Egypt's economy grows in response to wide-ranging reform programme

As Egypt enters 2018, a newly liberalised currency and the recent implementation of a much-anticipated investment framework have left it well positioned for continued economic expansion: the IMF expects the country’s GDP growth to reach 6% over the medium term. However, a structural fiscal deficit, high unemployment levels and socio-economic fragility are some of the challenges faced by the government as it presses forward with its ambitious reform agenda.

Economic Snapshot

Since 2014 Egypt has been implementing a wide-ranging programme of economic reform. The process started with a drive to rebalance the economy through a number of challenging initiatives, including the reduction of subsidies, the introduction of value-added tax (VAT) and the liberation of the Egyptian pound.

At the outset of 2018, these headline measures had been implemented, and the government’s focus has since shifted to the improvement of governance and the investment climate. This effort includes the implementation of the Civil Service Reform Law, aimed at cutting the large public sector wage bill, and an array of legislation designed to remove investment barriers, such as the Industrial Licensing Law, the Investment Law and the Company Law.

These efforts have begun to have a positive effect on the nation’s economic growth. In 2017 the World Bank estimated that GDP grew by 3.9% over the year, and forecast it would expand by 4.6% in 2018 – a significant improvement on the 2% average GDP growth rate seen during the period FY 2010/11 to FY 2013/14. The overall budget deficit for the first half of the 2017/18, which started in July 2017, dropped to 4.4% from 5% the previous year, the Ministry of Finance said in mid-January 2018.

Foreign reserves, which had been depleted over recent years as a result of the government’s attempts to defend the currency, have benefitted from the liberalisation of the Egyptian pound and the securing of development funding from the IMF. By the end of 2017 the nation’s foreign reserves stood at $37bn, their highest level since 2011. The flotation of the currency in late 2016, however, has contributed to inflation reaching over 30% in 2017 – and the effects of this phenomenon on households and businesses remains one of the chief obstacles to growth.

Fiscal Challenge

Despite a gradually improving fiscal scenario, a structural fiscal deficit remains the key economic challenge, and one which nearly all of its reforms aim to address. The problem has persisted since the revolution of 2011 and the political turbulence which immediately followed it. The rapid turnover of governments and the prevailing atmosphere of economic uncertainty resulted in a fiscally damaging era of lower revenue and rising expenditure, as business activity and investment decreased and the government set about meeting the demands from both state employees and the wider population for social justice. By FY 2012/13 the nation was running a fiscal deficit of 13.7%, a level considered to be unsustainable in the long term.

During the first term of President Abdel Fattah El Sisi the government initiated a process of fiscal reform aimed at shrinking the deficit, an effort that combined expenditure cuts with attempts to boost revenue. Its first target was the fuel subsidy system: expenditure trimming in the FY 2014/15 budget saw diesel grades rise between 64% and 78%; the price of natural gas – which most of the nation’s taxi fleet relies on – increase by 175%; and 92-octane petrol made 40% more expensive. In June 2017 fuel prices were hiked again, by as much as 100%, as the government sought further fiscal savings. According to the Ministry of Petroleum and Mineral Resources (MoPMR), the price of 92-octane gasoline rose by more than 40% from LE3.5 ($0.23) to LE5 ($0.33) per litre, while prices for diesel and 80-octane – the most popular fuel categories – went up by more than 50% from LE2.35 ($0.15) to LE3.65 ($0.24) per litre. The price of cooking gas cylinders rose from LE15 ($0.99) to LE30 ($1.98) per cylinder.

While gas prices to the industrial sector remained unchanged in a bid to protect growth, fuel oil prices to cement factories rose by 40%. As a result of the changes, the MoPMR expects to see subsidies on petroleum products fall to LE110bn ($7.2bn) in FY 2017/18, from LE145bn ($9.6bn) in the previous year. According to the government’s strategy, the coming years will see the complete removal of fuel subsidies, increasing efficiency in energy use, a diversification of the energy mix and the roll-out of a smart card system for fuel distribution.

The removal of electricity subsidies, first outlined in the 2014/15 budget, also continues, albeit at a slower pace than originally foreseen. Egypt spent more than twice the budgeted amount on electricity subsides in FY 2016/17 due to rising import costs for liquefied natural gas, which fuels most of its power stations. In the summer of 2017 the Ministry of Electricity and Renewable Energy announced a series of price increases which saw households paying between 18% and 42% more depending on the category and level of consumption. A ministry statement at the time indicated that an initial target of removing electricity subsidies entirely by the end of FY 2018/19 had been extended to the end of FY 2021/22, due to the challenging economic conditions brought about by the flotation of the currency.

