Egypt's project finance market is still very much in its infancy. It is only in the last two or three years that there has been much progress in international standard project financing. But despite its immaturity, it represents a tantalizing prospect for both sponsors and lenders.

?The country was more or less closed to international finance for a long time,? says Stephane Renard, director of syndication at SG in Paris. ?But the government has recognized over the past few years that privatization is the most economical way to raise finance for its projects and has since put in place a programme of privatization which has led to project finance opportunities there. Also given the fact that Egypt is the largest economy in North Africa it represents an obvious interest to international investors.?

Consequently, international appetite for Egyptian assets has picked up strongly over the past couple of years. This increase in appetite was triggered most noticeably by the investment grade rating of BBB- the country received from Standard & Poor's. ?The Egyptian market got a big boost in terms of international bank appetite when it achieved an investment grade rating from Standard & Poor's,? says Jan van Bilsen, head of loan syndications for the Middle East and Africa, at ABN Amro in London. ?It got the rating predominantly after the government had put in a lot of work over a number of years to improve the macroeconomic position and business environment of the country according to what seemed to be a well orchestrated plan?

From the perspective of macroeconomic fundamentals, Egypt looks impressive. Inflation is stable and low, foreign exchange reserves are substantial at around $17 billion, official reserves represent around 10 months worth of imports, the Government's budget deficit is just some 1% of gross domestic product (GDP) and the current account deficit is around 3% of GDP. Perhaps most importantly, the economy has continued to post robust, high growth rates, averaging around 5%, for a number of years. ?The Egyptian economy has demonstrated over the past couple of years that it has the ability to withstand very considerable stresses and still maintain a good level of economic growth,? says Neil Wigan, associate director of sovereign ratings, at Fitch IBCA in London. ?Between 1997 and 1999 the economy had to withstand the impact of the Asian crisis, a rapid fall in oil prices and the loss of tourism earnings following the Luxor attack. It was a serious stress test and it proved able to cope with it well.?

The country is also regarded as politically stable for the region with President Mubarak looking comfortably in control after several re-elections.

Not all are so positive on the country however. It still labours, for example, under a split rating ? with Moody's Investors Service maintaining a sub-investment grade rating. There is also concern that the Egyptian pound may come under severe pressure to devalue this year ? with some estimates suggesting a devaluation of as much as 40%.

Privatization provides the push

But for project finance, it is the government's programme of privatization which is perhaps the most important driver for the business. ?As a result of the government's privatization programme there are a lot of opportunities for project finance in Egypt,? says Van Bilsen at ABN Amro. ?And the fact that the government has embraced privatization demonstrates that they are willing to become more open to international firms.?

Related to this is the fact that the Egyptian economy is beginning a course of profound change ? now a net importer of oil, the government is looking to significantly develop its capacity as a gas exporting state. Fortunately, Egypt is potentially well-placed to realise this aim with its strong macroeconomic position and the positive sentiment of the markets towards it. ?There is a lot of goodwill in the markets towards Egypt and we at Chase are committed to the country as evidenced by the numerous project financings led by Chase,? explains Guy Spaull, managing director, global project finance and advisory, at Chase in London. ?And the expectation is that there will be a significant and increasing requirement for project finance in the country, particularly in the gas sector.?

But the costs of transforming its energy economy are vast and the government will need to consider carefully how best to achieve this through playing to its own advantages. Two offshore gas fields are being developed by international firms at the moment. The first is the Rosetta field which is being developed by BG, Edison SpA and Shell. The second in the West Delta deep marine field is being developed by BG and Edison. These companies are understood to be in negotiations with EGPC for a gas sales contract. The project is due to come onstream in 2002.

Lacking depth

Unlike some relatively developed project finance markets in the region, Egypt's activities span across a fairly diverse range of sectors. There has not been the concentration of activity in a particular sector which characterizes many of its regional neighbours, such as petrochemicals in Qatar.

