Government Institutions Efficiency And Sovereign Rating– The Case of Egypt May 2017

Moody’s Sovereign Rating Methodology: The Case of Egypt

Key factors Underpinning the Sovereign Rating Source: Moody’s Investors Service

Four Factors As Cornerstones Economic Strength Growth Dynamics Scale of the Economy Income (Wealth) Institutional Strength Institutional Framework and Effectiveness Policy Credibility and Effectiveness Fiscal Strength Debt Burden Debt Affordability Susceptibility to Event Risks Political Risks Government Liquidity Banking Sector Strength External Vulnerability Source: Moody’s Investors Service

Factor 1: Economic Strength Focus on growth dynamic, diversification, competitiveness, national income, and scale of economy, which is important in determining a country’s resilience or shock-absorption capacity. A sovereign’s relative ability to generate revenue and service debt over the medium term relies on fostering economic growth and prosperity.

Egypt’s Economic Strength: Moderate (+) Low GDP per capita and weak competitiveness, mitigated by a sizeable and fairly diversified economy. Growth has picked up on the back of recovering confidence and investment reaching 4.3% in FY2016. For the 10-year period spanning 2011-2020 growth will average 3.8%. Public and private investment is a key growth driver over the coming years. Structural challenges include weak competitiveness and high unemployment.

Egypt’s Economic Strength: Moderate (+) Source: Moody’s Investors Service

Egypt’s Economic Strength: Moderate (+) Source: Moody’s Investors Service

Factor 2: Institutional Strength Moody’s consider whether the country’s institutional features are conducive to supporting its ability and willingness to repay its debt. Institutional strength comes from: Government capacity to conduct sound economic policies that foster economic growth and prosperity. Institutional framework and effectiveness including the quality of government bureaucracy and administration, rule of law and control of corruption. Policy credibility and effectiveness including inflation performance as well as volatility.

Egypt’s Institutional Strength: Low (-) Two revolutions in three years have weakened Egypt’s government indicators – Egypt’s worldwide governance indicators (Political Stability, Government Effectiveness, Rule of Law, Control of Corruption, Voice and Accountability, Regulatory Quality) are weaker than peer group. The Central Bank of Egypt focuses on anchoring inflationary expectations. Excellent data availability and improved government transparency support institutional strength assessment.

Egypt’s Institutional Strength: Low (-) Source: Moody’s Investors Service

Egypt’s Institutional Strength: Low (-) Source: Moody’s Investors Service

Worldwide Governance Indicators Government Effectiveness captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies. Rule of Law captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. Control of Corruption captures perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as "capture" of the state by elites and private interests.

Worldwide Governance Indicators Voice and Accountability captures perceptions of the extent to which a country's citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and a free media. Political Stability and Absence of Violence/Terrorism measures perceptions of the likelihood of political instability and/or politically motivated violence, including terrorism. Regulatory Quality captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.

Worldwide Governance Indicators Source: Moody’s Investors Service

Worldwide Governance Indicators Source: Moody’s Investors Service

Let's dig deeper to understand how Worldwide Governance Indicators are measured, with more focus on the Government Effectiveness Index The Worldwide Governance Indicators (WGI) are a long-standing research project to develop cross-country indicators of governance. The WGI consist of six composite indicators of broad dimensions of governance covering over 200 countries since 1996: 1) Voice and Accountability, 2) Political Stability and Absence of Violence/Terrorism, 3) Government Effectiveness, 4) Regulatory Quality, 5) Rule of Law, and 6) Control of Corruption. These indicators are based on several hundred variables obtained from around 30 different data sources, capturing governance perceptions as reported by survey respondents, nongovernmental organizations, commercial business information providers, and public sector organizations worldwide. Not all data sources cover all countries. For some sources and countries, the underlying source data is confidential and cannot be publicly disclosed at the request of the organizations producing the data.

WGI Data Sources The WGI compile and summarize information from over 30 existing data sources that report the views and experiences of citizens, entrepreneurs, and experts in the public, private and NGO sectors from around the world, on the quality of various aspects of governance. The WGI draw on four different types of source data: Surveys of households and firms, including the Afrobarometer surveys, Gallup World Poll, and Global Competitiveness Report survey, Commercial business information providers, including the Economist Intelligence Unit, Global Insight, Political Risk Services, Non-governmental organizations, including Global Integrity, Freedom House, Reporters Without Borders, and Public sector organizations, including the CPIA assessments of World Bank and regional development banks, the EBRD Transition Report, French Ministry of Finance Institutional Profiles Database.

How WGIs are measured? Each of six aggregate WGI measures are constructed by averaging together data from the underlying sources that correspond to the concept of governance being measured. This is done in the three steps described below. STEP 1: Assigning data from individual sources to the six aggregate indicators. Individual questions from the underlying data sources are assigned to each of the six aggregate indicators. For example, a firm survey question on the regulatory environment would be assigned to Regulatory Quality, or a measure of press freedom would be assigned to Voice and Accountability. Note that not all of the data sources cover all countries, and so the aggregate governance scores are based on different sets of underlying data for different countries. STEP 2: Preliminary rescaling of the individual source data to run from 0 to 1. The questions from the individual data sources are first rescaled to range from 0 to 1, with higher values corresponding to better outcomes. If, for example, a survey question asks for responses on a scale from a minimum of 1 to a maximum of 4, we rescale a score of 2 as (2-min)/(max-min)=(2-1)/3=0.33. When an individual data source provides more than one question relating to a particular dimension of governance, we average together the rescaled scores.

