Weathering the storm: Conditions for growth remain, despite political setbacks

The Arab world’s second-largest economy, with a GDP of $257.3bn in 2012, according to the World Bank, has undergone more than two years of political transition that has yet to be resolved. The results of this process have had a deleterious effect on vulnerable sectors, such as the nation’s traditionally strong tourism industry, frozen out foreign investment, undercut government revenues and resulted in a strategic uncertainty that acts as a hindrance to national economic development. Nevertheless, the long-term strengths that led to annual GDP growth in the region of 7% in the years prior to the global economic crisis remain in place. Recalibrating Egypt’s diverse economy and harnessing the potential of its young population in a way that meets the people’s demand for social justice remains the principal challenge for the newly installed interim government. With the IMF cutting its 2013 forecast for GDP growth to 2% and predicting unemployment to hit 13.5%, combined with the budget deficit reaching 11.8% of GDP in the first 11 months of the 2012/13 fiscal year, according to the Ministry of Finance (MoF), the challenge remains a significant one.

REFORM TO REVOLUTION: The civil uprising that began in January 2011, and set in motion a period of political upheaval that has continued into 2013 with the recent ouster of President Mohammed Morsi’s administration, interrupted a period of sustained economic reform in Egypt. In 2004 the government began to introduce a number of new legislative and regulatory changes aimed at improving the business environment, increasing trade and promoting economic growth. These measures included floating the Egyptian pound, implementing a privatisation programme, cutting corporate and personal income taxes by 50% and rationalising a wide array of Customs and investment regulations that had for many years acted as barriers to private investment. The results of this wholesale process of reform soon became apparent in Egypt’s macro-economic indicators: in the three years prior to the global economic crisis of 2009, GDP growth averaged around 7% and foreign direct investment (FDI) peaked at $13.2bn in 2007/08, according to the MoF.

The robust standing of the economy allowed it to weather the international slowdown, posting a respectable 4.7% GDP growth for the 2008/09 financial year and exhibiting a rapid recovery thereafter to post a 6% quarter-on-quarter growth rate in late 2010. By the end of that year the MoF was predicting a return to the pre-crisis GDP expansion of 7%, and the nation was seemingly on the verge of returning to its programme of reform and the trajectory of growth which had accompanied it.

STAYING STRONG: However, the events of the past two years have underlined the fact that Egypt’s growth over the previous years has not been shared by all sectors of society, although the subsequent turmoil has dramatically complicated attempts to overhaul or reform some of the more delicate issues facing Egypt’s economy.

The consistent systemic uncertainty that has characterised Egypt's markets in recent months has led to a necessary focus on short-term challenges, meaning that it may be some time until the long-term concerns are addressed.

These challenges have been numerous: the disruption to business confidence in the early stages of the 2011 uprising forced the closure of the stock market for nearly eight weeks; tourism receipts, a key source of revenue and foreign currency, fell by 29.6% in 2011, according to the Ministry of Tourism. FDI, which had represented 5.8% of GDP in 2008, was transformed into a net outflow with a GDP contribution of -0.2% in 2011, according to the World Bank; and the Central Bank of Egypt (CBE) was compelled to dip into its foreign currency reserves in order to prop up the ailing Egyptian currency, with the result that by the start of 2012 its reserves were sufficient for only three months of import cover.

The reversals contributed to a decline in GDP growth to 1.8% in 2011 and to 2.2% in 2012, according to the IMF. The principal concern for the successive administrations that have governed Egypt since February 2011 has been to secure external funding from friendly donor countries or the IMF in order to bridge an increasingly problematic fiscal deficit.

The uncertainty over policies that currently prevails in the country has complicated this task, and the concerning state of some of the nation’s fiscal and macroeconomic indicators does not make things any easier. Navigating a way out of the challenging labyrinth of political, social and economic issues remains as one of the most significant challenges facing the country's governments in the short term, regardless of their composition.

PUBLIC FINANCES: One of the most unwelcome effects of Egypt’s political transition is the reversal of a trend of declining fiscal deficits. During the five years prior to 2011, the government met with considerable success in its attempts to reduce the budget deficit from the 10.2% of 2001/02, and by 2008/09 it had succeeded in reducing it to 6.9%.

