MIDEAST DEBT-Egypt sukuk issue would find buyers, end of year likely

* Big step for Islamic finance in North Africa

* Officials' projection of money to be raised is overblown

* But many Gulf investors would be interested

* Legal wrangling over sukuk structure must be resolved

* Issue likely towards end of this year

DUBAI/CAIRO, March 6 (Reuters) - Egypt is pinning its hopes

for a return to the international capital markets on Islamic

bonds. It is likely to be successful, provided it can hold

parliamentary elections and resolve domestic legal wrangling

over how to structure the bonds.

Struggling to narrow a big budget deficit and boost foreign

currency reserves that are at critically low levels, President

Mohamed Mursi's government last week approved a draft law that

would allow the state to issue sukuk for the first time.

With its credit rating repeatedly downgraded to junk status

by international rating agencies over the past year, and its

economy undermined by political instability, Egypt might seem an

unlikely borrower.

But analysts said strong investor demand for sukuk

worldwide, potential interest among cash-rich Gulf funds, and

the low global interest rate environment meant an Egyptian issue

could attract heavy orders.

"Naturally, there will be question marks in the minds of

investors, both regional and international, and appetite will

depend on how the issuer can address such concerns," said Chavan

Bhogaita, head of markets strategy at National Bank of Abu

Dhabi.

"It all depends on yield. Investors around the world are

still looking for yield and are willing to venture outside their

comfort zone to get it."

MAJOR STEP

An Egyptian sukuk issue would be seen as a major step for

Islamic finance in North Africa, making it easier for other

governments in the region to follow suit.

The regime of former Egyptian leader Hosni Mubarak, ousted

in February 2011, neglected Islamic finance for political

reasons; Mursi's government, backed by the Muslim Brotherhood,

is keen to promote it for both financial and religious reasons.

By themselves, sukuk will not come close to resolving

Egypt's financial problems, and the government's projections for

how much it could raise through them are almost certainly

overblown, analysts and regional debt traders believe.

Finance Minister Al-Mursi Al-Sayed Hegazy predicted Egypt

could raise around $10 billion a year via sukuk, but traders in

the Gulf think international issues of $1 billion or $2 billion

annually would be more realistic.

Domestically, the government might be able to boost its

ability to borrow from Egyptian savers, particularly religiously

conservative ones, by offering them Islamic instruments

denominated in Egyptian pounds.

But the amounts raised are likely to be dwarfed by the

government's budget deficit, which officials say could hit 180

billion pounds ($26.7 billion), or 10 percent of gross domestic

product, in the fiscal year through the end of June.

Nevertheless, debt traders said an international sukuk issue

from Egypt could attract strong interest from Gulf funds which

had not found enough sukuk to buy locally.

"Elections at the end of April will be key, but I am a big

believer in Egypt," said one regional debt capital markets

banker, declining to be identified because he was not authorised

to speak to media. "There will be lots of cash buying this for

many different reasons."

The banker said that once the political situation was

clearer - perhaps towards the end of this year - Egypt could

probably issue a sukuk at a yield in the high 5 percent or low 6

percent area. Other traders estimated yields of up to 8 percent.

Egypt's outstanding $1 billion conventional bond, which

matures in 2020, is currently bid at about 93 cents on the

dollar to yield 7 percent, according to Thomson Reuters data.

In a sign that the government is gearing up for debt issues,

a new head of the finance ministry's debt management office was

appointed this week: Hamdy Samir, previously head of fixed

income and money markets at National Bank of Egypt, a top

commercial bank.

ELECTIONS

Two things will need to happen to permit an Egyptian sukuk

issue, however. One is for the country to hold parliamentary

elections, which are due to begin next month but, under Egypt's

drawn-out electoral process, end only in late June.

The elections are expected to clear the way for Egypt to

resume detailed negotiations with the International Monetary

Fund on a $4.8 billion loan. An IMF deal could unlock other

international aid to Egypt and it would be seen by investors as

an important endorsement of the government's economic policies.

The other necessary condition is a resolution of the legal

wrangling that has plagued the drafting of the sukuk bill.

Hegazy, a former academic with a background in Islamic

economics, said last week that it would take at least three

months to push through regulations necessary for a sukuk issue.

The bill has been referred to the Islamist-dominated upper house

of parliament and is then to receive final approval from Mursi.

But like many economic policies in post-revolution Egypt,

the bill has been slowed by accusations that the government is

abusing its power. Two previous versions of the legislation had

to be amended after protests from critics including religious

scholars at Cairo's prestigious Al-Azhar university.

Because Islam bans interest payments, sukuk are based on

real assets and are supposed to pay investors with revenue from

those assets. The scholars complained the legislation could let

officials abuse their control of public assets or expose those

assets to seizure by private investors in case of a default.

This struck a chord in Egypt because of its history. Khedive

Ismael, a 19th century ruler, borrowed excessively from abroad,

falling into debt that eventually forced the sale of Egypt's

shares in the Suez Canal Company to Britain. The sale launched

the era of direct colonial intervention in Egypt.

Asked by Reuters this week whether assets behind the sukuk

could be seized by creditors, Hegazy insisted there was no risk.

"I would like to reassure you the lands won't be mortgaged.

It is a use of the project assets for a limited time, then the

entire project will return to the Egyptian people," he said,

adding that investors in the sukuk would bear the risk of the

assets behind them performing poorly.

However, the latest version of the bill appears to address

the problem by banning the use of current state assets to back

sukuk but allowing the use of "new" government assets - a

distinction which may not satisfy critics.

"It is a tricky wording," former finance minister Sameer

Radwan told Reuters. "There is a belief that any problem can be

sorted out by altering words. This is possible in politics, not

in economics."

David Butter, associate fellow at Chatham House in London,

said the government's struggle to pass the sukuk law had to some

extent distracted it from the vital task of securing the IMF

loan.

"The political and economic context makes the approval of

the Islamic finance law complicated," he said.

(Additional reporting by Mala Pancholia in Dubai; Editing by

Andrew Torchia)

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