Egypt's structural reform pays dividends despite high inflation

Five years after Egypt began to implement a comprehensive reform of its economy, the nation’s macroeconomic indicators are showing sustained improvement. However, while accelerating growth and a narrowing fiscal deficit have vindicated the government’s austerity measures, a high inflation environment continues to place pressure on the budgets of ordinary households. Passing on the benefits of the reformed economy to ordinary Egyptians has therefore emerged as a key challenge for the government in 2019.

Reform & Results

Egypt’s process of economic reform began soon after the election of President Abdel Fattah El Sisi in 2014, an event that brought stability to the country after a period of unrest. In 2016 the reform agenda was more clearly delineated as a result of Egypt obtaining a $12bn IMF loan which was contingent on a wide range of structural reforms. These included the floatation of the currency, a loosening of capital controls, the abolition of energy subsidies, a reform of public enterprises and a deep revision of monetary policy – the aim of which was to restore the economy to a stable trajectory of long-term growth.

The results of the reform effort are apparent across key macroeconomic indicators: GDP growth accelerated from 4.2% in FY 2016/17 to 5.3% in FY 2017/18, while unemployment declined to below 10% – its lowest level since 2011. Meanwhile, the current account deficit narrowed to 2.4% of GDP in FY 2017/18 from 5.6% the year before, thanks in large part to a recovery of tourism and strong remittances.

Robust growth and the government’s efforts to reduce public spending have also brought about a significant improvement in the nation’s level of debt: gross general government debt fell from 103% of GDP in FY 2016/17 to approximately 93% in FY 2017/18. The improving macroeconomic environment has helped to buoy investor confidence in the country, with the Egyptian Exchange’s benchmark EGX 30 index rising by 38.5% between December 2016 and September 2018.

In February 2019 the IMF determined that sufficient progress had been made for Egypt to draw another $2bn from its support facility, bringing the total amount to $10bn. These macroeconomic improvements, however, have come at a cost: the wide-ranging process of fiscal and monetary reform has brought new taxes, subsidy cuts and rising inflation. As a result, Egypt’s large number of low-income households have been faced with sharp price increases on even the most basic items, such as oil, rice and bread.

The government aims to achieve a GDP growth rate of around 7% by 2022, while reducing inflation and bringing the unemployment level to below 7%. These are ambitious targets, but the IMF’s forecast of 5.9% growth in 2020 is the highest in North Africa, and a clear recognition of the potential of Egypt’s economy to build on and sustain the expansion that it has recently demonstrated. The government’s ability to maintain its reform programme, however, may depend on its ability to support the most vulnerable segments of society, and convince the wider population of the benefits attached to what has been at times a painful process of economic rebalancing.

Fiscal Challenge

The task of supporting the less affluent in society, however, must be balanced against the need to reduce an annual fiscal deficit that has persisted since the revolution of 2011. Egypt’s medium-term fiscal policy is aimed at keeping general government debt on a clearly declining path and achieving a primary surplus of 2% of GDP. Recent years have seen incremental progress towards this goal. In FY 2012/13 the nation ran a deficit of 13.7%, and by 2017 this had been reduced to approximately 11%, according to the World Bank. In July 2018 the country announced that it had achieved a primary budget surplus for the first time in 15 years. However, this figure did not take into account interest payments on government debt. The country’s budget deficit for the year stood at about 9.8%, slightly above the 9.1% in the planned budget.

The FY 2018/19 budget, ratified in June 2018, foresees a budget deficit narrowing to 8.4% over the year, or LE438.6bn ($24.6bn). However, the current budget is the largest in the country’s history, with total expenditures of LE1.42trn ($79.8bn) – an increase of LE200bn ($11.2bn) on the previous year. A strong social dimension accounts for some of the extra expenditure, with public sector employees benefiting from a LE265 ($14.89) monthly raise, while there are unprecedented increases in allocations to the education and health sectors, the combined expenditure on which totals LE257.7bn ($14.5bn) compared to LE222bn ($12.5bn) in the previous fiscal year. In order to maintain high levels of social spending while simultaneously narrowing the budget deficit, the government is pursuing new efficiency gains, including increasing contributions of non-sovereign sectors in tax proceeds, incorporating informal businesses into the regular economy, combatting tax evasion and expanding automation. These measures form part of a broader process of fiscal reform that has been undertaken over recent years, in which the government has sought to cut costs and boost revenues in a bid to balance its books.

Cutting Costs

Reducing government spending on energy products has formed the central pillar of a cost-cutting strategy since 2014. The country’s long history of providing fuel to individuals and businesses at below-market prices has encouraged an inefficient use of energy and over investment in capital-intensive industries. The subsidy system was also widely criticised as being unbalanced, disproportionately benefiting the more wealthy and large energy consumers.

