By Lin Noueihed and Ahmed Aboulenein

CAIRO (Reuters) - The International Monetary Fund has agreed in principle to grant Egypt a $12 billion three-year loan facility, to support a government reform program aimed at plugging a budget gap and rebalancing the currency markets.

The long-awaited Extended Fund Facility (EFF) deal is subject to final approval by the IMF executive committee, likely in the coming weeks, the IMF said.

"Egypt is a strong country with great potential but it has some problems that need to be fixed urgently," the head of the IMF's mission in Cairo, Chris Jarvis, said.

Among the reforms agreed are subsidy cuts, introducing Value Added Tax (VAT) and reducing bureaucracy for foreign investors. The IMF also wants Egypt to focus monetary policy on easing the chronic dollar shortage and reduce inflation to single digits.

"The program aims to improve the functioning of the foreign exchange markets, bring down the budget deficit and government debt, and to raise growth and create jobs," Jarvis said in a statement.

Egypt's dollar-denominated 2025 bond rose to trade at its highest level since end-September 2015 after the deal. Egypt's stock market edged up 1.1 percent by mid-afternoon.

Fund managers said the loan could ease pressure on Egypt's finances and bolster foreign investment but were not rushing to buy stocks until they were more confident the deal would go through and reforms would be implemented.

In late 2012, Egypt reached an initial deal with the IMF for a $4.8 billion loan, but it was never finalised.

"We don’t expect IMF lending to lead to an immediate turnaround," London-based Capital Economics said in a note.

"In the near term, high inflation and tighter monetary and fiscal policy will prevent domestic demand from strengthening significantly. But we are more optimistic about what the deal means for medium-term growth prospects."


The IMF did not give implementation timeline, though Egypt began a five-year subsidy reform program in 2014 and announced further electricity price hikes this week. A VAT act is being debated in parliament.

But the big question is the nature and timing of exchange rate reforms in a country that has kept its currency artificially strong and rationed dollars since the 2011 uprising drove away tourists and investors, depriving it of hard currency.

The dollar shortage has all-but paralyzed trade and made it hard for factories to import components, interrupting production and undermining growth. It has also made it hard for overseas firms to repatriate profit, discouraging new foreign investment.

The IMF's Jarvis told a news conference that the aim of the exchange rate and monetary policy was to end hard currency shortages and cut inflation to single digits.

"Moving to a flexible exchange rate regime will strengthen competitiveness, support exports and tourism and attract foreign direct investment. This would foster growth and jobs and reduce financing needs," he said.

Central Bank Governor Tarek Amer has said that fixing the Egyptian pound had been a mistake but it would not be floated until foreign reserves are rebuilt to at least $25 billion.

They are now at about $15.5 billion, enough for under three months of imports and less than half their pre-2011 levels.

Economists say the IMF deal will lead to interest rate hikes to stabilize the currency and reduce inflation, which has reached 14 percent since a devaluation in March.

"In the near-term, a deal with the Fund is likely to lead to a devaluation of the pound and higher interest rates," Capital Economics said, forecasting the pound would be devalued to 9.5 to the dollar by year-end from about 8.78 now.

Egypt's reform program formed the basis of a $3 billion three-year loan deal with the World Bank in December. But the cash has yet to be disbursed as the Bank waits for parliament to ratify reforms, including VAT which has faced opposition.

(Writing by Lin Noueihed; Editing by Eric Knecht)