Investors' dream of La-La Land in Egypt, despite CBE decisions!
The Central Bank of Egypt’s (CBE) decisions to raise interest rates came to weaken what we call the “Triangle of Power”. Will these decisions end investors’ dreams and push them to be satisfied with a bird in hand?
By Markets Chimp
6/11/17 4:02 AM
Mahmoud Gad, CMA
“A bird in the hand is worth two in the bush”, the saying goes. Contrarily, in La-La Land—investors’ dream—organizations assume risk to earn more. But their success depends on the strength of their “Triangle of Power”: financing, investing, and operating.
In La-La Land, two birds are better than one
La-La Land is an imaginary attractive environment for investments that investors dream of. A successful business needs the “Triangle of Power”: strong operations, large investments, and inexpensive financing. All of this is made within a framework of decision making based on the analysis of expected benefits versus costs of the decision to hunt the best opportunities in an effective and efficient way.
Assuming we live in La-La Land, …
the “tree” would be the “market” where the organization operates,
the “birds” on the tree would be the “returns”,
the “sniper” would be the “management”,
the “sniper rifle” would be the “investments”,
the “source of money” to acquire those investments would be the required “finance”, whether self-finance (from investors) or external (from loans),
“catching” birds would be the “operations”,
“Effectiveness” would be to achieve the “best objectives” (i.e. hunting two birds, not only one bird), and …
“Efficiency” would be to achieve this with the “least possible resources” (i.e. hunting two birds with one shot).
The earthquake that toppled investors’ dream in La-La Land
This was all fine until the CBE’s decisions came as an earthquake for investors, waking up from their La-La Land dreams to the reality of having “a bird in hand”.
1. A “5 magnitude” earthquake – CBE’s decisions
Raising interest rates by 5 percentage points (pp)
Since the flotation of Egyptian pound versus the US dollar on 3 November 2016, the CBE has raised interest rates by 5 pp (or 500 basis points)—3 pp in November 2016 after the flotation and 2 pp on 21 May 2017, making total interest rate hikes amount to 7.5 pp since March 2016 until now.
…as a tool to curb inflation
By this, the CBE aims to limit inflation rates to a range of 13% (±3%) by Q4 2018 compared to rates that exceeded 30% after the flotation. Ideally, higher interest rates should (1) encourage people to save to generate a higher return and/or (2) limit the purchase of goods that depends on loans (e.g. automotive and home appliances). Thus, demand would decrease, which in turn would limit the rise of inflation.
…although it is cost driven
The CBE attributed higher inflation rates to the economic reforms that started by the end of 2016, such as the flotation of the local currency, the implementation of the value-added tax (VAT), a reduction in fuel and electricity subsidies, and higher customs on some goods. We note that the flotation led to a higher US dollar versus the EGP by more than 100% to exceed EGP18/USD. This fueled a significant increase in prices as the costs of many factors of production are priced in US dollars because they are imported.
…which we call “flogging a dead horse”
Although the CBE acknowledges that inflation is driven by higher costs (i.e. supply side), raisinginterest rates is focused on the “demand side”. Indeed, it is like “flogging a dead horse”. What if costs continue to rise, whether because of a possible weakness in the local currency or the upcoming rise in VAT and fuel prices?
2. Aftershocks – A severe crack in the ribs of the “Triangle of Power”
Lower consumer purchasing power
Rising inflation rates, as explained above, have led to a reduction in consumer purchasing power. This inevitably led to a decline in demand rates, which may result in a recession with rising prices—known as “stagflation”. By looking at Emirates NBD Egypt PMI readings, we note the continued contraction (monthly readings below 50 points) for the 20th month in a row through May 2017. This contraction, which sharply increased after the flotation, was due to the decline in output and new orders.
Despite a marked decline in output and new orders in May 2017, contraction eased due to increased new export orders benefiting from the EGP devaluation. New export orders in April 2017 recorded an expansion for the first time since almost two years then rose in May at the fastest rate since the inception of the PMI in April 2011. This is shown in the table below:
…with a higher cost of finance
On the other hand, rising interest rates, by 5 pp after flotation, have led to a rise in both the cost of debt (from 11.4% before the flotation to 15.3% after the floatation) and the cost of equity (from 27.6% before the floatation to 29.8% after the floatation). Hence, the weighted average cost of capital (WACC) rose from 23.6% before the floatation to 26.2% after the floatation (assuming a debt-to-capital ratio of 25%), as shown in the table below. If we assumed no debt, WACC would have risen from 27.6% before the floatation to 29.8% after the floatation. With a 50% debt-to-capital ratio, WACC would have risen from 19.5% before the floatation to 22.6% after the floatation.
…both reduced the attractiveness of investment
Investors accept only investments with an expected internal rate of return (IRR) equal to or greater than the investment’s WACC. So, increasing the WACC led to an increase in the target IRR. Accordingly, if we assumed a debt-to-capital ratio of 25%, IRR would reach 26.2% after the floatation compared to 23.6% before the flotation to match the WACC, as explained above. The challenge for investors is to achieve this new targeted IRR given the decline in the purchasing power of customers and rising costs. This would push investors to delay their entry into new investments. Indeed, Juhayna Food Industries (EGX: JUFO) and Edita Food Industries (EGX: EFID) delayed all new investments during this period due to the aforementioned issues and the absence of a clear vision in the market.
Accordingly, will the CBE’s decisions (to raise interest rates) end investors’ dreams and push them to be satisfied with a bird in the hand? This depends on the investors’ ability to achieve the new targeted IRR, given the aforementioned challenges. To explain it in numbers, we will need to introduce an exemplary case study, which we will do in our next article, where we will examine how investors’ decisions are sensitive to changes in (1) demand, (2) inflation, and (3) interest rates.