One area where there was a short burst of activity is telecoms. The government made significant steps in the privatization of its telecoms sector in 1998, with two licence acquisitions and subsequent network build out projects having been financed through a mixture of international and domestic debt.

The first of the two deals was the $490 million, 15-month non-recourse bridge financing for Egyptian Company for Mobile Services (ECMS). The company, sponsored by France Telecom, Motorola and Orascom, bought the existing mobile network off the government with a mandate to expand the service to cover 85% of the country within four years. The total term of the licence is 15 years.

Lead arrangers of the initial bridge financing were ABN Amro, Chase Manhattan, Commercial International Bank and SG. The debt was priced at 100bp over Libor stepping up to a high of 150bp.

The second stage of the project financing consisted of putting in place a long term package for which Chase Manhattan acted as overall global coordinator along with Commercial International Bank and National Bank of Egypt.

The total financing amounted to $670 million, which split between international and domestic portions. Tranche ?A' was a $220 million international senior credit facility with a six and a half year maturity. Tranche ?B' was a $350 million equivalent, seven and a half year senior facility. Tranche ?C' was a $100 million equivalent, eight year subordinated bond. This tranche was led by CIIC, a subsidiary of National Bank of Egypt, and was the first placement of its kind in Egypt.

The second Egyptian telecoms deal was for Misrfone ? sponsored by AirTouch Communications, Vodafone, Hermes, Alkan, Banque du Caire, CG Sat and Mobile Systems International. This project involves the design, supply and installation of a greenfield digital cellular GSM system. The first phase comprises a 70,000 line network designed for use in cars serving Cairo and Alexandria.

Barclays Capital arranged and underwrote an initial $200 million, 364-day bridging facility to support the acquisition costs of the mobile licence. This facility was then replaced by a longer term facility arranged and financed entirely in the domestic market by Banque du Caire and Banque Misr. This debt has a seven year term and is structured into two tranches. Tranche ?A' is a E£1.4 billion revolver while tranche ?B' is a E£1 billion term loan.

Aside from telecoms, there has been one noticeable industrial project financing which closed in 1999. Arranger Greenwich NatWest signed a well supported $260 million offshore limited recourse financing for Ezz Heavy Industries. The deal has a 13 year maturity and was priced at a margin of 250bp pre-completion and 225bp post-completion. Sace, the Italian export credit agency, provided risk coverage for the debt.

The debt will part finance the development of a $590 million steel mill. The project also raised money in the local bank market through tranches arranged by MISR Iran Development Bank and National Bank of Egypt. Sponsors of the project are Ezz Group (75%) and Danieli & C Officine Meccaniche SpA (25%).

A number of other industrial and energy related projects are also under development. A hydrocracker unit will be added to the existing simple distillation refinery at El Nasser to produce fuel oils. The project is being reviewed by at least one rating agency, although the financing plans for the project have not been revealed. A bank group consisting of Greenwich NatWest, Mediocredito Centrale and Sumitomo, and coordinated by Chase is working on the deal. The project is sponsored by EGPC and a number of other institutions.

Power pipeline

Egypt's power sector is probably the most developed in terms of project finance and there is a clear pipeline of deals to come over the next few years. The government is committed to awarding an average of just one concession a year until around 2007/8; and there is a strong growth in the demand for electricity. Although this does not give international sponsors or their bankers the volumes of deals they would perhaps wish for, it does give a certain consistency to the process. ?I think it is a sensible approach,? says one Cairo-based banker. ?This is still an under-developed market and it ensures that the market is not saturated with deals and also that the government can continue to improve the process with future concessions.?

But the power sector also throws into sharpest relief the crucial issue for Egyptian project finance ? withholding tax. While the deals mentioned above have largely avoided the issue through heavy reliance on domestic bank and bond markets or through ECA coverage. The first of Egypt's build-own-operate-transfer concessions (BOT) in the power sector ? Sidi Krir ? marked the first significant attempt to place uncovered long-term Egyptian project debt in the international market. As such, Sidi Krir is the prime example of the difficulties faced by arrangers in trying to place Egyptian assets into the international markets in a tax efficient way.

