EGYPT. Standard & Poor's Ratings Services today lowered its long-term foreign- and local-currency sovereign credit ratings on the Arab Republic of Egypt to 'B' from 'B+'. At the same time, we affirmed our 'B' short-term ratings on Egypt. The outlook is negative.
 
We revised the transfer and convertibility (T&C) assessment to 'B' in line with the sovereign ratings. The recovery rating on the unsecured foreign-currency debt remains unchanged at '3', indicating our expectation of 50%-70% recovery in the event of a default.
 
The downgrade reflects our opinion that Egypt's external position has deteriorated and is likely to weaken further, absent stabilization in the domestic political situation alongside external financial support.
 
We lowered our ratings on Egypt to 'B+' on Nov. 24, 2011. At that time, we said that we could lower the ratings again if we believed that policy developments during the political transition were further weakening Egypt's ability to fund its country's external needs. In our view, external financing is becoming more problematic in the face of the related problems of sharply falling reserves, exchange rate pressures, and capital flight.
 
In our view, Egypt's external financing risks have risen significantly, with foreign direct investment having declined sharply and net portfolio flows also having turned negative. Egyptian Central Bank interventions--to support the Egyptian pound in the face of significant capital outflows and double-digit annual inflation--have resulted in a sharp decline in net international reserves.

These were US$16 billion at end-January 2012, down from US$36 billion at the start of 2011. Historically, our assessment of Egypt's external score has been a relative strength to the rating; this is now being eroded. We estimate that net international reserves, excluding gold, now cover less than three months of goods and services imports compared with more than six months at the start of 2011.
 
We believe the program being discussed with the IMF, alongside potential funding from other multi- and bi-lateral lenders, could provide important near-term external financing. We note that lending conditionality supports structural improvements and encourages private sector capital inflows.
 
Our T&C assessment is equalized with the sovereign foreign-currency rating to reflect our opinion that the likelihood of the sovereign restricting access to foreign exchange needed by Egypt-based nonsovereign issuers for debt service is similar to the likelihood of the sovereign defaulting on its foreign currency obligations.
 
Our '3' recovery rating on Egypt's senior unsecured foreign-currency sovereign debt reflects a scenario in which fiscal slippages and additional reserve losses trigger a debt restructuring or default. Nonetheless, under our stress scenario, Egypt's history of cooperation with external creditors and its assumed relatively modest share of bond debt suggest a recovery range of between 50% and 70% of face value.
 
The negative outlook reflects our view of the likelihood of a downgrade either if the government fails to stem the decline in reserves, or an uncertain policy environment and weak institutions emerge from the ongoing political transition.

The political transition process could be undermined over the coming year as the constitution is redrafted and a new president is elected--currently expected by June 2012--after which a new government would be formed. In our view, the transition to more-participatory political institutions in Egypt could falter, leading to weaker political institutions and rising domestic conflict.
 
Conversely, if Egypt's political transition strengthens the social contract and if external pressures ease—an indication of which would be the stabilization of net international reserves--we could affirm the ratings at the current level.
 

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