Expected structural reforms should help to improve the fiscal position, while GDP growth is forecast to rise

With elections over, Egypt’s economy is showing signs of an incipient recovery. After three years of stagnation the IMF anticipates GDP growth will reach 3.5% by 2015, although much of this may be making up for lost time. The new government has outlined an ambitious vision for the future development of the country, and taken the first steps towards solving a structural fiscal deficit. Further challenges remain, and a balance must be struck between the need for immediate relief on a strained fiscus and the large vulnerable population. Yet the fundamentals for long-term growth – including a large youth demographic, rising purchasing power, developed industrial infrastructure and strong trade links – remain in place. The most salient issue for the year ahead, therefore, is the ability of the new administration to turn Egypt’s potential for growth into a reality.

New Stability

Although Egypt’s growing wealth was not shared by all in society in the pre-crisis period, the country posted the most buoyant macro-economic results in decades during that time. According to Ministry of Finance (MoF) data, in the three years prior to the global economic crisis of 2008, GDP growth averaged around 7%, while foreign direct investment (FDI) peaked at $13.2bn in 2007/08. Even against the backdrop of a cooling global economy, the nation managed respectable 4.7% GDP growth for the financial year 2008/09, which by late 2010 had swelled to a quarteron-quarter rate of 6%. The rebound in economic growth was interrupted by the political turbulence of 2011, and the ensuing period of rule by transitional government and military councils which were compelled to address short-term challenges rather than the plan for the nation’s longer-term economic welfare had a deleterious effect on almost all parts of the economy.

What appears to be a return to political stability in 2014, therefore, has been widely welcomed by the financial and business communities. “The economic decisions taken over the last year are a real improvement over the previous stasis. There is a sense of optimism again, which we haven’t seen for some time,” Mohammed Abdel Kader, director of fixed income, currencies and commodities at Citibank, told OBG.

This improvement in sentiment is apparent in the performance of the nation’s stock exchange, the main index of which rose by some 24% in 2013, with the majority of the growth coming after the suspension of the Mohammed Morsi government. After two years of muted activity, the market overtook its pre-crisis high set in January 2011, and these important gains have been consolidated in 2014. In the first six months of the year, the Egyptian Exchange’s EGX 30 posted an increase of 20.3%, while the EGC 70 and EGX 100 grew by 9% and 12%, respectively (see Capital Markets chapter). The new political accommodation also allowed the government to reach an agreement for the clearance of the external arrears of the state-owned Egyptian General Petroleum Corporation to foreign partners, the accumulation of which had slowed investment in the energy sector, resulting in fuel shortages and power outages (see Energy chapter).

Fiscal Matters 

However, Egypt’s economy remains in a fragile state, and the reform that is essential to its long-term recovery is a challenging prospect for any government. The magnitude of this task is readily discernible in the nation’s balance sheet. While a process of fiscal reform had reduced Egypt’s budget deficit to 6.8% by the 2007/08 fiscal year, the political unrest that began in 2011 reversed the contraction, and by 2012/13 the nation was running a deficit of 13.7%.

The reduction of this structural deficit is one of the publicly stated ambitions of newly elected President Abdel Fattah El Sisi, and in 2014 he returned a draft 2014/15 budget to the MoF with instructions to make further reductions in government spending. As a result, the proposed 2014/15 budget now envisages a deficit of LE240bn ($34.1bn), or 10% of GDP, down from the 12% outlined in the original proposal. The new budget was signed into law just two days before the start of the new fiscal year on July 1, 2014, and while details on the spending reductions requested by the president have yet to be made available, information previously released by the MoF shows that a distribution of expenses similar to that of the previous year.

The largest single category is subsidies and social benefits, which account for 30% of total spending, followed by public sector wages and interest payments on government debt. On the other side of the ledger, a new income-tax regime for high earners, the implementation of a capital gains tax on January 1, 2015 and the possible implementation of a new value-added tax (VAT) are expected to see tax revenues rise in 2014/15 by 27%. Non-tax revenues, in the form of Suez Canal receipts, income from state-owned companies, and revenues arising from the nation’s hydrocarbon and mineral extraction industries, are also expected to rise, for a total revenue take of LE548.6bn ($77.9bn).

