Overview -- We believe that the Muslim Brotherhood--Egypt's dominant political group--and the senior ranks of the Egyptian military are moving toward a working arrangement. -- In our view, this could lead to the authorities addressing some of Egypt's pressing structural challenges and stemming the deterioration in government and external finances. -- We are therefore affirming our 'B/B' long- and short-term sovereign credit ratings on Egypt. At the same time, we are removing the long-term ratings from CreditWatch, where they were placed with negative implications on June 25, 2012. -- The negative outlook reflects our view that we could lower the ratings if political or social tensions were to escalate again. In our view, uncertainties remain over the authorities' political goals and the status of key state institutions. We also think domestic unrest could resurface when the new constitution is drafted, or when new parliamentary elections are held. Rating Action On Aug. 23, 2012, Standard & Poor's Ratings Services affirmed its long- and short-term foreign and local currency sovereign credit ratings on Egypt at 'B/B'. At the same time, we removed the ratings from CreditWatch, where they were placed with negative implications on June 25, 2012. The outlook is negative. The transfer and convertibility (T&C) assessment is 'B' in line with the sovereign ratings. The recovery rating on the unsecured foreign-currency debt remains unchanged at '3', indicating our expectation of 50%-70% recovery in the event of a default. Rationale The ratings affirmation reflects our opinion that a working relationship between the military and the dominant political group, the Muslim Brotherhood, is gradually being reached. In our view, this could pave the way for an improvement in medium-term policymaking. We therefore project that Egypt's weak public sector finances and external position could stabilize. The negative outlook reflects our view that there is a one-in-three likelihood of a downgrade should political or social tensions escalate once more. If this happened, the current short-term approach to policymaking would likely continue, and foreign exchange reserves would likely decline further absent foreign donor inflows. We placed our long-term foreign and local currency sovereign credit ratings on Egypt on CreditWatch with negative implications on June 25, 2012. In our view, political tensions had been escalating between the ruling Supreme Council of the Armed Forces (SCAF) and the Islamist political groups following the dissolution of parliament on June 14, 2012. At that time, we believed that these tensions might exacerbate and prolong the authorities' ineffectiveness in addressing economic, fiscal, and external challenges. In our view, this would have further weakened key economic and external indicators while also undermining donors' and multilateral lending institutions' willingness to extend support. However, events have since unfolded to give recently elected president Mohamed Morsi what we understand to be full executive and legislative powers: -- On June 17, the SCAF had issued a decree extending its control to encompass legislative, as well as military, affairs until such time as parliamentary elections were re-held. -- On June 24, Egypt's election commission declared that the Muslim Brotherhood's candidate Mohamed Morsi had won the presidential run-off. The Muslim Brotherhood had already won more votes than any other political group (38%) at parliamentary elections held November 2011 to January 2012. -- On Aug. 12, President Morsi reversed the SCAF's June 17 decree, and regained the presidential powers that enabled him to make changes to senior military personnel. President Morsi has used these powers to retire the head of the SCAF, Field Marshal Tantawi, and his chief of staff. We understand that the president now has full executive and legislative powers until parliament is reconvened. We understand that, constitutionally, the military can now only exercise executive power when national security is threatened. We believe, however, that President Morsi would not have been able to make such a move without the acquiescence of senior officers in the military, who were content to see power shift from individuals associated with the Mubarak era to a new guard. In our view, the military gave consent to the changing of the guard as a compromise to reduce tensions between it and the new political powers. At the same time, we understand that the privileges and business interests of the military remain protected. We now expect a relatively stable few months ahead. In our opinion, this could give the authorities room to achieve political and policy consensus sufficient to facilitate the external and domestic financing necessary to fund the government deficit and support the Egyptian pound. The government projects net borrowing at EGGBP135 billion (7.6% of GDP) in the state's 2012/2013 budget. We estimate that it could be as much as EGGBP163 billion (9.1%). Media reports quote the finance minister Momtaz al-Saieed as saying that the government is prepared to cover EGGBP75 billion of this year's budget deficit, and will use IMF funds to cover the remaining portion. However, the balance of power remains delicate. With full legislative powers now in the president's hands, we see potential for the other main political actors--namely the military and the non-Islamist groups--to become frustrated with the transition process and for domestic conflict to resume, undermining investor and donor confidence. Outlook The negative outlook reflects our view that we could lower the ratings if political or social tensions were to escalate again. Moreover, the willingness of international donors/lenders and multilateral lending institutions to extend much-needed support could weaken if the Egyptian authorities are unable to effectively address ongoing economic, fiscal, and external challenges. Conversely, if Egypt's political transition strengthens the social contract and if external pressures ease--an indication of which would be an increase in net international reserves--we could revise the rating outlook to stable. Related Criteria And Research -- Sovereign Government Rating Methodology And Assumptions, June 30, 2011 -- Criteria For Determining Transfer And Convertibility Assessments, May 19, 2009 -- Introduction Of Sovereign Recovery Ratings, June 14, 2007 Ratings List Ratings Affirmed; CreditWatch/Outlook Action To From Egypt (Arab republic of) Sovereign Credit Rating B/Negative/B B/Watch Neg/B Senior Unsecured B B/Watch Neg Ratings Affirmed Egypt (Arab republic of) Transfer & Convertibility Assessment Local Currency B Short-Term Debt B Recovery Rating 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.