Arab Finance: Moody's Investors Services reported last Monday, the Central Bank of Egypt (CBE) instructed Egyptian banks to raise their lending to small and midsize enterprises (SMEs) to 20% of their loan books over the next four years, up from 5%-10% currently, according to our estimates. Along with other government-led growth-enhancing reforms, the CBE’s regulation will likely shore up the country’s fragile economic recovery, a credit positive for Egypt (B3 stable).

However, although the CBE has provided tools to partly mitigate the associated funding and credit risks, the rapid growth in SME loans necessary to reach the 20% target will likely weaken loan performance, a credit negative for Egyptian banks.

SME lending will support job creation and help lower the country’s high unemployment, which was 12.8% as of September 2015. SMEs employing fewer than 10 workers compose 97% of Egypt’s businesses, according to state-run statistics body CAPMAS, and a World Bank Enterprise Survey showed that a lack of access to credit is one of Egyptian business leaders’ chief complaints.

The central bank measure will support the country’s economic recovery by reviving investment. Although real GDP growth rose to 4.5% in second-quarter 2015 from 2.6% in the first quarter, and growth for the fiscal year that ended June 2015 was 4.2%, second quarter 2015 growth was primarily supported by a 15.7% fall in imports. Exports fell 4.1% in second-quarter 2015, while investment declined 3.0% (see exhibit), and we expect both to remain depressed. Meanwhile, the tourism sector is suffering from fresh security concerns.

In addition to the minimum lending requirements, the CBE has capped the interest rate that banks can charge for loans to certain SME categories at 5%. However, since the regulator will now allow banks to fund these loans out of their required liquidity reserves, which currently earn nothing, the profitability benefit will be higher for banks particularly once we include the fee income banks will earn from this business. As part of the initiative, the CBE introduced a nationwide definition for SMEs6 and will expand the training it offers to bank employees and individuals in order to raise financial literacy.

The CBE also has asked banks to submit their strategic plans over the next month and is requiring all banks to put in place dedicated units and robust procedures to cope with the high credit risk associated with the SME segment. Not all 40 banks operating in Egypt have units dedicated to SME lending. According to a CBE official, the authorities also plan to transform the Credit Guarantee Company (CGC, unrated), including a capital increase, so that it can guarantee 60%-70% of loans provided to certain SME categories.

The CGC is currently small, so its future role will depend on the size of that capital increase. Despite the authorities’ support, Egyptian banks will continue to face considerable challenges in the SME segment. Information to guide their credit decisions is limited. Few small businesses are officially registered, while the central credit registry has information on only a small number of SMEs. Banks are also hampered by the low financial literacy of SME managers and a lack of financial disclosure and strategic direction. The availability of collateral is limited and the process of enforcing creditor rights with regards to collateral is lengthy.

Exposures vary, but according to our calculations National Bank of Egypt SAE (B3 stable, caa17 ) will need to double its portfolio over the next four years to satisfy the CBE’s requirement. Meanwhile, Commercial International Bank (Egypt) SAE (B3 stable, b3) and Banque Misr SAE (B3 stable, caa1) will need to grow their SMEs at an annual growth rate of more than 50% because they currently have minimal SME loans. Such high growth rates will likely compromise their asset quality.