Much of the credit for this improvement has been directed towards a process of tax reform that replaced a bloated and inefficient system with a simplified structure within which tax revenues have increased year-on-year (y-o-y). The strength of the new tax framework was demonstrated in the wake of the uprising when overall tax revenue rose y-o-y in 2010/11. However, Egypt’s non-tax revenue, such as the income generated from the tourism sector, suffered a decline, falling by 25% over 2010/11. This, combined with rising government expenditures as the government worked to satisfy the salary demands of public sector workers, as well as calls for increased spending from the wider population, resulted in a fiscal-deficit-to-GDP ratio of 9.8% for 2010/11– reaching almost LE134.5bn ($19.14bn), compared to LE98bn ($13.9bn) the previous year. In the period July-May 2011/12, the overall deficit reached 8.8% relative to GDP, slightly overshooting the budgeted deficit for the year of 8.6% of GDP.

The essential fiscal challenge remains: with few options to boost revenue and rising government expenditures, a high budget deficit is inescapable. In the 2011/12 budget, subsidies, grants and social benefits represented the largest budgetary burden, constituting 32% of total government expenditure and amounting to LE154.5bn ($22bn), up from LE123.1bn ($17.5bn) in 2010/11.

On the revenue side, government income began to slide as soon as Egypt’s political unrest began in 2011: in 2009/10, revenues represented 22.2% of total GDP and by 2010/11 this figure had declined to 19.3%. However, revenues recovered modestly during July-May 2011/12, reaching 16.8% of GDP compared to 14.6% over the same period in the previous year. The budget for 2012/13 saw a further increase in government spending to LE533.7bn ($75.9bn), with public wages, subsidies, grants and social benefits, and interest payments accounting for 78% of total spending. On the monetary side, following a strategy aimed at addressing the threat of inflation, the CBE elected to raise the interest rate in November 2011 for the first time since 2009. It also attempted to inject more liquidity into the system by introducing seven-day repurchasing (repo) agreements at a fixed interest rate of 9.75%, which it followed up in July 2012 with a 28-day repo agreement at variable rates. Similarly, the desire to increase liquidity in the system lay behind its decision to lower the required reserve ratio on local currency deposits by 200 basis points to 12% in March 2012, and then to 10% the following May (see analysis).

DEALING WITH THE DEFICIT: Egypt’s fiscal position and the unusual political circumstance it finds itself in have compelled the government to resort to short-term measures that were not previously part of its economic expansion strategy. Securing external finance to assist in the bridging of the budget deficit has become a key priority, overriding almost all other major economic concerns, and has been rendered particularly challenging due to the country’s declining sovereign rating. In the wake of the 2011 uprising, the nation’s sovereign rating began a gradual downward trajectory, which by May 2013 had seen the three largest credit ratings agencies make 16 downward revisions between them. By this time credit rating agencies Moody’s and Standard & Poor’s had moved Egypt to Caa1 and CCC+ ratings, respectively, which places the country’s long-term debt in the “substantial risk” category, according to both companies’ definitions, and effectively prevents the nation from approaching the international bond markets. While many observers feel that securing a loan from the IMF would provide short-term fiscal relief and open the door to lending programmes from other developmental lenders the question of IMF finance is freighted with popular political concerns that have so far prevented the conclusion a $4.8bn loan agreement (see analysis).

SOLUTIONS: However, Egypt has met with considerable success in attracting short-term financial assistance from regional allies. During Morsi’s presidency, Egypt secured a total of $13bn in aid from Qatar ($8bn), Libya ($2bn), Turkey ($2bn) and Saudi Arabia ($1bn) in the form of deposits to the CBE, loans, oil exports and investments. Following the appointment of Adly Mansour as the new interim president, some $12bn was secured from Saudi Arabia ($5bn), the UAE ($3bn) and Kuwait ($4bn) in deposits, cash and energy products.

In addition to seeking international assistance, the government has turned to its domestic banking sector to help it meet its fiscal obligations. However, the government has paid a high price for its reliance on local lenders. After ramping up its T-bill programme in 2011, yields on government debt continued maintaining double figures, surpassing 13.5% for a nine-month note by October 2011. A government decision to reduce the local currency reserve requirement on banks in order to increase liquidity in the system brought only momentary relief, and an auction on May 3, 2012 saw record prices, with 182-day bills selling at 15.007%, while 357-day bills climbed as high as 15.748%. Since then, domestic banks have become accustomed to securing government debt at between 14% and 15%, a stubbornly high rate from the point of view of a cash-strapped government (see Banking chapter).

SUBSIDIES: While the short-term financing that Egypt has been able to secure from several international donors and the domestic banking sector has allowed it to maintain its government spending programme, it is clear that the long-term health of the economy is contingent on the nation’s ability to restructure an expensive and inefficient framework of subsidies that has played a significant part in the economy since the era of President Gamal Abdel Nasser in the late 1950s and 1960s.

