* Big step for Islamic finance in North Africa
* Officials' projection of money to be raised is overblown
* But many Gulf investors would be interested
* Legal wrangling over sukuk structure must be resolved
* Issue likely towards end of this year
By Rachna Uppal and Ahmed Lotfy
DUBAI/CAIRO, March 6 Egypt is pinning its hopes for a return to the international capital markets on Islamic bonds. It is likely to be successful, provided it can hold parliamentary elections and resolve domestic legal wrangling over how to structure the bonds.
Struggling to narrow a big budget deficit and boost foreign currency reserves that are at critically low levels, President Mohamed Mursi's government last week approved a draft law that would allow the state to issue sukuk for the first time.
With its credit rating repeatedly downgraded to junk status by international rating agencies over the past year, and its economy undermined by political instability, Egypt might seem an unlikely borrower.
But analysts said strong investor demand for sukuk worldwide, potential interest among cash-rich Gulf funds, and the low global interest rate environment meant an Egyptian issue could attract heavy orders.
"Naturally, there will be question marks in the minds of investors, both regional and international, and appetite will depend on how the issuer can address such concerns," said Chavan Bhogaita, head of markets strategy at National Bank of Abu Dhabi.
"It all depends on yield. Investors around the world are still looking for yield and are willing to venture outside their comfort zone to get it."
An Egyptian sukuk issue would be seen as a major step for Islamic finance in North Africa, making it easier for other governments in the region to follow suit.
The regime of former Egyptian leader Hosni Mubarak, ousted in February 2011, neglected Islamic finance for political reasons; Mursi's government, backed by the Muslim Brotherhood, is keen to promote it for both financial and religious reasons.
By themselves, sukuk will not come close to resolving Egypt's financial problems, and the government's projections for how much it could raise through them are almost certainly overblown, analysts and regional debt traders believe.
Finance Minister Al-Mursi Al-Sayed Hegazy predicted Egypt could raise around $10 billion a year via sukuk, but traders in the Gulf think international issues of $1 billion or $2 billion annually would be more realistic.
Domestically, the government might be able to boost its ability to borrow from Egyptian savers, particularly religiously conservative ones, by offering them Islamic instruments denominated in Egyptian pounds.
But the amounts raised are likely to be dwarfed by the government's budget deficit, which officials say could hit 180 billion pounds ($26.7 billion), or 10 percent of gross domestic product, in the fiscal year through the end of June.
Nevertheless, debt traders said an international sukuk issue from Egypt could attract strong interest from Gulf funds which had not found enough sukuk to buy locally.
"Elections at the end of April will be key, but I am a big believer in Egypt," said one regional debt capital markets banker, declining to be identified because he was not authorised to speak to media. "There will be lots of cash buying this for many different reasons."
The banker said that once the political situation was clearer - perhaps towards the end of this year - Egypt could probably issue a sukuk at a yield in the high 5 percent or low 6 percent area. Other traders estimated yields of up to 8 percent.
Egypt's outstanding $1 billion conventional bond, which matures in 2020, is currently bid at about 93 cents on the dollar to yield 7 percent, according to Thomson Reuters data.
In a sign that the government is gearing up for debt issues, a new head of the finance ministry's debt management office was appointed this week: Hamdy Samir, previously head of fixed income and money markets at National Bank of Egypt, a top commercial bank.
Two things will need to happen to permit an Egyptian sukuk issue, however. One is for the country to hold parliamentary elections, which are due to begin next month but, under Egypt's drawn-out electoral process, end only in late June.
The elections are expected to clear the way for Egypt to resume detailed negotiations with the International Monetary Fund on a $4.8 billion loan. An IMF deal could unlock other international aid to Egypt and it would be seen by investors as an important endorsement of the government's economic policies.
The other necessary condition is a resolution of the legal wrangling that has plagued the drafting of the sukuk bill.
Hegazy, a former academic with a background in Islamic economics, said last week that it would take at least three months to push through regulations necessary for a sukuk issue. The bill has been referred to the Islamist-dominated upper house of parliament and is then to receive final approval from Mursi.
But like many economic policies in post-revolution Egypt, the bill has been slowed by accusations that the government is abusing its power. Two previous versions of the legislation had to be amended after protests from critics including religious scholars at Cairo's prestigious Al-Azhar university.
Because Islam bans interest payments, sukuk are based on real assets and are supposed to pay investors with revenue from those assets. The scholars complained the legislation could let officials abuse their control of public assets or expose those assets to seizure by private investors in case of a default.
This struck a chord in Egypt because of its history. Khedive Ismael, a 19th century ruler, borrowed excessively from abroad, falling into debt that eventually forced the sale of Egypt's shares in the Suez Canal Company to Britain. The sale launched the era of direct colonial intervention in Egypt.
Asked by Reuters this week whether assets behind the sukuk could be seized by creditors, Hegazy insisted there was no risk.
"I would like to reassure you the lands won't be mortgaged. It is a use of the project assets for a limited time, then the entire project will return to the Egyptian people," he said, adding that investors in the sukuk would bear the risk of the assets behind them performing poorly.
However, the latest version of the bill appears to address the problem by banning the use of current state assets to back sukuk but allowing the use of "new" government assets - a distinction which may not satisfy critics.
"It is a tricky wording," former finance minister Sameer Radwan told Reuters. "There is a belief that any problem can be sorted out by altering words. This is possible in politics, not in economics."
David Butter, associate fellow at Chatham House in London, said the government's struggle to pass the sukuk law had to some extent distracted it from the vital task of securing the IMF loan.
"The political and economic context makes the approval of the Islamic finance law complicated," he said. (Additional reporting by Mala Pancholia in Dubai; Editing by Andrew Torchia)
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