How WGIs are measured? STEP 3: Using an Unobserved Components Model (UCM) to construct a weighted average of the individual indicators for each source. A statistical tool known as an Unobserved Components Model (UCM) is used to make the 0-1 rescaled data comparable across sources, and then to construct a weighted average of the data from each source for each country. The resulting estimates of governance are a weighted average of the data from each source, with weights reflecting the pattern of correlation among data sources. The UCM assigns greater weight to data sources that tend to be more strongly correlated with each other. While this weighting improves the statistical precision of the aggregate indicators, it typically does not affect very much the ranking of countries on the aggregate indicators. The composite measures of governance generated by the UCM are in units running from approximately -2.5 to 2.5, with higher values corresponding to better governance.

Government Effectiveness Concepts Measured Individual Indicators used to construct Government Effectiveness for Egypt: Source: The Worldwide Governance Indicators (WGI) project

Egypt Government Effectiveness Index Egypt scored -0.76 in the Government Effectiveness index as of 2015 and ranked 163 out of the 209 countries being covered by the Worldwide Government Effectiveness Index, as shown in the following table.

Worldwide Government Effectiveness Index by Country/Territory - 2015 Source: The Worldwide Governance Indicators (WGI) project

Worldwide Government Effectiveness Index by Country/Territory - 2015 Source: The Worldwide Governance Indicators (WGI) project

Worldwide Government Effectiveness Index by Country/Territory - 2015 Source: The Worldwide Governance Indicators (WGI) project

Factor 3: Fiscal Strength It captures the overall health of government finances and debt structure. The starting point is to assess relative debt burden (debt/GDP, debt/revenues) and debt affordability (interest payments relative to revenue and GDP).

Egypt’s Fiscal Strength: Very Low (-) Fiscal reforms will gradually improve Egypt’s challenging fiscal and government debt metrics. Mixed track record of revenue-enhancing measures. Balancing act between rationalizing current spending and maintaining social spending commitments. Government debt will continue to rise.

Egypt’s Fiscal Strength: Very Low (-) Source: Moody’s Investors Service

Egypt’s Fiscal Strength: Very Low (-) Source: Moody’s Investors Service

Factor 4: Susceptibility to Event Risk It denotes the risk that sudden, extreme events may severely strain public finances, thus sharply increasing the sovereign’s probability of default. It comprises political risk, government liquidity risk, banking sector risk and external vulnerability risk.

Egypt’s Susceptibility to Event Risk: High Policy risks have subsided, but security risks persist; government liquidity risks are moderate. Domestic political event risk has declined but is still elevated. Security risks persist, with the potential of negatively affecting sentiment. Susceptibility to geopolitical event risk is determined by Egypt’s exposure to regional sectarian conflict. Very large government financing needs are balanced by largely domestic and local currency funding.

Egypt’s Susceptibility to Event Risk: High Source: Moody’s Investors Service

Egypt’s Susceptibility to Event Risk: High Source: Moody’s Investors Service

Source: Moody’s Investors Service

Egypt’s Sovereign Rating Cornerstones

Sovereign Rating Metrics - Egypt B3-Caa2 B3 Source: Moody’s Investors Service

Credit Challenges Credit Strengths Large and diversified economy; External donor support that provides some buffer for the external payments position; Large domestic funding base for government debt. Sizable fiscal deficits, high public debt, and very large gross borrowing requirements; Social pressures from high unemployment and high inflation; Elevated security risks.

Rating Outlook The outlook on Egypt's B3 government bond rating is stable, which signals that upward and downward rating pressures are balanced. Upward pressure on the rating is constrained by the sovereign's very high gross financing needs relative to peers, indicative of weak government finances. Moreover, risks to domestic political stability and security remain elevated, weighing on the growth outlook. Downward pressures are mitigated by donor support, which we expect would be forthcoming if funding pressures were to resurface, as well as the improved relationship with the IMF.

What Could Change the Rating Up Factors that could lead to an Upgrade an accelerated implementation of measures to lower fiscal deficits and government debt; a sustained growth recovery to pre-revolution levels, combined with a sharper reduction in inflation rates; a faster-than-envisaged build-up of foreign exchange reserve buffers, driven by less reliance on external donor support; and/or further improvement in the domestic security situation.

What Could Change the Rating Down Factors that could lead to a Downgrade a renewed intensification of political turmoil and instability; a significant deterioration in the external payments position; a slippage or reversal of fiscal and economic reforms, which leads to a sharp rise in the government's funding costs; and/or diminution in the banking system's capacity to fund government deficits.

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