Violent unrest in Egypt threatens to accelerate the country's slide towards a currency crisis, forcing a sharp depreciation of the Egyptian pound in coming months and conceivably prompting Cairo to impose capital controls.
Even before this month's clashes between government forces and protestors in Cairo, which have killed at least 33 people since Saturday, Egypt was heading towards monetary turmoil as the central bank battled to keep the pound stable by running down its foreign exchange reserves.
The recent violence, which calls into question whether Egypt can smoothly hold parliamentary elections beginning next week, is likely to increase pressure on the reserves and may bring a full-blown crisis forward to the next several months from the late-2012 tipping point previously predicted by some analysts.
Even in advance of recent events we were very concerned about the balance of payments and the burn-through in reserves, said Farouk Soussa, Middle East chief economist at Citigroup.
The violence and political noise is going to erode whatever confidence was left in the Egyptian economy, and may result in the current atmosphere in an acceleration of capital outflows.
Egypt's net foreign reserves have tumbled from around $36 billion (23 billion pounds) at the start of the year to $22.1 billion in October, as the violence and political uncertainty surrounding the ouster as president of Hosni Mubarak caused an exodus of foreign investors and tourists. Reserves sank $1.93 billion last month, the biggest drop since April, central bank data show.
By supplying foreign currency to the market, the central bank has so far managed to preserve the pound's buying power and curb pressure for inflation in the face of this capital flight. It has kept the pound remarkably stable in a range of roughly 5.92-5.99 against the dollar since Mubarak's overthrow.
But pressure on the pound is clearly growing as the market speculates about when the central bank may run out of money to maintain its defence; the currency edged down last week to its lowest level in nearly seven years.
Raza Agha, senior Middle East and North Africa economist at RBS, estimates the reserves are large enough to pay for about 4-1/2 months' worth of Egypt's imports. But liquid reserves -- currencies, deposits and securities that can be mobilised quickly to defend the pound -- are about $16.1 billion or 3.2 months of imports, he calculates.
Egyptian reserves are still not at the panic-inducing levels, but they are extremely vulnerable to capital flight, Agha wrote in a report last week.
Some traders think the market could panic, with expectations for currency depreciation causing bigger fund outflows that overwhelm the central bank, if liquid reserves fall near two months' import cover.
If the unrest causes the decline in reserves to accelerate from October's rate, as the violence hurts tourism revenues further and prompts foreign investors to sell their remaining holdings of Egyptian Treasury bills, crunch time could be reached in three months or so.
The forward market, in which banks hedge against future currency moves, clearly fears this point may be reached next year. Prices there imply an exchange rate of 6.15 in three months' time and 6.62 in a year.
The stock market also reflects the darkening mood. The main index, which is down 46 percent this year, rebounded 17 percent in October but in the last two weeks has given up almost all those gains.
International aid for Egypt could buy it valuable time and, conceivably, keep it afloat while the elections proceed and political stability returns.
Egypt turned down the offer of a $3.2 billion financing facility from the International Monetary Fund this summer, partly, officials indicated privately, because of national pride. The then finance minister said Egypt's ruling military did not want to build up debts.
The inexorable decline of the reserves has forced a rethink, and Finance Minister Hazem el-Beblawi said this week that Egypt would formally ask the IMF to start negotiations on a package similar to the one it previously rejected. The IMF has signalled it will not put onerous conditions on the loans.
The wealthy governments of the Gulf and the international community in general have strong geopolitical reasons to try to keep Egypt stable; Cairo has received in-principle offers of aid totalling well over $10 billion from Qatar, Saudi Arabia, the United Arab Emirates and other sources.
But actual aid flows have been slow to arrive partly, analysts speculate, because of political tensions between governments in Egypt and the Gulf. Cairo has so far received $1 billion of budget support from Saudi Arabia and Qatar; the UAE said last month it planned to provide $3 billion but was still discussing the mechanism to deliver it.
Meanwhile, the euro zone debt crisis and a global economic slowdown may reduce the ability of the IMF and Western countries to help Cairo. Bloodshed in Egypt, or any resulting delay in its election timetable, could make it politically difficult for the West to aid the Egyptian government.
Angus Blair, head of research at Middle Eastern investment bank Beltone Financial in Cairo, said there were some positive factors for Egypt: Suez Canal revenues, tourism numbers and remittances from its workers abroad had held up fairly well in the circumstances.
But the country is threatened on several fronts, including high food price inflation, its budget deficit and its trade and current account deficits, he said.
It's quite difficult for Egypt to have all of these issues addressed at the same time because it's in a global environment that's less conducive to help -- not because the world doesn't want to help Egypt, but because there are so many other global issues to deal with at the moment, Blair said.
Any sharp depreciation of the Egyptian pound could fuel inflation -- one of the factors which sparked the unrest that toppled Mubarak. Soussa said the central bank therefore appeared determined to defend the currency at least through January, when elections for the lower house of parliament are due to end.
If pressure on the pound continues to increase, authorities may impose capital controls, he said, though officials have denied any intention to do so. If that does not work, Egypt may be forced to let the pound fall; Citigroup thinks the pound may depreciate between 20 and 25 percent in 2012.
(With additional reporting by Nadia Saleem in Dubai; editing by Anna Willard)