Egypt's tetchy negotiations with the IMF on slashing subsidies as a part of a loan deal reflect a far broader fiscal and social conundrum in the region, raising the stakes for investors.
Egyptian stocks have rallied 50% this year on greater political stability and hopes for a deal with the International Monetary Fund, after shedding half their value in 2011 after the ousting of Hosni Mubarak.
For many investors, securing a $4.8 billion IMF deal will be the catalyst for a much-needed rebound in private-sector investment.
"If the IMF gives Egypt a loan, that would supersede everything else," said Sergei Strigo, head of emerging debt management at French asset manager Amundi.
But it could also pose risks: the IMF is demanding a reform of Egypt's hefty subsidies t hat could hurt foreign investment in sectors such as energy and raise the prospect of renewed social unrest.
"In a time of political transition and a fragile rebuilding of the social fabric, a brutal cut in the subsidy system could prove very sensitive," said Philippe Dauba-Pantanacce, economist at Standard Chartered.
It's a dilemma that extends across the Middle East and North Africa as lenders and ratings agencies demand that governments cut budget deficits, at a time when authorities are reluctant to reduce handouts for fear of aggravating the social turmoil that has gripped the region.
Standard & Poor's downgraded Morocco's outlook in October to 'negative' and warned the country could lose its investment grade rating if it does not significantly narrow its fiscal and current account deficits.
Morocco's subsidy bill reached 6% of GDP in 2011. Its fiscal deficit soared 462% in the first seven months of this year as subsidies increased by 58%, according to Standard Chartered.
In Jordan, a $2 billion stand-by arrangement secured with the IMF in August has provided a lifeline after foreign direct investment slumped 31% in the first quarter of 2012 from a year earlier and government subsidies rose 41% in the first half of this year.
That has pushed public debt to above 72% of GDP, according to Standard Chartered.
But worries about social tension have already prompted King Abdullah in September to intervene and block a fuel price hike recommended by the IMF, in order to quell street protests that erupted on news of higher prices.
Jordan spends $2.3 billion on subsidies, almost a quarter of its annual budget, and is trying to gradually force businesses to pay higher fuel and electricity prices.
"Jordan is essentially on the brink of financial collapse without IMF help," said Said Hirsh, economist at Capital Economics.
Eaton Vance's Parametric Structured Emerging Markets fund has trimmed its 0.8% allocation in Jordan slightly, while Templeton's frontier fund has reduced its Jordan weighting to 0.8% from 1.18, according to data from Lipper.
Across the Middle East and North Africa, dedicated MENA funds tracked by Lipper, and with a little over $1.3 billion in assets, have seen net outflows of just over $200 million this year. Funds covering only Arab nations in the Gulf Cooperation Council, with about $1.8 billion in assets, have seen net outflows of just over $100 million.
Oil importers Egypt and Jordan in particular need to address their balance of payments to attract loans and investment, analysts say.
INVESTORS UNCONVINCED
Egypt spent $15.7 billion, or 20% of government spending, on subsidising petroleum products, including cooking gas, in the financial year that ended on June 30.
Under the current system, a canister of butane cooking gas, or "butagas", sells for around 5 Egyptian pounds, while it costs almost 70 pounds to produce.
"There is still a lot to do for Egypt to avoid a big financial crisis in the immediate term," Hirsh said.
"People are buying into Egypt's medium- to long-term story rather than what's going to happen next year."
Egypt's finance minister said this week that the government hoped to reach a deal with the IMF in the middle of next month, but some investors are not so optimistic and it is unclear what commitments Cairo will make to secure a financial backstop.
"It would appear that markets have taken an IMF deal as a given … It's probably a bit of an overreaction on the part of investors," Hirsh said.
Templeton's Frontier Markets Fund has cut its Egypt allocation to 4.6% of its portfolio from 6.2% at the end of 2011, according to Lipper, while Morgan Stanley's Emerging EMEA fund more than halved its holding to just over 2%, signalling caution.
Egypt's new leadership under President Mohamed Mursi seems more willing to reduce its subsidies bill than Hosni Mubarak's administration. But the government has been moving carefully to sell austerity measures to a public whose economic expectations have risen since last year's popular revolt.
