OREANDA-NEWS. The recent devaluation of the Egyptian pound against the US dollar will likely be supportive of foreign currency liquidity in the domestic banking sector, Fitch Ratings says. At the same time, the Egyptian banks' almost negligible foreign currency positions and regulatory restrictions against lending in foreign currency to corporates without foreign currency revenue should mitigate the short-term impact of the weaker pound on the banks' asset quality.

On 14 March, the Central Bank of Egypt (CBE) devalued the Egyptian pound (EGP) by around 14% against the US dollar (see also "Fitch: Egypt Devaluation Positive, Economic Challenges Remain", published 21 March 2016). Traditionally, the EGP/USD exchange rate has largely been controlled by the CBE through US dollar auctions, which resulted in a parallel foreign currency market. The CBE last week sold USD1.5bn of USD to domestic banks in an exceptional auction to cover imports of strategic products, which is still insufficient to cover the existing back-log in foreign currency demand. We expect a further depreciation of the Egyptian pound as the CBE tries to completely eliminate the parallel market.

The CBE's ability to increase foreign currency liquidity in the banking sector is a function of its net international reserves. International reserves in turn rely heavily on Suez Canal, tourism revenues and foreign direct investments (FDI), which have come under pressure since 2015, as well as grants, predominately from Gulf Cooperation Council (GCC) countries. International reserves stood at USD16.5bn at end-February 2016, down from USD35.2bn at end-June 2010.

However, the devaluation is a positive step to improving foreign currency supply in the banking system. A more flexible exchange-rate policy reflecting the actual value of the EGP is expected to attract FDI and improve foreign currency proceeds. The CBE has also recently lifted the limits on individual foreign currency deposits and withdrawals that were imposed in February 2015 (a monthly limit of USD50,000 on deposits). In addition, Egypt's three state-owned banks (National Bank of Egypt (B/Stable/b), Banque Misr and Banque du Caire) will issue US dollar-denominated one- to five-year certificates to Egyptian expatriates, which will help improve their long term foreign currency funding.

While the devaluation of the Egyptian pound, following a period of artificially low exchange rates at around EGP7.80 per US dollar, is a step towards a more flexible exchange rate regime based on market mechanism, further measures including the removal of caps on all FCY corporate deposits are in our view necessary to eliminate the distortions in Egypt's exchange rate regime and improve foreign currency supply in the banking sector.

We do not believe that the current devaluation will have a meaningful negative impact on the banks' asset quality metrics. Egyptian banks only lend in foreign currency to counterparties with corresponding foreign currency proceeds and in the medium-term, a better-functioning foreign currency market should support the credit profile of corporates relying on foreign currency proceeds. However, in the short-term, growth of foreign currency loans (reported in Egyptian pounds on the banks' balance sheets) will be artificially inflated by the devaluation.

On 17 March, to combat expected inflation following the devaluation, the CBE increased the overnight deposit and lending rates by 150 bps to 10.75% and 11.75% respectively. We expect yields on sovereign bonds and treasury bills to follow suit. In the short-term, the increase in government bond yields will support domestic banks' net interest margins (NIM) and overall profitability since government debt accounts for a high 40% of banking system assets. At the same time, higher yields will, however, negatively affect the valuation of the banks' current government debt portfolio and will - depending on accounting classifications - adversely affect their profitability and/or capital ratios. Some banks (eg Commercial International Bank, B/Stable/b) use a mark-to-model approach when valuing government debt which should soften the impact from higher government yields on the valuation of their existing portfolio, thereby mitigating the impact on the banks' equity base.