Capital Structure of Non-financial Companies in Egypt - Essay Example

Chapter Introduction Due to current financial crisis, the overall impact of the changes has not only been felt by developed countries like US andUK but other countries also faced difficult economic situation to tackle. During March 2009, Egyptian government, as a result of the interest cut by Federal Reserve, slashed the interest rates by 50 basis points.(Guillen, 2010). Similarly, the economy of countries like Russia has also been affected and Government intervention prevented the further decline in economic activity. This indicates that the cross border affect of the changes in global economy produce significantly similar results for different countries depending upon their economy and its nature. The current financial crisis therefore has significantly affected the financial institutions of the world along with other non-financial institutions also. Due to this reason, the overall extension of credit to the non-financial institutions has been affected over the period of time. It is however, important to note that international banks specially working in developing countries have relatively limited contacts or business relationships with the international banks therefore they have not been affected the way international banks have been. In countries like China where the financial sector is mostly under the control of government, banks exposure towards toxic debt is limited therefore despite having the international presence, these banks are not fully affected by these changes. It is also however, critical to understand that there is an indirect threat faced by the international banks due to general decline in the stock prices as well as the falling housing market. Since most of the banks do not keep most of their capital in the form of cash therefore declining asset values will force them to allocate more capital to cover the potential risks. In such an environment there are chances that the overall credit extension to private sector may decline and financial institutions may require the support of their governments to keep them solvent. Theory also suggests that a reduction in the bank credit may result into a decline in the investment activity in the country and this will invariably affect the growth and may result into the creation of unemployment within a country. Since most of the emerging countries such as China, India, Korea and Japan are depending on exports as their major economic variable for growth therefore the current financial crisis may result into the substantial decline in the export business and thus may suppress the growth of these countries. A recession in developed countries therefore would mean that the developing countries will certainly feel the pressure of maintaining the existing level of foreign direct investment as well as other managing other important economic variables such as stable foreign exchange rates etc. (Naude,2009). Due to this inter-connectivity between the economies of the world, it is easier to have trickle down effect on the industries of other countries also. Such changes therefore certainly restrict the choices for the firms in developing countries to obtain external financing and develop a critical mix of capital structure. It is also critical to note that due to the current financial crisis there are changes in the capital structure of the non-financial firms due to changes in the interest rates as well as the lack of credit extension by the banks. This is important due to the fact that the changes are being witnessed by the firms working in developed as well as developing countries. It would therefore be more important to track the typical changes in the characteristics of the which took place as the result of current financial crisis. Objective of Study The researcher thinks that financial crisis can have an impact on determinates of capital structure. It is generally believed that that capital structure responds to profitability, size, and tangibility and growth variability. Therefore the changes after the financial crisis can play critical role to change significantly the determinants of capital structure. This is because of changes in the effect of some the factors which control the relationship between research variable and capital structure such as information asymmetry, agency problem, government’s regulation, capital market, inflation and cost of debt. Thus, the objective of research highlighted as follow: To find an empirical evidence of the determinants of capital structure before and after the financial crisis, in listed non-financial Companies in Egypt Problem Statement Capital Structure of firms is one of the mostly debated topics in corporate finance however; little emphasis has been placed on understanding and exploration of capital structure of firms in emerging and transition economies. Further, most of the theories of capital structure are based on the valuation principles therefore they assume the development of capital markets in a country to fully apply them. In such circumstances, these theories may not fully explain the dynamics behind the capital structure determination specially in economies where capital markets are not fully developed. Though Egypt has a long history of having sound capital markets however, the overall activity declined specially after the nationalization during 1950s. Stock Exchange in Alexandria was the fifth established stock exchange in the world after the establishment of Paris Stock Exchange during 1880s. Stock Exchange in Cairo was opened during the first decade of 20th Century thus the history of capital markets is quite rich in this country. More recently, there were further fundamental changes in Egyptian economy owing to conditions set by International Monetary Fund