Bridging The Gap

Egypt has met the discrepancy between its budgeted spending commitments and its total revenue in two ways. Since the 2011 revolution, it has turned to the domestic banking sector for funding support, by greatly expanding a debt programme built largely on the regular issuance of Treasury bills ( Tbills). However, it has paid a high price for its reliance on local lenders. After ramping up its T-bill schedule in 2011, yields on government debt quickly expanded into double digits, surpassing 13.5% for a nine-month note by October 2011. In 2013 yields remained at elevated levels, with the nine-month note still offering a yield in excess of 13%.

While local banks have eagerly purchased government debt at these attractive rates, the stubbornly high yields have made this financing option an expensive one from the government’s point of view. Moreover, given that banks have grown their loan books through government securities, this has resulted in knock-on effects for the issuance of credit to the broader business community (see Banking chapter).

In addition to its debt programme, the government has turned to regional allies to assist it in meeting its bills. During 2013 and 2014, Egypt received aid packages in the form of cash grants, deposits at the central bank and petroleum products from Saudi Arabia, the UAE, Kuwait, as well as soft loans and grants from development finance institutions such as the World Bank and the Arab Fund for Economic and Social Development (see analysis). However, according to the 2014/15 budget, the government foresees a reduction in the amount of grants it receives from donors such as Saudi Arabia and the UAE, from the LE117.2bn ($16.6bn) of 2013/14 to LE23.5bn ($3.3bn). Egypt’s long-term financial stability depends not on its ability to borrow from its banks and attract foreign aid, but on its ability to reform its economy and balance its budget.

Deficit Reduction

Egypt has a number of routes to deficit reduction, each of them challenging. On the expenditure side, a rise in populist rhetoric following the 2011 revolution has put pressure on the government to raise public sector wages. In January 2014 officials announced a new minimum wage of LE1200 ($170), to be applied to around 4.9m of the approximately 7m Egyptians employed by the state in some capacity, and calls for the level to be increased to LE3000 ($426) or more are not infrequent.

In trying to cut expenditure, therefore, the government has concentrated on pruning its subsidy system. Nearly 70% of Egyptians are granted ration cards with which they can gain access to subsidised bread and other staples, and according to MoF data, some LE30.8bn ($4.4bn) of a total subsidy grant and social benefit spend of LE205.5bn ($29.2bn) was directed to basic foodstuffs in the 2013/14 financial year.

However, Egypt’s subsidisation of energy is the most burdensome element of the programme. In 2013/14 some LE99.6bn ($14.1bn) was directed to supplying industry and citizens with cheap fuel – the single biggest item of the subsidy bill. While reform of the system has been at the top of the agenda of successive administrations since the 2011 revolution, it was only with in the wake of the 2014 presidential elections that the government made a move to tackle the issue. In July 2014 it announced significant subsidy cuts across a range of fuels aimed at reducing discrepancy between price at which the government purchases products and that at which it sells them. The move resulted in significant price increases for consumers: diesel grades rose between 64% and 78%, natural gas (which most of the nation’s taxi fleet relies on) saw an increase of 175%, while 92-octane petrol was made 40% more expensive. Despite some initial protests from taxi drivers, the subsidy alterations made so far have been accepted by the population (see analysis).

The government is also seeking to achieve more balanced budgets by increasing revenues. While long-term possibilities include a recovery of tourism receipts and boosting income from the Suez Canal as the result of a project to expand its capacity, in the shorter term tax reform represents the fastest means of increasing revenue (see analysis). For instance, the theoretical revenue from VAT would stand at around LE113.8bn ($16.2bn) per year, assuming a VAT rate of 10%, according to the Egyptian Centre for Economic Studies.

Monetary Policy

As well as allowing for the possibility of economic reform, the stabilisation of the political environment has meant that the Egyptian pound has continued to depreciate. The government made strenuous efforts to support the pound in the wake of the 2011 revolution, to avoid excessive rises in domestic food and energy prices. The government intervention, although successful, came at a price, and foreign currency reserves fell by half in the 18 months following the revolution, and concern grew regarding the government’s ability to sustain its defensive action.

However, with the economy stabilising, the Central Bank of Egypt (CBE) in 2014 has allowed the pound to fall in the official market – a managed devaluation that has not resulted in panic selling. According to XE.com, the Egyptian pound decreased in value against the US dollar from LE6.099 on October 1, 2012 to LE7.152 as of October 1, 2014. In the longer term, a properly free-floated Egyptian pound has the potential to attract supplies of dollars. In the shorter term, the loosening of the currency has had the effect of squeezing a currency black market that has thrived since Egypt’s 2011 revolution. In June 2014 the spread between the official rate and the rate charged by illicit currency dealers shrank from 4.7% to just 2.7% in the course of a week.

