consecutive treasury bond sales due to “unrealistic” yields – or return on investment – offered from investors. Offered yields went over 19 percent, as opposed to 16-17 percent in previous auctions.

Consequently, practitioners and high-ranking executives tied the incident to the so-called emerging markets (EM) crisis, led by Turkey’s financial crisis which caused the Turkish lira to depreciate by 40 percent.

While the notion of an EM crisis may indeed scare off investments, there are other factors at play that have thus-far been overlooked.

Associate dean for graduate studies and research and assistant professor of economics at the American University in Cairo (AUC) Diaa Noureldin sheds some light on an alternative explanation, complementary to the one circulating in the news today.

“Attributing this outcome to one specific cause has its shortcomings,” Noureldin says, emphasizing that a multiplicity of factors are at play.

In his view, the lack of attractiveness of government bonds in Egypt in the past two months is certainly a story of squeezed liquidity due to the significant outflows from the government debt market by international institutions, but it could also be related to expectations of inflation and currency depreciation in the coming period.

While the notion of an EM crisis may indeed scare off investments, there are other factors at play that have thus-far been overlooked

Why were banks opting into the government’s treasury bonds during the past year?
Before diving into the specifics of why banks stopped buying the government’s debt instruments, it is important to understand why they have been avid buyers in the preceding 13 months.

After the floatation of the Egyptian pound in November 2016, the Central Bank of Egypt (CBE) said that its goal is to decrease inflation by the end of 2018 to 13 percent, plus or minus 3 percent. Hence, the banks bought in. Meanwhile, year-on-year inflation has in fact been dropping, reaching its lowest level in May 2018 at 11.4 percent, after reaching an all-time high of 32.9 percent in July a year earlier. In August 2018, inflation marked 14.2 percent. This made the bonds attractive.

“Many of those banks are local market players. In 2017, they were hit really hard because they committed themselves to lend to the government for [a] 16-17 percent [yield] while inflation had passed the 30-percent mark,” Noureldin explains. “In real terms, they had negative returns.”

While the difference of 1.5-2 percent in the yield may not sound groundbreaking to some, it equates to a large sum of money for the government

So what is the problem this time around?
In recent treasury bond auctions, banks have offered yields in excess of 19 percent due to two reasons.

“Firstly, we are already in an inflationary environment and we know that the government is committed to further increases in energy prices due to removing subsidies. The recent increase in international oil prices exacerbates the situation. The increase in yields in the last three auctions partly reflect expectations of a rise in future inflation,” Noureldin highlights.  “Secondly, there is also evidence of expectations of further depreciation in the currency.”

Going more into detail, he explains that these are nominal yields, so the real return for the banks is the difference between the nominal yield they offer (this time around 19 percent) and the rate of inflation.

“If I’m a bank and I expect that I’m going to lend to the government for one year, [I will look at the inflation rate for that time period.] I will naturally ask for a higher yield if I have higher inflation expectations. Otherwise, I would be losing in real terms when the bond matures,” Noureldin says.

Regarding an expected depreciation, he points out that depreciation feeds almost immediately into inflation. The evidence for an expected depreciation is both his own research findings, and current market expectations implied by forward contracts on the Egyptian pound vis-a-vis the US dollar. The forward contract is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date.

“Currently, the 12-month forward contract on the Egyptian pound versus the US dollar stands at LE19.95. That is what the market is expecting and it suggests pressure on the currency,” he states. Since there is a market expectation that there will be a devaluation, then there is an expectation that inflation will go up as well.

He added that “some of that has already been priced in the yields since May 2018, but I think further revision in expectations may be at play in addition to the shortage in liquidity in the government debt market.”

Why is the government wary of such high yields?
While the difference of 1.5-2 percent in the yield may not sound groundbreaking to some, it equates to a large sum of money for the government, “being equivalent to LE50-60 billion in additional interest expense. This will not help the government meet its target of reducing the budget deficit”.

So are the banks not interested anymore?
“The banks want to buy, many of them thrive on this high-yield instrument and there are not that many attractive alternative opportunities. But they want to buy at the right price point such that they get the nominal yields that are consistent with their own expectations of future inflation and currency movement”, Noureldin concludes.

Further reading
For further reading into the near future outlook of the exchange rate for the Egyptian pound, see Noureldin, D. (2018), “Much ado about the Egyptian pound: Exchange rate misalignment and the path towards equilibrium”, Middle East Review of Economics and Finance, volume 14, issue 2. Available at  https://doi.org/10.1515/rmeef-2018-0002.  

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