In carrying out its energy subsidy trimming exercise, the authorities have attempted to protect the most vulnerable in society. For example, in June 2017 the president announced a range of new spending plans, including a doubling of monthly food subsidies, a freeze of tax on agricultural lands for three years and a 15% increase in civil servant pensions.

Revenue Raising

Raising revenue is another way the government is attempting to tackle the fiscal deficit. The centrepiece of this agenda is the implementation of VAT, which has replaced the old sales tax framework. As a broad-based consumer tax, VAT offers gains in terms of efficiency and revenue, while the ability of the government to define the exemption list enables it to protect the most vulnerable segments of the population from its effects. The timing of the VAT’s introduction in late 2016 was driven by both the government’s desire to push ahead with its reform programme, and the fact that its implementation is tied to an IMF funding package.

The government has succeeded in implementing a real estate tax, an annual tax that is applied on all constructed real estate units, which had previously met with strong opposition. In addition, it rationalised 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% and rising to 0.175% by 2019.

In the first half of FY 2017/18, tax revenue reached LE249bn ($16.4bn), a year-on-year (y-o-y) increase of 66%. However, while this represents a success for the government, the difficulties it has faced with the implementation of capital gains tax are a reminder of the challenges associated with any change to the nation’s taxation framework (see analysis).

Bridging The Gap

Egypt’s structural deficit requires the government to seek external funding to meet its expenditure commitments. In the years following the overthrow of President Mohamed Morsi, this was largely secured from regional allies in the form of cash grants and deposits to the Central Bank of Egypt (CBE), loans, investment packages and preferential rates on petroleum products. However, Egypt has since reduced its dependence on ad-hoc support from GCC allies by securing substantial development funding from global institutions. The World Bank agreed to a $3bn loan programme in 2015, which is being disbursed in three tranches linked to a number of planned reform measures. In 2017 the World Bank released its second $1bn tranche to the country, which was welcomed by the Ministry of Investment and International Cooperation as an important spur to private sector investment and development projects.

Funding

Egypt’s standing in the global economy received a more significant boost in November 2016, when the country signed a $12bn loan programme with the IMF. The first disbursement of $2.75bn was made the same month, with the remainder to be paid out over three years and three tranches. As with the World Bank development loan, the IMF funding is contingent upon Egypt’s ability to implement its ambitious agenda of economic reform. In July 2017 the IMF executive board disbursed the final $1.25bn of the first $4bn tranche of the loan, after a favourable review of Egypt’s reform programme. Moody’s described the development as credit positive for the country, stating that its reforms were showing results, particularly the foreign exchange rate liberalisation in 2016, which “helped reduce balance-of-payment pressures from large current-account deficits and support the sovereign’s external liquidity position”. Egypt is expected to receive the second $4bn tranche in two instalments during FY 2017/18.

Egypt has also shown itself capable of raising funds in the global markets over the course of 2017, despite ratings downgrades that have placed the sovereign in speculative territory. In January 2017 the country successfully raised $4bn of debt in its first sovereign bond offering since it devalued its currency and secured IMF assistance. The offer attracted strong interest from global investors, receiving orders of approximately $13.5bn, and priced at yields below the initial price talk: the five-year notes were priced at 6.125%, while the 10- and 30-year bonds had a yield of 7.5% and 8.5%, respectively.

Global appetite for Egyptian Treasury bills (T-bill) has been equally robust, reaching record levels in 2017. The currency devaluation and some of the world’s highest yields brought around $18bn of T-bill purchases by October 2017, as portfolio investment flooded into the system. The average yield on Egyptian Treasuries climbed as high as 22% in the period after the flotation, but investors were also incentivised by the government’s investment-friendly approach in its ongoing process of economic reform, as well as robust GDP growth forecasts of 3.5% for 2017 and 4.2% in 2018. Foreign investors now own more than 30% of Egypt’s outstanding T-bill stock, more than at any time in the republic’s history.