Expenditure trimming in the FY 2014/15 budget saw the price of diesel grades rise by between 64% and 78%, natural gas – which most of the nation’s taxi fleet relies on – increase by 175% and 92-octane petrol rise by 40%. In June 2017 fuel prices were hiked again, by as much as 100%, as the government sought further fiscal savings. The latest round of fuel subsidy cuts came in June 2018, resulting in some petrol grades rising in price by as much as 50%. The Ministry of Petroleum also raised the price for a canister of gas for Egyptian households from LE30 ($1.69) to LE50 ($2.81), while a bottle of gas for commercial purposes was raised from LE60 ($3.37) to LE100 ($5.62). The FY 2018/19 budget allocates around LE89bn ($5bn) for petroleum products, against LE110bn ($6.2bn) in the prior year.

The removal of electricity subsidies, first outlined in the FY 2014/15 budget, also continued, with the government adjustment to the pricing system raising rates by 26% from July 2018 onwards. Moreover, the state increased taxi fares by 10% to 20% at the same time, as well as raising water costs. Price hikes were also applied to the Cairo metro system: in May 2018 a uniform LE2 ($0.11) metro ticket was replaced with fares ranging from LE3 ($0.17) to LE7 ($0.39).

Revenue Raising

The taxation efficiencies outlined in the FY 2018/19 budget statement are only the latest phase of the revenue-raising drive that has accompanied the state’s cost-cutting efforts. The centrepiece of which is the replacement of the old sales tax framework with a new value-added tax (VAT) system, introduced in late 2016 at a rate of 13% and adjusted to 14% in 2017. The government has also introduced a real estate tax and reworked the corporate income tax system to establish a standard rate of 22.5%, which also covers new companies in free zones. Egypt’s rate of personal income taxes is low compared to corporate tax levels, based on a progressive rate which in 2017 was adjusted to provide relief for those on lower incomes.

A capital gains tax implemented in 2015, but suspended due to public opposition, was postponed for another three years in 2017. However, the government did succeed in introducing stamp duty on trades made in the capital markets, beginning at a rate of 0.15% which will rise to 0.175% from June 2019 onwards. According to the Ministry of Finance, tax revenue rose by 61% in FY 2017/18 to LE248.8bn ($14bn), compared to LE154bn ($8.7bn) the previous year.

Bridging the Gap

Despite a successful programme of fiscal reform, Egypt’s structural fiscal deficit means that it must seek external funding in order to meet its spending commitments. In the wake of the 2011 revolution the government was compelled to rely on ad hoc support from regional allies, but since then it has secured a number of funding arrangements with developmental institutions. After agreeing to a $3bn loan programme in 2015, the last tranche of which was disbursed in 2017, the World Bank signed another agreement with Egypt in December 2018 for a $1bn programme to support the next phase of the country’s reform strategy. The country has recourse to other developmental lenders, such the African Development Bank, from which it received the third and last $500m tranche of a $1.5bn loan in September 2018.

By far the most significant support programme, however, is the IMF $12bn facility, due to be fully disbursed by the close of 2019. The regular schedule of payments, contingent on the government’s ability to follow through with its wide-ranging programme of economic reform, have greatly eased the balance-of-payment pressures from large current account deficits, as well as supported the sovereign’s external liquidity position.

At the same time Egypt has demonstrated its ability to approach the global bond markets for funding. In January 2017 the country raised $4bn of debt in its first sovereign bond offering since it devalued its currency and secured IMF assistance. Another $4bn in sovereign bonds was issued in February 2018, and was followed up in April 2018 by a €2bn sovereign bond issuance. In October 2018 officials revealed plans to issue up to $20bn in Samurai and Panda, or Japanese and Chinese, bonds before 2022. The pivot to Asian markets was widely interpreted as a response to declining appetite for regular Treasury bill issuances, which led the Central Bank of Egypt (CBE) to cancel four offerings in 2018.

Although Egypt’s level of debt as a percentage of GDP has declined in recent years, it remains high. The ratio of local and external debt to GDP was recorded at 108% in June 2017, before falling to 97% a year later. Addressing this issue, Mohamed Maait, the minister of finance, announced in February 2019 a state strategy to lower the ratio to 93% by mid-2019, followed by targets of 88% in 2020 and 80% in 2022.

Ratings Influence 

At the same time, rising global interest rates and a strengthening US dollar are raising financing rates for emerging market economies such as Egypt. However, in the short term fundraising costs may be helped by more positive assessments by some of the world’s top ratings agencies.