Since 2003, the CBE has focused largely on maintaining low inflation rates, albeit with some level of price stability. The body charged with pursuing this objective is the Monetary Policy Committee (MPC). Its principal achievement has been the creation of an interest rate corridor, the floor and ceiling of which are defined by the overnight lending and overnight deposit rates, respectively. This mechanism has proved an effective inflation-management tool in the past. Prior to the global economic crisis the MPC tackled the troublesome inflationary trend by raising the overnight deposit and lending rates which delineated the corridor by 50 basis points, to stand at 11.5% and 13.5%, respectively. As the crisis took hold, the MCP enacted a series of corridor rate reductions to encourage economic growth, and since the 2011 revolution it has sought a compromise between lowering rates to encourage economic growth and raising them to combat inflation. It was concern surrounding the rising consumer price index which led to the most recent rate rise in 2014. At its July meeting, the MPC decided to raise the overnight deposit rate to 9.25% and the overnight lending rate to 10.25%. Explaining its decision in a statement to the press, the MPC said that it judged that a “pre-emptive rate hike is warranted to anchor inflation expectations and hence limit a generalised price increase, which is detrimental to the economy over the medium term”.

Diverse Economy

Although the government’s near-term fiscal manoeuvring will certainly be challenging, the broader fundamentals of the economy remain fairly solid, benefitting from a high level of diversification and a sizeable secondary and tertiary sector. Much of this can be attributed to the efforts of Gamal Abdel Nasser in the years after the nation’s independence in 1952. His ambitious re-structuring of the economy built on the efforts of Muhammad Ali Pasha in the 19th century to transform an almost exclusively agricultural economy into an industrial power. Nasser’s goal of national self-sufficiency, although never realised, brought about a well-balanced economy by regional standards, diversified across manufacturing, extraction activity (which includes the mining, oil and gas sectors), agriculture, construction, tourism and the various segments of the rapidly emerging services sector.

Agriculture

Despite the broadening of Egypt’s economic base, agriculture still plays a central part in nation’s economy, accounting for 14.5% of GDP in first half of FY2013/14, according to CBE data. The sector, which includes irrigation and fisheries, expanded at an average annual rate of 3.45% during the 1990s, accelerating to 4% in 2008/09 before dropping to 3% annual growth in the wake of the global economic crisis. Government strategies have sought to boost efficiency in the sector, such as through the introduction of modern farming methods, with the ultimate goal of reducing Egypt’s wheat imports from around 50% of the national requirement to 45%. However, the process of agricultural reform has been balanced with the need to protect the large and generally unskilled workforce. In 2011 the agricultural sector accounted for around 29.2% of the total labour market, according to the Central Agency for Public Mobilisation and Statistics.

Extraction

According to the CBE, the extraction sector, including petroleum, gas and mining activity, is the second-largest contributor to GDP, accounting for 17.3% of the total in the 2013/14 financial year. Egypt is the largest non-OPEC oil producer in Africa and is a significant producer of natural gas, and the exploitation of its hydrocarbon resources has played an important economic role almost from the first discovery of oil in the Nile Delta in 1886. Proven oil reserves have been growing steadily over recent decades, with BP data showing a rise from 3.4bn barrels in 1993 to 3.5bn barrels in 2003 and 3.9bn barrels as of the close of 2013.

Natural gas was first discovered in Egypt in 1967 in the Nile Delta region, and since then reserves have grown rapidly. By the close of 2013 proved natural gas reserves stood at 65.2trn cu feet, the third highest on the African continent after Algeria and Nigeria.

By the time of the 2011 revolution, the cumulative investment in the extraction sector had reached 19.5% of investment in the country, according to data from the Ministry of Planning. However, delays in payments to international oil companies over recent years have resulted in a slowdown in upstream investment and, while a government commitment to paying off its debt was welcomed by the industry in 2014, the long-term nature of hydrocarbon projects means that it will be some time before the effects of this move become apparent (see Energy chapter).

Manufacturing

Egypt’s manufacturing sector is the third-largest contributor to GDP, accounting for 15.6% of the total in 2013/14. Egypt has developed large and well-resourced manufacturing industries in areas such as clothing, textiles, furniture, paper, cement and pharmaceuticals. Within the sector, fertiliser manufacturing represents one of the most prominent success stories, with the steady growth in this area allowing the country to transform itself from a net importer of fertiliser to a net exporter. Textiles activity in particular has been a driver of manufacturing growth in recent years, especially as a result of the 2004 qualifying industrial zones agreement, by which Egyptian textile goods are granted tariff-free access to the US market. According to the agreement, a minimum of 11.7% of the production input must be sourced from Israel.