Currency Challenge

One reason for increased investor confidence is Egypt’s successful handling of a troubling currency issue. The policy of controlling the value of its currency through central bank operations became problematic after the 2011 revolution, as a significant drop-off in tourism numbers and a slowdown in foreign investment resulted in a dollar shortage in the country. The nation spent a considerable portion of its foreign reserves defending the currency, while the dwindling dollar supply made it difficult for Egyptian importers to meet their dollar invoices and foreign investors to repatriate profits. This scenario undermined Egypt’s attempts to improve its investment environment, and resulted in a number of high-profile difficulties with global companies. Backlogs in foreign currency requests from customers resulted in the rise of a parallel currency market, causing yet another problem for the CBE in the form of unreported and unregulated transactions. In November 2016 the CBE was compelled to make the historic decision of allowing the flotation of the Egyptian pound. It set an initial target price of LE13 to $1, which represented a considerable devaluation from the previous official exchange rate of LE8.88. The depreciation of the pound which followed its liberalisation, however, was greater than most market observers had anticipated: by December 20, 2016 it hit LE19.63 to $1, close to the barrier of LE20 to the dollar. Since that time the currency has settled at a steady level of approximately LE18 to the dollar.

As a result, the past year has seen significantly improved foreign currency liquidity. In July 2017 Tarek Amer, governor of the CBE, told the local press that $57bn of cash inflows had flooded into the domestic banking system since the flotation the previous November. With liquidity strengthening and foreign exchange reserves following a rising trend, in June 2017 the CBE removed limits on international currency transfers. In November 2017 it removed all restrictions on US dollar deposits and withdrawals for importers of non-essential goods. By lifting the currency controls the government aims to increase the flows of foreign investment into the country, as well as attract more deposits from Egyptians abroad.

The downside to the flotation of the currency, however, is the rapid rise in consumer price inflation, which has had a negative effect on both household consumption and business growth. The CBE reacted to this challenge by tightening monetary policy, starting with a 3% interest rate rise in November 2016 and making two further rate rises in 2017. The efficacy of this policy has become a matter of debate within the business community, with some market observers believing that the rate rises will have only a minimal impact on inflation, but a significantly adverse influence on the ability of businesses to borrow and expand their operations (see analysis).

Trade

One area of the national accounts where the currency devaluation has had a beneficial effect is the trade deficit, which narrowed by 46% y-o-y in the first half of 2017. According to the Ministry of Trade and Industry, imports fell by 30% to $24bn, while the country’s newly competitive exports increased by 8% to $11bn. In 2017 the trade deficit fell by 25%. The ministry has been working to limit the import of low-quality products, rationing imports and increasing a reliance on local production. As part of the ministry’s strategy to promote industrial development in the country, it aims to leverage trade offices and export councils in key markets to increase non-oil exports by 10% by 2020. Turning around Egypt’s trade deficit is a significant challenge, however. The country’s overall trade balance has remained in negative territory since 2004, as imports demanded by a rapidly expanding economy have outpaced export growth. The nation has, however, established itself as a sizeable exporter of oil and other mineral products, chemicals, agricultural products, livestock and food products. Primary imports, which are later exported as manufactured goods, account for a large share. These include mineral and chemical products, agricultural products, livestock and foodstuff, machinery and electrical equipment and base metals.

The nation’s largest export markets, according to the UN Statistical Division, are the UAE, which accounted for $2.83bn of total exports in 2016, Saudi Arabia with $1.75bn, Italy at $1.47bn, Turkey with $1.44bn and the UK with $1.05bn.

In terms of imports, China is the origin of the biggest single share of the total ($10.4bn), followed by Germany ($5.01bn), Russia (3.7bn), the US ($3.4bn) and Italy ($3.42bn). One of the more interesting questions regarding Egyptian trading patterns is the country’s ability to respond to the changing shape of the global economy. This may include a greater effort to tap into eastern markets: a 2017 report from HSBC foresees the country’s three biggest export markets remaining the same during the period to 2030, but India overtaking the US to claim fourth position.

Foreign Investment

A drive to attract more investment in the economy runs parallel to Egypt’s trade development effort. Despite the nation’s political and economic challenges, it remains a favoured destination for global investors. In 2016 the country ranked second among Arab countries for the amount of foreign direct investment (FDI) it attracted, according to the Arab Investment and Export Credit Guarantee Corporation. Since 2014 the government has introduced a range of legislative and regulatory measures aimed at boosting FDI. Of these, the most important in recent months has been the promulgation of the new investment law at the end of May 2017. The publishing of this long-anticipated piece of legislation has established a number of investment guarantees, such as equal treatment for foreign and national investors, the granting of residence rights for the duration of projects, a protection against nationalisation or the seizure of funds (without a court order) and the right to transfer profits abroad.

The new law is also cognisant of some of the difficulties in securing suitable local labour, in that it allows for a 10% quota of foreign workers, which can be increased to 20% in the absence of national labour with the necessary qualifications.