Later attempts to dismantle the increasingly costly subsidy system were met with hostile reactions from a populace accustomed to heavily subsidised bread and fuel, most notably during the period of the Egyptian “bread riots” of 1977. Nearly 70% of Egyptians are granted ration cards with which they can gain access to subsidised bread and other staples, and the price of subsidised baladi bread, the round, unleavened loaves that are a daily staple for much of the population, has remained unchanged since the assumption of power by Hosni Mubarak in 1981.

POWERING THE ECONOMY: However, Egypt’s subsidisation of energy is the most burdensome element of the programme. In 2010/11 energy subsidies, which include a variety of fuels as well as provision of cheap electricity to homes and businesses, accounted for 61% of total aid, and between July 2011 and May 2012 the energy subsidy bill hit LE86.9bn ($12.4bn) – up from LE40.2bn ($5.7bn) during the same period in the previous year.

Such government largesse has become an increasingly unsustainable solution over recent years, and the subsidy issue has become a permanent fixture in the public debate regarding the future of the nation’s economic direction. “The subsidy system is one of the biggest problems facing the government, with subsidies, grants and social benefits accounting for around a third of total government expenditures,” Professor Lobna Abdel Latif, the head of the economics faculty at Cairo University, told OBG.

Part of the problem is that the subsidies are across-the-board, which means the benefits are not always distributed to those most in need. Proposed remedies to the subsidy issue have, therefore, concentrated on recalibrating the system so that those who are disadvantaged are protected from any structural change, while the higher-end of the income spectrum is gradually exposed to real market forces. Among the reforms that have been initiated include a new smart card system for accessing subsidised fuel prices, which will not only ensure a more targeted subsidy programme but also limit smuggling and other fiscal leakage. As of summer 2013, roughly 20,000 cards had been distributed, with an ultimate goal of 11m participants. The roll-out of the smart cards is being managed by a local electronic payment company e-Finance, who won the contract for a three-year period. Similar smart card initiatives have been implemented in other countries, such as Iran, but the size and scale of the project is unique in Egypt. Most crucially, by narrowing the scope of subsidies, it paves the way for further needed changes to the overall system. Efforts to limit consumption will likely have a similar effect. “This project of fuel rationing is very important because the success could lead to implementations of other vital and major subsidy reforms that are urgently needed if the country is to reduce its fiscal bill,” said Ibrahim Sarhan, the chairman and managing director of the MoF’s e-finance programme. During 2012 the government liberalised the energy prices for energy-intensive industries, and also began to investigate the possibility of a new distribution system for liquefied petroleum gas (LPG), by which cylinders would be made available to households on a coupon system – an innovation through which the government hoped to save LE6bn ($853.8bn) per year.

DIVERSIFYING ECONOMY: As the nation awaits a return to consensus politics and the implementation of a long-term economic strategy, one of Egypt’s essential advantages remains unchanged: a relatively well balanced economy by regional standards, diversified across manufacturing and extraction activity, including the mining, oil and gas sectors (15.5%), agriculture (14.75%) construction (4.6%), tourism (3.1%), as well as various segments in a rapidly emerging services sector.

According to Ministry of Planning figures, manufacturing activity is the largest single contributor to GDP, accounting for 16.2% of the total in 2011/12 (see Industry chapter). Egypt has developed large and well-resourced manufacturing segments in clothing, textiles, furniture, paper, cement and pharmaceuticals. While the current political landscape has hindered government strategy development, prior to 2011 the expansion of the manufacturing sector was an important element of the broader national expansion plan, with six segments identified as areas of potential growth: engineering machinery and equipment, consumer electronics, life sciences, biotechnology, automotive components and handicrafts. Championing manufacturing is likely to continue under the future administrations faced with the challenge of seeking to provide employment opportunities for the young population.

MAJOR SEGMENTS: Extraction activity, which includes the nation’s sizeable oil and gas sectors as well as a small mining industry, is the second-largest contributor to GDP, accounting for 15.5% of the total in 2011/12. Egypt is the largest non-OPEC oil producer in Africa as well as the continent’s second-largest natural gas producer, and the exploitation of its hydrocarbons 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 1992, 3.5bn barrels in 2002 and 4.3bn barrels by the end of 2012. Natural gas was first discovered in Egypt in 1967 in the Nile Delta region, and proven reserves of the resource have since grown rapidly over recent years, establishing the segment as the most vibrant in the energy sector. By the end of 2012 Egypt’s proven natural gas reserve stood at 72trn cu feet, or 1.1% of the global total, the third-highest on the African continent behind Algeria and Nigeria. By the 2010/11 financial year, the cumulative investment in the extraction sector had reached 19.5% of total investment in the country, according to the Ministry of Planning, and, as the geographic dispersal of the upstream segment protected it from many of the disruptions of 2011, the government’s plan to increase production by 5% per year until 2020 remains unaltered.