and the radical economic program adapted after 1991. Most of these changes were the direct result of the debt rescheduling as well as the other conditions put forward by International Monetary Fund i.e. IMF. After 1991, there was a conscious effort from the Government to stimulate the economy and achieve the desired growth rates however, this could not be possible without the increase in the local as well as foreign direct investment in the country. As a result of this economic program, there is a phenomenal growth in the activity at stock exchange of the country- in terms of both market capitalization as well as in share trade volume also This has also allowed the stock market to be more competitive because of the reduction in the concentration of firms as well as the lesser influence of large firms on the market volume. Considering such encouraging environment, there occurs a natural inclination to ask the question of whether the determinants of capital structure in Egypt are same as compared to other developed economies or they differ considerably from others?. Studies conducted by Omran (2009) clarified the relationship between the capital structure and the overall characteristics of the firm therefore Researcher consider it appropriate to probe this conclusion further and apply it to Egyptian market to gain further insight. Since, financial crisis tend to have brought peculiar changes in the way firms at international level tend to compete, therefore, researcher considers it important to re-check and re-evaluate the relationship between the capital structure of the firm and its characteristics specially after the financial crisis. The basic motivation therefore is to empirically validate if there occurred a change in the capital structure of the firms in the wake of the changes in their characteristics after the financial crisis. This is also significant due to the fact that Egypt, before financial crisis, was one of the emerging markets in the world with strong potential to grow and achieve consistent growth. However, since the overall dynamics of world economy has changed during these financial crisis, researcher therefore considers Egypt as a very typical case of studying the corporate capital structure of the firms in Egypt and test the empirical validity of different models under different settings. Background of Research Egyptian Economy- before Crisis The overall economic progress of Egypt has been good since 2004 owing to implementation of important economic policies in the country. Some of the critical changes involved better control and management of the monetary policy of the country, liberalization of foreign trade, massive privatization initiative resulting into the sell off State run organizations, better and more prudent management of public finance as well as the better regulation of the exchange market to name a few. Such massive and critical changes in the way economy is run in the country therefore ensured that the country’s overall economic performance remain sustainable. It was only because of these changes and reforms that post-reform annual GDP of the country almost doubled as compared to previous decades. (Hatab,2009). This was mainly due to the huge inflows of foreign direct investment which resulted into the increase in economic activity of the country. Apart from this, local industry of the country also started to pick up and contributed positively towards the increase in economic growth. During fiscal year 2007-2008, Egyptian Economy witnessed growth rates of over 7% which was almost double of what it was during 2003-4. Apart from the increase in the nominal GDP, real GDP also increased by 5.2% during the same period indicating the government was able to contain inflation while at the same time achieved the necessary growth targets during a very short span of time.(Radwan, 2009) Such huge increase in the economic growth also resulted into the increase in the tax revenues for the government also. During 2007-8 period, the overall tax revenues for the government increased by over 20% on year on year basis indicating the implementation of effective tax collection system as well as the necessary economic growth which helped generate the government increased tax revenue. The overall tax to GDP ratio of the country therefore increased to 15.8% mainly due to increase in the tax revenue collected from goods and services as well as from foreign trade.(Radwan,2009). With macroeconomic policies, there occurred stabilization in the foreign exchange market of the country as well as deepening of the inter-bank market also. Budget deficit started to decline and due to liberal changes, the financial sector of the country also started to become flexible and credit extension to private sector increased to 12.6% as compared to 4.5% in June 2004. The overall external position of the country also started to improve due to net inflow of foreign direct investment (FDI) into the country and strong export led growth. The balance of payment within the country remained in positive zone during the period as it remained at the level of 3.4% during 2007-2008. During same period, Net FDI inflow touched the figure of $13.2 Billion US dollars- more than double the level of FDI in the country during 2004 and 2005. It is also important to note that during this period, current account balance of the country also remained in surplus. The overall current account balance was in surplus at a level of 0.6% of the GDP despite the fact that country witnessed growth in its imports as well as an increase in the international prices specially of fuel. The overall non-oil related exports of the country increased 25% during the period and remained little under $15 billions during this period. This was also remained the significant part of the country’s exports