The topic of this report is a commodity exchange framework, and the feasibility of having commodities cash and futures exchange in Egypt. If the project appears viable it is important to highlight key considerations and steps on how to proceed.
Both the public and private sector have shown a keenness for the establishment of a commodities exchange in Egypt. The importance of agriculture to the Egyptian economy is clear; Egypt has an active commodities market. Examples of major products with low perishability include cotton, potatoes, citrus, rice, wheat, corn, tobacco, sugar, and chickpeas. In a recent meeting with Horus Trading, they highlighted that plans for Egypt to stop production of rice and sugar due to the constraints on the country’s water resources Egypt, will switch the economy from a net exporter to a net importer.
The government (GASC) also has an interest in the establishment of an exchange. Domestically produced wheat in Egypt is exclusively purchased by the Egyptian government and, due to the political sensitivity of wheat production in Egypt, they encourages domestic wheat production with high subsidies. The cost to the Egyptian government of subsidizing the production of 72% flour baladi bread is estimated at 0.8 percent of Egypt’s GDP. These subsidies have distorted the market price in Egypt with domestic wheat priced above the international wheat. In order to meet the countries growing demand for wheat the government depends on imports. The Egyptian government is also the world’s single largest importer of wheat, importing between four to five million metric tonnes of wheat annually. In addition, the government has occasionally had difficulties securing foreign exchange to purchase imports of wheat, placing the country’s food security at risk.
In November, the government made a commitment to start buying local wheat from farmers at the average global price starting April 2016. Reuters reported that in the 2015 season, Egypt offered a fixed price of 420 pounds per ardeb, which is equivalent to about 150 kg. The price was about $168 a tonne to $200 a tonne higher than the international market. This is a positive move from the government as relinquishing control of domestic wheat prices will make the establishment of a commodities exchange much smoother.
In 2015 domestic production of wheat was approximately 9 million tonnes, up from the three-year average of 8.7 million tonnes. 60% of domestic production is either used as seed for replanting, animal feed or consumed on farms. Wheat consumed on-farm is stored and milled in small-scale village mills into very coarse 100 percent extraction flour. In terms of domestic wheat purchases there are three channels through which the government purchases domestic wheat.
The General Authority for Supply Commodities (GASC) agency carries out Egyptian government wheat buying internationally. At the same time it oversees and channels funds to the various state entities that buy domestic wheat for subsidized bread. Farmers are required to deliver to the public mills or the Shounas under the Principal Bank for Development and Agricultural Credit (PBDAC). Even with attractive government subsidies for domestic wheat, Egypt remains the world’s largest wheat importer. Wheat imports for the 2015/16 marketing year are estimated at 11 million tonnes, about the same as the previous year and the average for the last five years. Given the potential size of the cash market for wheat in Egypt, it is a good candidate for being introduced as an exchange traded product and will go some way to helping local conditions in Egypt have an influence on the establishment of global prices.
GASC alone imports approximately 5 million metric tonnes of wheat annually in order to meet demand for 82% extraction baladi bread. However, GASC is constrained in terms of storage at port with only 400,000 metric tonnes of storage capacity. Railways and truck are used to transport wheat imports inland to be received by silos for storage. In a report this year, the FAO stated that according to government sources the 2014 price offered by the government for a tonne of wheat amounted to EGP 2,800 (USD 392), while the import price was approximately EGP 2,200 (USD 308). This is equivalent to a difference of about USD 84 per tonne as per the 15 May 2014 (mid-harvest) exchange rate and has been encouraging black market trading for international wheat disguised as domestic wheat.
Quality control at port is carried out by inspectors and the shipment is re-tested once it arrives inland to ensure quality is maintained after transportation. If it doesn’t meet the standards set by the Ministry of Supply and Internal Trade (MoSIT) it is rejected and the farmers/traders must arrange cleaning to meet the specification. Quality control checks are carried out every two to three days. A grain sample is taken and if the sample is below quality standards set by the MoSIT then the batch is sent to the aeration and fumigation systems for cleaning.
Milling company takes a share of government grain each day for processing and this share is dictated by the MoSIT. Government mill are working at below capacity with daily milling capacity at 28,000 metric tonnes versus actual milling rates in the region of 17,000 metric tonnes. Government mills do not receive any cash payment for the 82% extraction flour and nor do they pay for the wheat inputs. They are purely processors that are permitted by the government to retain a by-product of the wheat production process called bran which they are then able to sell at between 1,500 - 1,600 EGP per metric tonne. With processing costs for millers at approximately 300 EGP per metric tonne, the net total essentially represents the processing fee received by the miller per tonne of 1,300 EGP.