In May 2018 Standard & Poor’s upgraded the nation’s sovereign debt from “B-” to “B”, citing a “more broadbased recovery and a slight move away from consumption” towards greater investment and net exports. In addition to this, later in the year Moody’s Investors Services raised Egypt’s credit outlook from stable to positive, citing the government’s successful implementation of its IMF-supported programme of reform as the determining factor in its decision. Egypt’s long-term rating remained at “B3”, which, although six levels below investment grade, is its best rating since 2011.

Inflation & Policy 

Upward revisions by global ratings agencies are partly the result of the government’s successful resolution of a challenging currency crisis. Falling tourism levels and a slowdown in foreign investment after the 2011 revolution led to an acute dollar shortage that acted as a severe brake on the economy. The response came in November 2016, when the CBE made the historic decision to allow the previously managed Egyptian pound to float freely. The subsequent devaluation of the pound was long overdue, and by allowing foreign exchange rates to settle at a market-determined level the foreign currency challenge was eradicated. The downside to the flotation of the currency, however, has been a rapid rise in consumer price inflation, which has had a negative effect on both household consumption and business growth. The CBE reacted to this development by tightening monetary policy, starting with a 3% interest rate rise in November 2016, followed by further rises in 2017.

By 2018 the central bank was sufficiently convinced that inflationary pressure was under control to make rate cuts in the early part of the year, leaving the overnight deposit rate and the overnight lending rate at 16.75% and 17.75%, respectively. The CBE’s prudent monetary policy helped bring down annual inflation from 33% in July 2017 to 11.4% percent in May 2018. An uptick of inflation in the fourth quarter of 2018 and early 2019 was largely due to the pass-through from energy price hikes and a stronger-than-anticipated increase in volatile food prices. Egypt’s monetary policy is directed at the medium-term goal of bringing inflation into single digits. While that goal remains remote, the inflation trend is slanting in the right direction: in mid-2018 a Reuters survey of economists found that they expected inflation to drop to 14.2% in the current fiscal year, down from a previous prediction of 20.9%, before dropping to 12.2% in FY 2019/20.

Trade

The devalued currency had only a temporary effect on trade deficit, helping to narrow it by 46% yearon-year in the first half of 2017, as imports fell by 30% to $24bn and the country’s newly competitive exports increased by 8% to $11bn. The last time a trade surplus was posted was in 2004, after which the trade deficit gradually deepened to reach an all-time low in 2016 of just over $5bn. Since then it has followed a broadly sideways trend, narrowing to less than $2bn in 2017 before widening again in 2018. In December of the year it stood at $3.87bn, a 14.1% increase over the same month of 2017. The widening gap was the result of a 9% rise in the value of imports – driven by cars, plastics and pharmaceuticals, rising by 28.7%, 7.4% and 24.3%, respectively – and a decline in the value of a number of commodity exports, such as crude oil, fertiliser, pastries and food preparations, and fresh fruit, which fell by 15.7%, 14.8%, 12.2% and 2.2%, respectively.

The Ministry of Trade and Industry is following a policy of limiting the import of low-quality products, rationing imports and increasing a reliance on local production to increase non-oil exports by an annual average of 13% to reach $35bn by FY 2020/21. According to the UN Statistics Division, the nation’s largest export market is the UAE, which accounted for $2.69bn of total exports in 2017, followed by Italy ($2.02bn), Turkey ($1.98bn), the US ($1.69bn) and Germany ($1.51bn). In terms of imports in 2017, China was in the top spot ($8.07bn), while the remaining in the top five were held by Russia ($5.84bn), Germany ($3.45bn), the US ($3.38bn) and Italy ($3.19bn).

Investment

Egypt is also working hard to establish itself as a more desirable location for investment, most notably through the 2017 promulgation of a new investment law (see analysis). The decline in the value of the nation’s currency has also made the domestic market a more interesting proposition for foreign investors, lowering costs for labour and materials. In August 2018 the planning minister announced that Egypt is aiming to attract $11bn in foreign direct investment (FDI) during FY 2018/19, up from $7.9bn the year before.

However, despite the optimism arising from the improved legislative framework and currency scenario, there are still some challenges in the broader business environment. For instance, between 2017 and 2019 Egypt rose by an impressive 50 places in the World Bank’s “Doing Business” report; however, as it started from a low base, it currently ranks 120th out of 190 countries. Egypt continues to show vulnerability with regard to the legal framework and bureaucracy surrounding paying taxes, trading across borders and enforcing contracts. Areas where the country performs well include getting credit, obtaining electricity, dealing with construction permits and protecting minority investors. In terms of target sectors, the oil sector accounts for the largest volume of FDI on an annual basis – making up nearly two-thirds of the total in FY 2016/17 – according to data from the CBE, followed by manufacturing, construction, communication and real estate. The biggest investor in the country is the UK.