The 2X325MW project is sponsored by InterGen, First Arabian Development & Investment and Kato Development. Mandated international lead arrangers for the deal are ABN Amro, Dresdner Kleinwort Benson, Paribas and SG ? these were subsequently joined by EDC of Canada as an international arranger. All five banks underwrote the debt on a pro rata basis.

The debt for the plant is divided between four project tranches and one guaranteed $35 million equity bridge loan and between international and local currency facilities despite which all tranches will be drawn in dollars. Arrangers of the local debt tranches are National Bank of Egypt, Commercial International Bank and MI Bank. Tranche ?B' is a $187 million, 15 year domestic facility. Pricing was set at 175bp pre-completion, at completion this rises to 200bp through to year five from then it rises to 230bp through to maturity. Tranche ?D' is a $6 million, 15 year working capital facility and tranche ?E' is a $19.5 million, 15 year guarantee facility.

But it is Tranche ?C' ? a $130 million, 12 year international facility ? which is the most significant. This carries a margin of 175bp pre-completion before rising to 200bp for the first five years after completion and then rises to 250bp to maturity.

Banks were invited to commit to the deal as either co-arrangers and lead managers. Co-arrangers are being asked to provide $13 million for the project tranches and $3.5 million for the equity bridge. Lead managers are asked to provide $9.1 million for the project tranches and $2.45 million for the equity portion.

This tranche also features a cash sweep mechanism which effectively reduces the facility's tenor to eight years in an effort to encourage international banks uncomfortable with taking 12 year uncovered Egyptian risk. Even with this feature however, the syndication has been onerous to say the least. The arrangers were mandated at the end of 1998 and the deal was launched into syndication in mid-1999. By April 2000, the arrangers were still struggling to close the books without subjecting the sponsors to paying the full level of withholding tax ? some 32% of the interest payable on the debt. ?We knew that the syndication would be challenging,? explains Renard at SG in Paris. ?But as a deal like this had not been done before it was difficult to quantify just how difficult it would be.?

The difficulty of placing this deal is not a function of lack of appetite ? most project finance bankers agree that the deal looks like a strong credit. The issue is that so few banks have the ability to book the deal in the two places which avoids the withholding tax ? Egypt itself or Switzerland. By attempting to place the deal in these jurisdictions, sponsors and their arrangers effectively reduce their potential market, so far as to make syndication more difficult than the quality of the assets being sold warrants.

To complicate matters further, international banks cannot get a licence for a full operating branch in Egypt and therefore are forced to buy an existing bank there. One Gulf-based bank did so this year and a number of other international banks are also closely looking at acquiring local banks. Even though Egypt is heavily over-banked, with around 50 public and private institutions, this is not a realistic solution to the problem.

There has been some talk recently of a tax treaty being developed with Bahrain. If this materializes, it will help open up the market to banks but it would, at best, be an incremental increase and not sufficient to meet the country's demand for international capital. At most, this will only allow some Gulf-based institutions to book deals tax-efficiently from Egypt.

?The whole withholding tax issue is a real pain in the neck,? says the Cairo-based banker. ?It almost forces borrowers to use ECAs or the local markets and reduces their desire to tap the international private markets and this is probably not the most efficient way to do things.?

The tax hits the project sponsors ? whose interest in Egypt is crucial ? and not their bankers, as the lenders require borrowers to gross up their interest payments. And within a project finance deal, which has a limited economic flexibility due to its reliance on defined cashflows, this can be tough on a project's economics. Although banks conduct sensitivity analyses to ensure a project can meet this threat, it is still a worst-case scenario. With the tax amounting to as much as 33% of gross interest amounts ? which can represent something like a 250bp premium on funds for a even strong project credit ? it can have a serious effect on the economic appeal of sponsoring a project in Egypt.