There are approximately 25,000 bakers of local baladi bread made from 72% extraction flour. They are required to collect flour from the public mills depending on a schedule dictated by the MoSIT. Bakers receive 5 piastres from the customer for each loaf plus 30 piastres subsidy from GASC making the free market price per loaf 35 piastres.
Imported wheat can only be used from the production of 72% extraction flour which is typically used to make high value cakes, breads and biscuits. It is typically imported from Russia and Ukraine at an average purchase price of USD 180 to USD 220, much lower than the price of domestic wheat.
The private sector in Egypt typically purchases between 5 and 6 million metric tonnes per year with private port storage at almost 3 million metric tonnes this far exceeds that of GASC despite comparable import quantities. Like in the public sector, quality standards are imposed on imported grain and inspectors are imported at ports to provide quality certification and assurances.
Traders sell their imported product to private millers on the over-the-counter (OTC) spot market. The refined wheat is typically sold back to traders who sell to the final stage manufacturers, the bakers.
The number of importers of wheat in Egypt is 12 who are expected to be active participants in EGYCOMEX as they perform automatic hedging via brokers to manage their exposure to price volatility.
Egypt already has an existing equities market (EGX) regulated by EFSA, Egypt’s financial regulations authority. This means that there is an existing international and local investor base in Egypt. Foreign investors trading in the Egyptian stock market must trade thorough locally registered stock brokers. Stock brokers will ensure the commodity exchange will be far-reaching increasing the level of trading activity, liquidity and credibility of the exchange as a mechanism for price discovery and risk management. With 100,000 active trading members (defined as having executed a transaction within the last year), the equities market has laid the foundations attracting interested investors to Egypt, which the commodities exchange will be able to leverage.
The EGX is decentralized from government control indicating a willingness from the government to encourage free market trading. Additionally, we have seen a willingness from EFSA to accommodate a commodities exchange. EFSA ultimately sets rules and regulations based on guiding principles to provide the following assurances:
Currently, no regulations have been established for the trading of derivatives contracts on the equities market except for the prohibition of short-selling. EFSA will require assurances from the exchange that the appropriate technology and infrastructure are in place to be able to facilitate commodities trading under the aforementioned principles. These challenges will be discussed in the next section.
There are however, existing EFSA regulations, which, in principle, can be applied to a commodities exchange. For example, margin trading law already exists the equities market and can be applied to the commodities market. Likewise Egypt’s EFSA informed the government has recently passed a new law on movable goods guarantees, which aims to create an online registry for movables goods such as machinery. This law could be the basis for warehousing financing allowing spot traders to use deposits as collateral for loans. EFSA is currently in the process of drafting the regulations for this law.
Financing is currently available for large importers with Egyptian banks also providing letters of credit for smaller importers. This expands financing options for spot trading in the Egyptian market.
The presence of an equities clearing house provides significant advantages as there are many mechanisms, processes and existing knowledge and infrastructure the EGYCOMEX will be able to leverage in order to establish a commodities exchange. Misr for Central Clearing and Depository and Registry (MCDR) provide clearing, depository and settlement services for clients trading in the Egyptian equities market. In a recent meeting MCDR stated that they already have plans drawn up on how they would integrate a commodities exchange into their existing processes.
MCDR clearly have the technological know-how to be able to absorb the demands of a commodities exchange. They have the ability and capacity to absorb any clearing and depository services required by a commodities exchange, in particular with respect to the trading of cotton, cement and orange. Approximately $500m-$800m worth of transactions are processed daily which amounts to between 15,000 to 25,000 individual transactions daily, with the capacity to process 250,000 transactions per day. They undertake efficient settlement in line with international standards as they are able to process same day gross settlement. There are also various ways for the delivery of cash settlement to clients making it very accessible for a range of market participants (from large trading houses to small farmers). Further assurances in the form of the settlement guarantee fund protect clients from counterparty default and ensure that brokers set adequate client criteria. The presence of in-house technical experts means that implementation will be quicker and more efficient with minimal errors. An additional benefit is that they have developed the system in-house allowing an element of flexibility as they would be able to provide a more bespoke system tailored to the requirements of the commodities exchange.
Despite many positive indicators there are still some important considerations to bear in mind for the successful establishment of a commodities exchange.