Prior to 2011 the expansion of the manufacturing sector was an important element of the broader national economic strategy, with six segments identified as areas of potential growth: engineering machinery and equipment, consumer electronics, automotive components, life sciences, biotechnology and handicrafts. The sale of these manufactured goods, along with imported goods – wholesale and retail activity – accounted for 11% of GDP in 2013/14.

Construction

Construction activity continues to play an important part in economic activity, accounting for 4.6% of GDP in 2013/14. The pre-crisis years saw the sector expand exponentially, with total investments in it increasing from LE24.8bn ($3.5bn) in 2005/06 to LE60bn ($8.5bn) in 2010/11, driven by the rising demand for housing and a growing number of commercial, hospitality and industrial projects. The same drivers have helped to propel the expansion of the real estate sector over recent years, which in 2013/14 accounted for 2.4% of GDP.

Financial Services

Egypt’s well-capitalised financial services sector is also a significant contributor to GDP, accounting for 3.5% of the total in 2013/14. Five public banks compete with 25 private lenders in a competitive market, which also includes a raft of private equity firms and brokerages. Cairo is home to the oldest stock exchange in the region, the breadth of which in terms of listings reflects the diversity of the nation’s economy. According to the EGX’s annual report for 2013, the largest sector as of the end of 2013 was construction and materials, with 21.4% of total market capitalisation, followed by telecoms (15.7%), banks (14.3%) and financial services, excluding banks (7.3%).

Other Sectors

The remaining sectors are comprised of real estate (7%), chemicals (6.4%), basic resources (5.9%), travel and leisure (4.8%), and industrial goods and services (5%), and food and beverages (4.7%). Egypt is also home to an expanding insurance segment, which added 0.3% to GDP in 2013/14. This is comprised of nearly 20 direct insurers and more than 600 private insurance funds overseen by the Egyptian Insurance Supervisory Authority, as well as the hundreds of intermediaries that facilitate the growth of the market.

A growing and increasingly tech-savvy population has also underwritten the expansion of the telecommunications sector, where three licensed mobile operators – Vodafone, Etisalat and Mobinil – compete to offer voice and data services to an increasingly connected population. According to the Ministry of Communications and Information Technology, the country had 33.26m internet users at the close of May 2013, which represents an annual growth rate of 7.92% and penetration of 39.86%.

The mobile penetration rate, meanwhile, stood at 113.35% in May 2013, up 1.74% from the previous year, and in 2013/14 was a major contributor to the 2.6% of GDP claimed by the telecommunications sector.

Finally, tourism remains a notable contributor, although its role is even more important as a foreign currency earner. Egypt’s position as a major destination for tourism was established in the 19th century when tour companies such as Thomas Cook and Son began to open up the country to mass travel, and in 2013/14 the sector accounted for 2.3% of total GDP. An estimated 14% of the population work within the industry, which is built around the nation’s ancient heritage and the more recent development of its Red Sea and Mediterranean coastlines. While tourism in Egypt recovered quickly after the global economic crisis, rebounding from a 2.3% dip in 2009 to rise by 21.4% in the first half of 2010, the effects of the more recent political unrest have been more persistent.

In early 2012 Mounir Fakhry Abdel Nour, the minister for tourism at the time, revealed that in the first year after the uprising the tourism sector had suffered a LE27bn ($3.8bn) fall in revenue and a 32% decline in visitor numbers. The performance of the industry remained muted in 2013, with revenues for the year declining 41% on 2012, from $10bn to $5.9bn.

Trade

In addition to the diversified economy, another bright spot for Egypt has been its trade profile. While the country runs a trade deficit, Egypt’s export activity has continued to grow over recent years, despite a backdrop of unrest. According to data from the MoF, total exports stood at LE143.1bn ($20.3bn) in the revolutionary year of 2010/11, and by 2012/13 the value of goods leaving the nation’s shores had risen to some LE160.5bn ($22.8bn).