Incentives

A variety of incentives is also outlined, divided into three categories: general incentives for projects not occurring in free zones, including stamp duty exemptions on loans and a low Customs duty rate of 2% on machinery and equipment; specific incentives for some qualifying investment projects (for example, those established in labour-intensive sectors or geographical areas in need of employment opportunities), such as tax deductions of up to 50% on investment costs; and incentives applied on an ad-hoc basis, such as the establishment of special Customs points for a project’s exports and imports, and financial assistance from the government for the cost of technical training of employees.

With its new investment framework in place, Egypt targeted $10bn in FDI in 2017, compared to the $8.7bn it attracted in FY 2016/17, according to the Ministry of Investment and International Cooperation. This ambition was made more attainable by the weaker local currency, which has lowered costs of material and labour for investors, as well as the removal of currency controls later in the year. According to the ministry, the pipeline of FDI for FY 2017/18 includes projects and investments in sectors including oil and gas, real estate, tourism and logistics.

However, despite an improved legislative framework, the country’s broader business environment is still seen as a challenging one. Egypt was ranked 128th out of 190 countries in the World Bank’s “Doing Business Report 2018”, a decline of six places over the previous year. The country showed particular vulnerability with regard to the legal frameworks and bureaucracy surrounding paying taxes, trading across borders and enforcing contracts. The government responded to the report with a number of initiatives which, if fully implemented, will have beneficial consequences on the business environment over the short and medium term (see analysis).

“We have not seen a flood of multinational companies leaving Egypt; on the contrary, firms appear to be considering their investments in Egypt seriously,” Mark Lipton, managing director of G4S, told OBG. “Despite some external negative perceptions, the security situation is actually quite stable for doing business, providing you carefully consider your risks and have good resilience plans in place.”

Opportunities

Egypt’s efforts to attract more investment are aided by the fact that it has one of the most diverse economies in the region. Agriculture continues to play an important role in the economy, accounting for around 26% of the workforce and contributing 12% to GDP in 2015, according to the World Bank. However, over the past century successive governments have pursued a range of developmental agendas which have expanded the economy to include manufacturing, extraction activity – including the mining, oil and gas sectors – construction, tourism and the various segments of the rapidly emerging services sector. Manufacturing, which includes the refining of petroleum products as well as the production of clothes, textiles, furniture, paper, cement and pharmaceuticals, is the largest single contributor to GDP, accounting for approximately 17% of the total. Wholesale and retail activity, based on Egypt’s large consumer market and the emergence of a middle class with disposable income since the turn of the century, makes up around 13% of GDP. Extraction activity claims a similarly-sized share of the GDP total – Egypt is the largest non-OPEC oil producer in Africa and has in recent decades built a gas extraction industry based on significant finds in the Nile Delta and its offshore territories. Other important contributors to GDP include construction, transport and storage, and tourism. The latter, traditionally an important source of foreign currency, has been particularly adversely affected by Egypt’s recent political turbulence – although 2017 saw an improvement in tourism numbers. According to the Ministry of Tourism, investments in security and a cheaper Egyptian pound helped to boost tourist arrivals to 8.3m in 2017 – a level not seen since 2011 (see Tourism chapter).

Outlook

As well as the tourism revival, other areas of the economy show signs of recovery. Most notably, significant gas finds in 2016 hold out the promise of increased export growth and a boost to GDP, as well as easing electricity constraints and reducing the country’s import requirements. The Zohr gas field has the potential to produce the equivalent of 40% of Egypt’s total natural gas production based on 2015 rates. At the other end of the business spectrum, a government drive to boost activity in the small and medium-sized enterprises (SMEs) sector, which requires banks to allocate 20% of their portfolios to SME businesses by 2020, has recently been augmented with a new microfinance law. Thanks to the ongoing reform initiative, Egypt’s macro outlook is a positive one: the World Bank estimates inflation to decline to 14.2% in 2018, further easing to 11.3% in 2019, and Moody’s expects the budget deficit to shrink gradually to about 3% of GDP by the end of the 2020 fiscal year, supported by a pickup in exports. The challenges of the large fiscal and external deficits, meanwhile, are offset by support from the IMF programme and, to a lesser extent, similar assistance from the World Bank. This has prompted the major ratings agencies to grant Egypt a stable outlook.

Difficulties remain, however. Egypt enters a presidential election year facing fundamental challenges, including an official unemployment rate of 13%, a youth unemployment level of 24%, and more than one-quarter of the population living under the poverty line. Maintaining the support of the public for the remainder of the reform process is thus paramount.