Egyptian Economic Challenges and Policy Exigencies

By Zubair Iqbal | Scholar - The Middle East Institute | Sep 08, 2014
Egyptian Economic Challenges and Policy Exigencies
Bread vendor making a delivery in Cairo

In the last three years, Egypt’s economic position has deteriorated dramatically. Domestic and external deficits have increased, causing public debt to grow sharply, external reserves to fall, investment to shrink, and inflation to increase. In the process, growth decelerated, unemployment rose, income distribution worsened, and the medium term economic outlook became clouded. Confronted with the need to create jobs and ease inflation, the authorities had, over these years, pursued politically expedient expansionary fiscal policies, including higher subsidies and increase in public sector wages, which were partly financed by generous aid from oil-exporting Arab countries (Gulf Cooperation Council, GCC). The impact was unsatisfactory:  fiscal and external deficits increased and inflation continued unabated, while growth fell in a politically unstable environment. As political and security concerns increased, tourisma mainstay of the economyand private investment fell and capital flight increased.

However, in conjunction with the 2014/15 budget, the current government has initiated important steps to address the mounting economic challenges. Steps to reduce fuel and food subsidies and to mobilize revenues, if fully implemented, could reduce the fiscal deficit by 1.5 percent of GDP. The authorities have also considered reforming subsidy policy under a planned social safety net, which would target subsidies toward the poorer segments of the society. In order to contain inflationary pressures, the Central Bank of Egypt has tentatively increased interest rates. GCC financial support and temporary  exchange rate flexibility have helped stave off any further weakening of the external position; external current account deficit is estimated to remain manageable in 2014/15.

Economic Challenges

Notwithstanding this promising beginning, economic challenges remain daunting at a time of continued political uncertainty and heightened regional security concerns.   Reflecting a fall in investment, growth is projected to remain low in 2014 at about 3 percent and recover only modestly to about 4 percent in 2015, which is well below Egypt’s potential growth rate and will be insufficient to make a dent in the high unemployment level. Fiscal deficit, after declining in 2014/15, would, in the absence of intensified reforms, resume its upward trend, pushing public debt toward unsustainable levels, and increasing dependence on uncertain external assistance. Unless fiscal deficit is reduced sharply, inflationary pressures will persist on account of the continued bank financing of the deficit, worsening income distribution and increasing market uncertainty.

The external sector will remain a drag on the economy. A widening fiscal deficit supported by accommodating monetary policy could further effectively appreciate the Egyptian pound, thus discouraging exports. The external financial gap (presently about $ 10 billion per year) that can be substantially financed by the present level of GCC countries’ assistance would widen. External reserves, which are presently the equivalent of about three months of imports, could become inadequate to sustain external stability. Also, less than robust recovery in the global economy would have negative implications for the Egyptian economy.

Given the emerging challenges, the Egyptian authorities need to build upon the steps taken so far with a two-pronged strategy. At the very outset, they must strengthen policies to restore macroeconomic stability by reducing fiscal and external imbalances but with a firm commitment to take steps for creating jobs in order to make stabilization politically palatable. At the same time, structural reforms are needed to restore conditions for sustainable high growth and employment generation by improving conditions for private investment. These measures must be complemented with steps to improve income distribution, which is a pre-condition for political stability.

Macroeconomic Corrections

In the short run, Egypt needs to reduce macroeconomic imbalances through an aggressive use of fiscal and monetary policies as part of a comprehensive medium term strategy. Continued reduction in subsidies, in conjunction with their improved targeting, and restraints on public sector wage increases, should be combined with the redirection of public expenditure toward well-designed public sector projects and easing of energy shortages that would help create jobs. While external assistance—in particular—from the GCC countries will be crucial, any borrowing to undertake large public sector projects should not lead to excessive debt burden. Similarly, continued arrears to foreign energy companies should be eliminated expeditiously so that energy supplies are regularized, leading to a better use of installed capacity (and thus, increasing employment). The twin objectives of macroeconomic correction and creation of jobs will have to be carefully balanced: higher external assistance would make it easier to stretch the adjustment period and allow greater focus on job creation.