Primary manufactured inputs made up the single largest export category, accounting for LE63.6bn ($9bn) of the total, followed by fuel and oil (LE34.2bn, $4.9bn), manufactured fuels (LE16.9bn, $2.4bn), semi-durable consumption goods (LE8.5bn, $1.2bn) and primary foodstuffs (LE8.2bn, $1.2bn). Egypt’s biggest trading partner is the EU, which accounted for 32.6% of its exports in 2012/13, according to the MoF.

Commercial channels between Egypt and the European market are governed by the 2004 EU-Egypt Association Agreement, which established a 12-year trade liberalisation programme by which Egypt’s goods already enter Europe tariff-free, while around half of Europe’s manufactured exports are currently granted tariff-free access to Egypt. Although the deal has proved beneficial to both parties, Europe’s slow recovery from the economic downturn has limited Egypt’s ability to grow its European export activity, which reached a recent peak in 2010/11 and has since declined moderately.

However, Egypt has several other well-established trading relationships, and it has been particularly successful in expanding its trading activity with Arab countries. In 2008/09 trade with Arab states accounted for 15.3% of the total, but by 2012/13 some 21.5% of exports went to its regional neighbours. Asian markets, too, represent a potential area of interest for Egypt’s exporters. It shipped $4.6bn worth of goods to the Asian region in 2012/13, equal to 18.8% of total exports. Africa accounted for just 1.9% of Egypt’s exports, or $452m, in 2012/13, yet with GDP growth rates south of the Sahara outperforming the global norm, the country’s African neighbours are of renewed interest.

For now, however, the gap between the amount that Egypt exports and the cost of the goods it imports continues to grow, rising from a trade deficit of LE187.3bn ($26.6bn) in 2008/9 to LE267.4bn ($38bn) in 2012/13, according to MoF data. The country’s main imports include mineral and chemical products, agricultural products, livestock and foodstuff, machinery and electrical equipment, as well as base metals.

FDI 

Stoking FDI to previous historic highs has been a challenge for Egypt since 2008, when it saw strong inflows. The global economic crisis saw foreign net investment in the country fall from a high of nearly $13.2bn in 2007/08 to $8.1bn the following year, according to the MoF. The effects of a cooling global economy were further compounded by domestic unrest, and in 2010/11 the level of net FDI to Egypt reached a recent low of $2.2bn. However, more recently the trend has reversed and foreign investment levels are once again beginning to expand, and by 2012/13 net FDI had staged a partial recovery to reach nearly $5.2bn.

Ahmed Heikal, founder and chairman of investment holding company Qalaa Holding (formerly known as Citadel Capital), told OBG, “Egypt needs to emphasise the fact that its population will add 40m people over the next 40 years in order to further attract FDI.”

In a bid to boost investor interest in the country, the government in 2014 introduced a new investment law which sought to ban legal challenges to investor-state contracts by third parties.

In terms of FDI origin, the UK is the largest source of investment, accounting for 34.7% of total inflows in 2012/13, followed by the US (22.7%), the UAE (5%) and France (2.8%). Following the return of political stability, the oil and gas extraction sector is likely to be the biggest beneficiary of FDI, although the Ministry of Investment has also identified infrastructure, renewable energy, and small- and medium-sized enterprises (SMEs) in areas such as garment manufacturing and food processing as potential destinations.

Outlook

Egypt’s improving political situation has brought a new sense of optimism regarding an economic recovery after three years of turbulence. The new political establishment has succeeded in securing aid from Gulf allies and outlined in broad terms an ambitious vision for the nation. Large-scale infrastructural plans include a development corridor that will see a chain of new urban centres established on a line parallel to the Nile, connected by an eight-lane highway, and a $4bn project to increase the capacity of the Suez canal. While the benefits of projects of this scale will not be felt for some time, the more settled political and economic base has led to upward revisions for growth forecasts. The IMF anticipates that GDP growth will rise to 2.2% in 2014 and to 3.5% thereafter.

In the shorter term, a number of significant challenges remain. Egypt’s fiscal deficit calls for structural reform, and therefore the government’s attention is likely to remain focused on reworking the nation’s expensive subsidy system and overhauling the tax regime, building on the steps it has already taken in 2014.

Egypt’s young and rapidly expanding population also means job creation is a top priority. The anticipated recovery of the labour-intensive tourism industry offers some hope in this regard; however, the nurturing of the country’s SMEs is seen by many as the key to job creation in the longer term. The potential for economic recovery over the coming year is a real one, but much depends on the new government’s ability to cement the putative stability the nation achieved in 2014 and carry out its process of wholesale economic reform.