Agriculture, once the single largest component of GDP, continues to play an important role in the economy, accounting for 14.75% of GDP in 2011/12 (see Agriculture chapter). The sector, which includes irrigation and fisheries, grew at an average annual rate of 3.45% during the 1990s, accelerating to 4% in 2008/09 before falling to 3% annual growth in the wake of the global economic crisis. Against the subdued economic backdrop of 2011, it achieved a growth rate of 2.7%. Government strategies have sought to introduce more efficiency into 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 implementation 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 (CAPMAS).

RECENT GROWTH: The nation’s growing economy in the years prior to the global credit crisis resulted in the significant growth in the construction sector, for which total investments rose from LE24.8bn ($3.5bn) in 2005/06 to LE60bn ($8.5bn) in 2010/11, driven by the rising demand for housing and an increasing number of commercial, hospitality and industrial developments. In 2011/12 construction and building activity accounted for 4.6% of GDP (see Construction and Real Estate chapter).

The same growth factors combined over a similar period to underpin the expansion of the telecommunications sector (see Telecoms and IT chapter). According to the Ministry of Communications and Internet Technology, Egypt had 33.26m internet users at the close of May 2013, which represents an annual growth rate of 3.53%. The mobile penetration rate, meanwhile, stood at 113.35% in May 2013, up 1.74% from the previous year, and in 2011/12 was a major contributor to the 2.6% of GDP claimed by the telecommunications sector.

Egypt’s financial services sector is both an enabler and beneficiary of this growth. The country’s financial intermediaries, which include six public banks, three commercial banks, 27 private lenders and a host of private equity firms and brokerages, comprised 3.37% of GDP in 2011/12. Cairo is also home to the oldest stock exchange in the region and one of the largest on the continent, and the breadth of its listings reflects the diversity of the economy. The largest sector as of the end of 2012 was construction and materials, with 22% of total market capitalisation, followed by telecommunications (16%), banks (14%) and financial services excluding banks (8%). The remaining sectors are comprised of real estate (7%), chemicals (6%), basic resources (5%), travel and leisure (5%) and industrial goods and services (5%).

Finally, in 2011/12 the tourism sector accounted for 3.1% of total GDP. An estimated 14% of the population work within the industry, and 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 recent political unrest have been more persistent. In early 2012 the Ministry of Tourism revealed that in the first year after the uprising the tourism sector suffered a LE27bn ($3.8bn) fall in revenue and a 32% decline in visitor numbers. While 2012 saw a 17% rise in arrival numbers, according to the subsequent tourism minister, the levels still fall considerably short of those that the sector enjoyed prior to 2011 (see Tourism chapter).

TRADE: Egypt’s export activity has continued to grow during the recent period of political unrest, rising from LE143.1bn ($20.36bn) in 2010/11 to LE159.9bn ($22.75bn) in 2011/12, according to the MoF. However, the country has been running a trade deficit for many years, and in 2011/12 imported LE362.9bn ($51.6bn) worth of goods, for a trade deficit of LE233bn ($33.15bn). In terms of exports, the largest category is generally fuel and crude oil, shipments of which reached a value of LE28.6bn ($4.1bn) in 2011/12, followed by manufactured oils (LE18.7bn, $2.66bn), and non-durable consumption goods (LE8.5bn, $1.2bn). The most valuable import is usually primary manufactured inputs, which in 2011/12 totalled LE125.3bn ($17.8bn), followed by primary industrial inputs (LE33.9bn, $4.82bn) and primary foodstuffs (LE29.3bn, $4.17bn).

Egypt’s biggest trading partner is the EU, which accounted for 40.7% of its exports in 2011/12, according to the MoF. The trading relationship with the bloc was cemented in 2004 by the 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 agreement has proved beneficial to both parties, Europe’s slow recovery from its economic downturn has led to concerns that its export policy is skewed too heavily towards its northern trade partners.

REGIONAL PARTNERS: However, Egypt has several other well-established trading relationships upon which it might expand when its economy further stabilises. Egypt exported $5.3bn worth of goods to Arab states in 2011/12, representing 19.7% of total exports, a marked increase from 12% in 2006/07. With forecasts for GCC growth in 2013 settling within the 4.5% to 5.5% range, Egypt’s regional neighbours offer a promising avenue of export expansion.