Opportunities

Efforts to attract more investment are aided by the fact that Egypt has one of the most diverse economies in the region. Opportunities exist within the well-developed agriculture sector, manufacturing industries, construction, tourism and various segments of the rapidly emerging services sector. Moreover, Egypt is Africa’s largest oil producer that is not a member of the Organisation of the Petroleum Exporting Countries, and in recent decades it has constructed a gas extraction industry based on significant finds in the Nile Delta area and its offshore territories. As a result of this renewed activity the El Zohr natural gas field, discovered in 2015 by Italy’s Eni, has become central to Egypt’s drive to re-establish itself as a gas exporter and a regional hub for the production of liquefied natural gas (see Energy chapter).

Efforts to shift the economy to a more private sector footing are helping to open up an increasing array of activities to private sector investment. However, in some areas the state continues to play a prominent role. The military’s presence in the economy is organised under three entities: the Ministry of Defence, which owns dozens of companies in a wide range of sectors; the Ministry of Military Production, which operates around twenty businesses; and the Arab Organisation for Industrialisation, which in 2018 owned at least 12 companies. Since the election of President El Sisi in 2014, the state has taken the lead in developments of national importance. The military has a controlling stake in the firm that is developing a new $45bn capital city 75 km east of Cairo, and another military-owned company is building the nation’s biggest cement plant. Other business interests range from fisheries to holiday resorts. While some observers have welcomed the military’s ability to execute projects quickly and efficiently, others have voiced concern that its growing presence in the economy is suppressing the private sector activity considered essential for the nation’s long-term economic stability (see analysis).

Protective Measures

With the currency stable, inflation under control and the fiscal deficit narrowing, the nation’s macroeconomic indicators are considerably stronger than they were just a few years ago. Nevertheless, for a large segment of the population life has become increasingly difficult. The devaluation of the currency and the subsequent period of high inflation that followed the floatation of the Egyptian pound have led to spiralling costs in basic needs. This has been exacerbated by the removal of subsidy support on staples such as bread, cooking oil and sugar, more than doubling their cost. The reform of energy subsidies, meanwhile, has resulted in a tripling of gas prices between 2015 and late 2018, and a quadrupling of electricity rates. More than one-quarter of the population live below the national poverty line, while some 40% of Egyptians subsist on less than $2 a day, and salaries have not kept pace with rising living costs. High unemployment, labour market inefficiencies and weak health care and education levels have also yet to be adequately addressed by the economic reform effort.

Societal Investment

Against this backdrop the state’s strategy to protect the most vulnerable in society has taken on increasing significance. The Takaful and Karama (“Solidarity and Dignity”) cash transfer programme, established in 2015 with assistance from the World Bank, forms the central pillar of the country’s new social support system. Administered by the Ministry of Social Solidarity, it currently covers around 9.4m individuals, or about 10% of the population.

The Solidarity component of the programme aims to provide conditional income support, with households receiving LE325 ($18.27) per month provided they meet a number of requirements, which include stipulations such as an 80% school attendance record for children between six and 18 years of age, and regular visits to health clinics for mothers and young children. Moreover, households are given additional support with allotments designated to children below six years of age, primary students, preparatory-stage students and secondary-stage students, which range in value from LE60 ($3.37) to LE140 ($7.87). Meanwhile, the Dignity aspect of the programme protects Egypt’s pensioners, orphans, and citizens with severe disabilities and diseases. These vulnerable citizens receive a monthly pension of LE450 ($25.29) with no conditions.

Outlook

The past year has been a challenging one for emerging markets, with investors concerned by rising global interest rates and a strengthening dollar. However, Egypt has been able to build strong buffers since the flotation of the Egyptian pound: in December 2018 foreign reserves stood at approximately $44.5bn, compared to less than $17bn at the end of 2016. This external buffer and the nation’s flexible exchange rate afford the country some protection against tightening global financial conditions. Looking ahead, the IMF estimates that GDP will grow by 5.5% in 2019, powered mainly by a recovery in tourism and rising natural gas output. However, while the macroeconomic outlook is positive, the challenge of maintaining the support of a population that has yet to feel the benefits of economic reform remains. A partial response to this question came in August 2018, when the social and urban development goals of the medium-term sustainable strategy were revealed, with aims to reduce population growth from 2.7% in 2017 to 2.1% by 2022, and lower the inflation rate from 14.3% to 8.5% during the same period. The government also intends to reduce the number of people below the poverty line from the 27.8% seen in 2015 to 22% by 2022. Demonstrating to ordinary Egyptians how economic reform stands to benefit them in the future is likely to remain a key element of government strategy over the medium-term horizon.