Concurrently, the authorities must accelerate tax reforms, especially the introduction of value added tax and rationalize the tax structure so as to minimize revenue loss and improve allocation of resources in line with market conditions. Reduction in fiscal deficit would also allow a reallocation of bank credit to the private sector, thus facilitating growth. A more flexible exchange rate supported by prudent monetary policy would contain inflation, ease external imbalances, and allow fiscal policy to address domestic policy challenges. Such a policy stance would also facilitate capital inflows and help reduce pressures on external reserves.

Structural Reforms

Egypt needs to undertake structural reforms to eliminate impediments to productive private investment and sustainable high growth in an environment of macroeconomic stability. Egypt has a long history of government intervention in the market through discretionary allocation of resources, a large and inefficient public sector, and widespread use of subsidies and price controls, which distort resource allocation. Ideally, reforms should span development of financial institutions to promote market-based allocation of credit, liberalization of rules and regulations governing investment, a strengthened business and legal environment to ensure a level playing field, fundamental reform of the subsidy system, and a closer integration with the global economy through improved competitiveness.

Egypt is also characterized by a significant and rising mismatch of skills produced and those needed for sustained growth in a rapidly changing global economy. A focused shift in education policy and retraining to generate new skills will be crucial for encouraging private investment in technology and skill-intensive products, mainly for exports. This will call for a significant increase in public sector investment strategy.

Setting Priorities

The preceding paragraphs describe a large menu of reforms. Given Egypt’s polito-economic environment, financial resource constraints, and limited administrative capacity to simultaneously undertake reforms on all fronts, prioritization will be essential. It should be expected that reforms in certain critical areas would create the needed virtuous cycle, unhinging impediments in other areas. With this in mind, the authorities should initially focus on overhauling the subsidy policy so that market pricing starts to play a more dominant role in resource allocation and consumption. In particular, reduction in energy subsidies would not only improve the fiscal and external accounts, but also shift investment away from energy-intensive and toward labor-intensive activities. Tax policy reforms, which will have been initiated as part of the short-term stabilization, must be built upon to mobilize revenue in line with elimination of implicit and distorting subsidies. Care may also be used in the selection and financing of large public sector projects (such as the Suez Canal expansion) in order to avoid waste and build up of unsustainable debt burden.

Encouraging Foreign and Domestic Investment

Egypt’s complex and burdensome business regulation has inhibited not only foreign direct investment but also domestic investment. The World Bank Index for Doing Business places Egypt far below other emerging economies.  Streamlining of business regulation aimed at cutting red tape and corruption, elimination of non-transparent and arbitrary intervention, and strengthened institutional accountability, would go a long way toward improving business climate and enhancing investor confidence. Financial liberalization and improved access to bank credit under market-based interest rates will also promote private sector investment.  Bank competition will have to be improved while the role of public sector banks curtailed. Reduction in fiscal financing needs should free up credit for the private sector.

Finally, the authorities will need to agree on a mix of monetary and exchange rate policies. Given the high inflation and continued inflation expectations, it would be prudent for Egypt to adopt a more flexible exchange rate than practiced so far.

What Will It Take for Reforms to Succeed?

The success of reforms will, in addition to intensified mobilization of resources through fiscal policy and  external financing, crucially depend upon the process through which policies are formulated and implemented. Notwithstanding presidential elections, political uncertainty continues to prevail. The fact that policy measures taken with the 2014/15 budget were not discussed publically implies the absence of consensus and differences among stakeholders. The measures envisaged for the next stage are clearly more complex and will have to contend with winners and losers. Their success will therefore require greater transparency and broad acceptance of policy changes by all stakeholders. It remains to be seen whether the new political setup is able to address this challenge without spurring political polarization. An early and credible election of the Parliament may provide the needed platform for agreeing on the necessary reforms.

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