to the international market and contributed heavily towards the achievement of economic targets of the country. This shift towards increasing the non-oil related exports of the country also indicate towards the new and renewed focus of the government to strengthen the non-oil related exports of the country and lessen the dependence of the country on oil related exports. It is however, critical to note that most of the exports from Egypt went to United States of America as well as to other European countries and with the emergence of the financial crisis and slow down of economic activity in the main markets of Egypt, the economy of the country also got affected. With the emergence of financial crisis in United States, Egyptian economy also affected as the Stock markets of the country shrunk by 43% registering one of the largest declines in the overall history of capital markets in the country. This fall continued and the overall decline in the stock markets almost eroded 50% of the investors’ money from Egyptian Stock Exchange.(Hatab,2008). This sharp decline in the capital markets of the country therefore indicated that Egypt was one of the affected economies owing to the economic crisis in United States and other developed countries. The impact of the financial crisis on Egypt Global financial crisis came in a time when Egypt was passing through one of its best periods of economic growth. During the second half of 2008, the overall impact of financial crisis started to have its real influence on the economic progress of the Egypt’s economy. Most importantly, the revenues from tourism started to decline, the export proceeds also declined and the revenues from Suez Canals also started to decrease owing to the changes in global economy. These changes were not only rapid but also were in greater magnitude therefore affecting the economy badly. During the first half of 2008, GDP of the country grew by more than 7% however, due to crisis the overall decline in the economic activity caused this growth rate to decline to 6.7% during the last quarter of year 2008. This trend continued and the economy registered further decline in the growth drastically owing to changes in important economic variables of the country such as manufacturing activity, foreign remittances from Egyptian living abroad, receipts from Suez Canals etc.(Central Bank of Egypt, 2009). It is however, expected that with the help from the Egyptian government’s stimulus package, it is possible that the economy may start to show positive signs during 2010 and recovery in most of the developed countries of the world. Reduction in Revenues Tourism Revenues Tourism always played critical role in the economy of Egypt due to its historical roots and linkages with one of the ancient civilizations of the world. Egypt is ranked at 23 of the top 50 tourist hubs of the world and is the leading tourism spot in North Africa. However, due to the financial crisis, the overall inflow of the tourists from European and other countries has declined. This decline in the number of tourists therefore have created a decline in the tourism revenues for the country and resulted into the slow down in the economic growth of the country. Suez Canal Revenues Suez Canal is considered as the vital link between East and West and is one of the leading sources of revenue for Egypt. The overall slow down in the international trade activity via Suez Canal as the net tonnage carried over Suez Canal has declined. Further the revenues from the Suez Canal have declined by 22% after the financial crisis. Decline in Manufacturing Activity It has been reported that due to current financial crisis, the overall manufacturing activity has declined after the financial crisis. It was forecasted that the growth in manufacturing activity will reduce to 3.8% during 2009-2010 thus registering a significant decline in the overall manufacturing activity within the country. Egypt is also the producer of one of the finest cotton in the world and the reduction in the cotton prices at international level has affected this sector of the economy also. Due to decrease in the cotton prices, many cotton producers of the country have unsold inventories estimated around 80,000 tons thus contributing towards increased cost of maintaining and storing them. It is mostly because of this reason that most of the cotton producers of the country are facing high cost of business and are on the verge of bankruptcy. Due to overall uncertainty in the international markets, chances are that most of the sectors of the economy including oil production will be affected in coming periods. Reduced flow of domestic and Foreign Investment Though the total investment in the last quarter of 2008-2009 increased however, the overall net flow of investment declined during this period. This was despite the fact that banking sector was liquid however, despite this, the overall credit extension to the private sector declined thus resulting into the decline of the investment. The overall flow of FDI which was approximately 9% of the GDP during 2007-2008 however, it sharply declined during 2009 by almost 60%. This also resulted into the increased level of uncertainty within the businesses to restrain themselves from making new investments and expand and develop to new levels. Different studies including studies conducted by Héricourt J. & Poncet S. (2007) indicate the relationship between FDI and the credit constraints for the local firms. Thus the inflow of the FDI depends upon how much restrictions are placed on the extension of credit to private sector and as such FDI tend to reduce the market imperfections which local firms may face when dealing with the financial institutions. The reduction in the market imperfections therefore allow firms to better negotiate the credit