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DUBAI, Feb 25 (Reuters) - The outlook for Egypt's banking system is negative because of political instability and banks' increasing exposure to the indebted government, Moody's Investors Service said in a report that contrasted with many investors' growing optimism.
Yields on Egypt's international bonds have tumbled and its stock market has soared 62 percent since last July, when the ouster of Islamist President Mohamed Mursi brought to power an army-backed government promising better economic management.
Billions of dollars in aid to Egypt from Gulf allies since Mursi's ouster have averted a balance of payments crisis and allowed the government to spend on economic stimulus plans.
But credit rating agency Moody's, which rates Egypt's sovereign debt Caa1, deep in junk territory, said on Tuesday that it still had a negative outlook for the mass of Egyptian banks - unchanged since 2011, when the country's political turmoil began.
One reason is Egypt's continuing political tensions, Moody's said. Although it is moving towards elections, the government remains locked in a confrontation with Mursi's Muslim Brotherhood and also faces incidents of militant violence.
"Against the backdrop of the unsettled security situation and political climate, the banks' operating environment will remain difficult," Constantinos Kypreos, senior credit officer at Moody's, said in a statement.
"This is because the outlook for foreign investment, tourism and consumer confidence remains weak, leading to subdued credit growth and low business generation for banks."
The rating agency forecast Egyptian gross domestic product growth of just 2.6 percent in 2014, well below an average of 4.9 percent between 2001 and 2010 - and below the roughly 5 percent which many analysts think is needed to cut high unemployment.
Moody's also cited "banks' high and increasing exposure to Caa1-rated Egyptian government debt", which ties the system's solvency to sovereign default risk.
It predicted that over the next 12 to 18 months, banks' exposure to government securities, which reached 5.7 times shareholders' equity in September 2013, would rise further.
"The government continues to rely on local banks to fill the funding gap in the absence of foreign funding and continues to run high budget deficits," Moody's noted, predicting banks' asset quality metrics would deteriorate further as corporate loans were restructured.
Although Egyptian banks reported an average Tier 1 capital ratio of 11.8 percent last September, Moody's said that level was low given the likelihood of deterioration in assets.
Egypt's national regulator gives a zero risk-weighting to the banks' holdings of Egyptian government securities but applying a weighting of 150 percent, more in line with global standards, would yield a capital ratio below 6 percent, it said.
However, Moody's said it expected Egyptian banks to remain well-funded because of their strong deposit bases, supported by remittances from Egyptians working abroad. This lets them avoid relying on riskier funding from domestic or foreign markets.
Last month Fitch Ratings raised the outlook for its B-minus rating of Egypt to stable from negative, citing financial aid from the Gulf and a somewhat calmer political situation.
But it said public finances remained the main weakness in the country's sovereign credit profile, and that it did not expect the state budget deficit to drop significantly in the next two years. (Reporting by Andrew Torchia; Editing by Olzhas Auyezov)