Vibrant Asian markets, too, represent a potential area of interest for Egypt’s exporters. Egypt shipped $4.6bn worth of goods to the Asian region in 2011/12, equal to 17.1% of total exports – a 5.5% increase on Asia’s share in 2006/07. Africa accounted for just 1.8% of Egypt’s exports, or some $499m, in 2011/12, yet with GDP growth predictions by the IMF for South Africa, Nigeria, Angola and Ghana ranging from 2.6% to 8%, Egypt’s African neighbours are of renewed interest to a government intent on reducing a persistent trade imbalance.

FDI: As with the trade deficit, the decline of FDI to Egypt predates the recent political unrest. 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 measured decline continued into 2009/10, which finished with an FDI level of $6.8bn, and in 2010/11 and 2011/12 it suffered a more precipitous drop as the political instability took its toll, registering $2.2bn and $2.1bn, respectively.

In terms of FDI origin, recent years have seen the UK overtake the US as the largest source of investment. In 2007/08 inflows from the US stood at $6.4bn against the UK’s $3.2bn, but by 2008/09 they had almost equalised. As the global economic crisis set in, American inflows slowed and contracted further in the wake of Egypt’s uprising of 2011 to register a modest $577m in 2011/12. Conversely, inflows from the UK continued to expand throughout the period, rising to a record high of $5.8bn in 2011/12, significantly bolstered by the participation of UK companies in Egypt’s oil and gas sector (see Energy chapter). The US was the second-largest source of FDI in 2011/12, with $577.6m, followed by the UAE ($559.8m) and the Netherlands ($409.4). Once political stability is restored, the oil and gas extraction sector is likely to be the biggest beneficiary of FDI. However, the Ministry of Investment has identified infrastructure, renewable energy, and small and medium-sized enterprises (SMEs) in various areas as potential destinations for international funding.

PPP: Egypt had achieved some success with the public-private partnership (PPP) investment model in the years prior to the recent political unrest, establishing a PPP unit in 2006 that oversaw a number of large infrastructural projects. The passing of a PPP law in 2010 aimed to further encourage external input by providing a more comprehensive framework for such ventures. The projects to which the new law will be applied are defined in the first chapter of the legislation as those of a total contract value in excess of LE100m ($14.23m) and involving a concession or offtake agreement of five years or more in duration. The law also establishes the PPP Central Unit, previously part of the technical office of the minister of finance, as an independent entity. From the bidders’ perspective, the most salient innovations brought by the new law are a mandatory prequalification process and competitive dialogue process by which bidders will be required to present an initial non-binding bid which then forms the basis of discussions with the client. The purview of the PPP unit covers a wide range of sectors, including water, electricity, communications, health, transport, education and hydrocarbons. After a slowdown in project activity in the wake of the civil unrest of 2011, the Ministry of Finance in 2013 announced that 10 new PPP projects would be put out to tender in the short term, including water treatment plants, industrial ports, hospitals, desalination facilities, a river bus operation and major road works. Unlike the privatisation programme of the early 2000s, which has become a political grievance as a result of its poor implementation, the PPP programme offers an attractive route to providing a sustainable form of collaboration for an Egyptian government with limited fiscal options.

OUTLOOK: Egypt’s ongoing political transition and the current lack of economic certainty continue to hamper the nation’s recovery from the events of 2011 and 2013. However, regardless of the complexion of the country’s government over the coming 12 months, the economic challenges are the same. Fiscal consolidation will be a priority in the future. According to the Egyptian Centre for Economic Studies, fuel and food subsidies alone absorb 10% of GDP, and much of the government money directed towards them would be better spent on programmes ranging from infrastructure development to targeted support for job-creation initiatives.

On the other side of the ledger, Egypt’s tax reform may serve the dual purpose of bolstering revenue and distributing income more equitably, although it would have to do so in the face of a large informal economy. Among the possible tax changes are a new value-added tax that was first mooted in the final years of the Mubarak administration and a more equitable version of the real estate tax, a concept that predates the 2011 uprising, which brings the possibility of more revenue and encouraging better usage of Egypt’s underutilised housing stock.

Perhaps the biggest challenge for the government, given the young population, is the question of job creation. The anticipated recovery of the labour-intensive tourism industry should Egypt regain the political stability it once enjoyed will help in this regard, but the nurturing of Egypt’s SMEs is seen by many as key to job creation in the long run. The government’s SME strategy has been dispersed across a number of ministries and agencies, but Egypt’s banks have shown an increased interest in extending finance to the SME sector as traditional routes to revenue have diminished (see Banking chapter).