terms and obtain external credit with relative ease. Studies conducted by Massoud (2010) explored the impact of FDI on the economic growth in Egypt and it was concluded that Greenfield FDI projects tend to have larger influence on the economic growth and produce better chances of creating economic growth. This study further indicated that FDI tend to create better impact on the economic growth when it is done on the basis of sectoral basis i.e. conscious direction of FDI funds into specific economic sectors tend to produce better results for the economy. Thus the overall impact of FDI stock differs from industry to industry and overall impact therefore can be explored by understanding the impact of FDI on different sectors of the economy. Massoud (2010) concluded that those industries which tend to attract efficiency will be more affected by the inflow of FDI whereas there is a very small effect of FDI on industries which are termed as market seeking. This therefore also means that FDI depends upon the overall nature of the local industry and the financial sector of the country. If credit extension to private sector is relatively unrestricted, chances are the flow of FDI will be higher and local firms will also benefit from the inflow of FDI in terms of reducing the imperfections in financial markets. Impact on corporations’ behavior in Egypt As a result of the financial crisis and resulting decline in the stock market, it has been observed that many Egyptian companies have started to buy back their shares from the market. This is despite the fact that the overall internal funds available to firms are relatively low as compared to the level of internal funds they used to have before the start of the financial crisis. Some of the examples of companies buying back their shares or subsidiaries include Orascam which requested the authorities to allow telecommunication companies to selectively repurchase their own securities from open market due to favorable market conditions.1 Apart from Orascam, Olympic Group, one of the leading manufacturers of the domestic appliances also disclosed its plan to repurchase some of its stocks from the open market in order to take advantage of the favorable market conditions.2 Impact on Capital Markets There were number of factors which resulted into the exacerbation of the performance of stock exchange in the country. During the later part of 2007, foreign investors engaged into rush behavior and they accelerated the liquidation of their positions in the market in the wake of the subprime mortgage crisis in the developed world. Apart from this the May Decree also served as a critical signal to the investors regarding the change in the stance of government towards the economic reforms which it undertook during the decade. It is also important to note that rising inflation in the country also resulted into the increase in prices specially food prices inflated. This also resulted into a negative influence on the investors and resulted into the generation of expectations which contributed negatively for the investors regarding the overall recovery of Egyptian economy and the stock markets of the country. These factors combined together to produce a negative impact on the stock markets and the market prices dropped by 20% during the month of August 2008. With the continuous decline in the economic activity at the global level, the stock markets of the country continued to slide and dropped by more than 40% by the end of year 2008. The overall estimated decline in the stock market was more than 50% indicating that the Egyptian Stock market was one of the worst effected institutions in the country. This not only resulted into the decline in the returns to shareholders but also created significant agency problems for the companies as managers became more cautious in terms of making good investment decisions. Conclusion The above discussion therefore indicates that the financial crisis has affected the economy of Egypt in significant manner. Before the crisis emerged, Egypt was on its way to become economically self sufficient however, the emergence of crisis led into the slide in economic recovery of the country and put at risk its long standing economic reforms program which was undergoing with the help of IMF. With the emergence of financial crisis, not only financial sector of the country got affected but non-financial sector of the country was affected too. As a result of the general slow down in the economy, not only inflation increased but also the overall consumer sentiments were suppressed too. The credit extension to private sector declined resulting into restricted choices for the private sector firms to borrow whereas due to decline in the stock market, many large firms started to repurchase their own shares from the market thus potentially changing their capital structure. References 1. Central Bank of Egypt (2009). Economic Review [online]. [Accessed 23rd October 2010]. Available from: . 2. Guillen, M (2010). The Global Economic [online]. [Accessed 22nd October 2010]. Available from: . 3. Hatab, A (2008). Egypt within the Framework of the Global Financial Crisis: Impact, Response and Way Forward [online]. [Accessed 21st October 2010]. Available from: . 4. Héricourta, J, Ponce, S (2009). FDI and credit constraints: Firm-level evidence from China . Economic Systems. 33 (1), pp.1-21. 5. Massoud, N (2010). Impact of A Crisis-induced FDI Drop on Growth in Egypt [online]. [Accessed 22nd October 2010]. Available from: . 6. Naude, W (2009). The Financial Crisis of 2008 and the Developing Countries [online]. [Accessed 22nd October 2010]. Available from: . 7. Radwan, S (2009). Economic and Social Impact of the Financial and Economic Crisis on Egypt [online]. [Accessed 22nd October 2010]. Available from: . Read More