?The withholding tax issue is a difficult one for borrowers and lenders,? says Van Bilsen at ABN Amro. ?While there can be a lot of appetite for a deal the banks do not often have the capability to book a deal in a withholding tax free jurisdiction. This could potentially hamper international investment in Egypt and borrowers may be faced with additional costs in absorbing gross-up costs.?

The second Egyptian power concession was recently awarded to Electricité de France, which will develop two IPPs ? East Port Said and Suez Power. The sponsor has mandated Barclays Capital, Credit Lyonnais and SG to arrange the financing which will require around $475 million in debt to develop.

The sponsor and arrangers are taking a different route to that of Sidi Krir in an effort to bypass the difficulties that project has experienced in terms of placing debt internationally. The new deal is likely to be structured as an IFC A/B loan facility and with the supranational IFC as lender of record to the projects will not be liable to withholding tax.

Local liquidity lacking

To compound the urgency of the issue of addressing the withholding tax, is a tightening of local bank market liquidity. The growth of the economy and a consequent demand for credit has put pressure on the liquidity of the domestic banking market. The demand for both dollar and Egyptian pound assets is growing faster than banks can meet it and this will inevitably place greater emphasis on raising international capital for projects in the country. ?The domestic bank market is suffering from a tightening of liquidity,? says Gordon Scott, senior director, financial institutions, at Fitch IBCA in London. ?This is more pronounced with respect to foreign currency liquidity but is also evident in the domestic sector.?

Related to the overall level of domestic market liquidity is the specific question of how long will the domestic banks be willing to finance these deals at maturities far greater than their international counterparts. On Sidi Krir, for example, domestic bank tranches have maturities of up to 15 years while the international tranche has a headline 12 year but effective eight year tenor.

Listening to the markets

Essentially, if Egypt is to realise its project finance ambitions, particularly in terms of becoming an LNG product exporter it is going to have to shift its position on withholding tax.

The rationale for the tax as it stands is twofold. Firstly, it is a potentially lucrative source of tax revenue for the government and secondly it helps to protect the business lines of Egyptian banks ? the largest four of which are state-owned.

At the moment, this tax is stifling the latent liquidity in the international markets for the country. If nothing is done, then sooner or later sponsors and their banks will switch their focus elsewhere ? for very few other active project finance markets in the region have the tax. The amount of capital required just to build the infrastructure to convert natural gas into a form which can be shipped, whether it be LNG, fertilisers or petrochemicals, is enormous. ?The costs of building the LNG and other conversion facilities is so great that there is a clear need to access the international capital markets to meet this capital expenditure,? says Spaull at Chase.

And there's the rub. With the domestic bank liquidity tightening, the international markets become more critical to meet the investment needs of the these projects. However, unless the Egyptian authorities address the restrictions imposed by the withholding tax, there is a risk that international liquidity will be far too constrained to meet these needs.

?The transition the country is now undertaking to become a significant natural gas exporter requires such a massive investment that the government urgently needs to consider what action it can take to optimize access to the international capital markets,? says Chase's Spaull.

Put bluntly, if Egypt is serious about these projects it needs to listen carefully and act on what the international markets require. The government needs to make a choice. Does it want to preserve the interests of the local banks, which are, in any case, increasingly unable to deliver the capital these projects need and also continue receiving revenue from withholding tax ? a source which is unlikely to see much growth? Or abandon, or at the very least, reduce withholding tax and thereby allow the international markets to finance the country's infrastructural development and transition to a gas exporting state. Effectively, it is a choice between the protection of short-term interests or the creation of long-term value.

So far, bankers in Egypt and abroad are not convinced that the government is listening to these concerns. ?The government occasionally makes some noises on the subject but really we get the sense that this is just lip service,? says the Cairo-based banker. If this is the case, then project finance in Egypt may never amount to much more than a tantalizing prospect.