A. Macroeconomic Outlook and Risks

12. Medium-term prospects are favorable provided short-term challenges can be addressed and growth-friendly policies and reforms implemented. Inherent strengths of the economy include a dynamic and young population, a large market size, a favorable location, and access to important foreign markets. The opening of the parallel Suez Canal last August, large investments in the energy sector, and the discovery of a major gas field also bode well for Egypt’s medium-term development. However, realizing this potential depends on overcoming near-term challenges such as foreign currency shortages, low policy buffers, and weakened market confidence as well as implementing wide-ranging structural reforms that support inclusive growth. This is a key objective of the authorities’ program

13. The program’s macroeconomic projections are based on the following assumptions:

• Helped by macroeconomic stabilization, removal of foreign exchange shortages, and the improved business climate, GDP growth is projected to recover to its potential growth of 5–6 percent over the medium term. Depreciation of the pound should make Egyptian goods and services more competitive and the yields on Egyptian assets more attractive. Investment, including FDI, and exports are expected to grow and replace debt-financed consumption as growth engines.

• Prudent monetary policy is projected to bring inflation down to single digits after one-off effects of depreciation, subsidy reforms, and the introduction of VAT dissipate. The pass-through from the exchange rate to inflation is expected to be limited this year given that a significant part of imports is already priced at the parallel market rate.

• Fiscal consolidation will be underpinned by improved revenue mobilization, including through the new VAT law and better tax administration, and expenditure optimization through PFM measures, subsidy reductions, and the civil service reform. This should ease pressure on the external sector and place general government debt on a declining path to reach 85.8 percent of GDP by the end of the program and decline further to 78.3 percent of GDP by 2020/21.

• The current account deficit is expected to narrow to 3 percent of GDP by 2018/19. Export recovery is predicated on exploration of new gas fields and competitiveness gains from real depreciation of the pound and growth-friendly reforms. Import demand will be contained by tighter fiscal and monetary policies, with imports of investment goods financed in part by increasing inflows of FDI. The financial account is projected to benefit from the increased access to international capital markets. The overall BoP surpluses would rebuild international reserves.

• In 2016/17, output is projected to remain well below its potential. Fiscal consolidation coupled with monetary tightening would inevitably constrain growth. The planned structural reforms will take time to bear fruit. However, elimination of foreign exchange shortages—the single most widely cited impediment to business activities and removal of currency overvaluation should provide a significant boost to production and exports. On balance, real GDP growth is expected to be about 4 percent, broadly the same as in the previous year.

14. The risks to the program are significant and mainly arise from the difficulties inherent in implementing a strong and wide-ranging reform program. Potential fiscal slippages due to revenue shortfalls, higher than programmed wage increases or delays in implementing expenditure measures could undermine the program’s debt sustainability objective, especially in light of persistently high fiscal deficits in the previous several years. Attempts to manage the exchange rate could lead to a loss of reserves or reemergence of a large parallel market premium. Failure to tighten monetary policy sufficiently could lead to strong exchange rate and inflationary pressures and loss of reserves. Opposition by vested interests could derail structural reforms and weaken medium-term growth prospects. These risks are mitigated by the strength of the policies under the program, significant frontloading of major measures, and the program’s backing at the highest political level. The authorities’ commitment to the program was also demonstrated by the implementation of the prior actions.

15. Egypt is also exposed to external shocks. Tighter or more volatile global financial conditions may raise borrowing costs. Lower growth in trade partners (Eurozone, Russia) or a worsening of regional security would hurt trade and tourism. Persistently lower energy prices would reduce remittances and financing from the Gulf countries. On the upside, lower energy prices would help trade and fiscal balances. Egypt’s new flexible exchange regime and prudent macroeconomic policies under the program provide sufficient buffers against these vulnerabilities.

B. Monetary and Exchange Rate Policies

16. On November 3, 2016 the CBE devalued the Egyptian pound by 32.5 percent against the US dollar and allowed the exchange rate to float. In anticipation of the exchange rate move, the parallel market premium exceeded 50 percent at end-October. On November 1 and 2, however, the pound rebounded somewhat in the parallel market, suggesting that the prior rapid depreciation was in part reflective of overshooting. The CBE took advantage of this opportune timing and devalued the official exchange rate to EGP/$13. At the same time, it removed restrictions on setting own buy and sell rates by banks, eliminated the priority import list, and allowed the exchange rate to be market-determined. The CBE’s subsequent foreign exchange auction of $100 million produced a weighted average exchange rate of EGP/$ 14.645. On November 6 buy and sell rates were quoted at 15.7/16.3 per U.S. dollar.

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Exchange Rate

(Egyptian pounds per $)

Citation: IMF Staff Country Reports 2017, 017; 10.5089/9781475566901.002.A001

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17. In response to mounting inflationary pressures and in conjunction with the float, monetary policy was preemptively tightened. On November 3 the CBE raised policy rates by 300 basis points, and sterilized part of the large liquidity surplus that had built up in the system due to the prior accommodative stance by introducing deposit auctions with maturities of 118 days. At the first such auction the CBE auctioned EGP50 billion and accepted EGP38.8 billion at an average interest rate of 17.5 percent. The CBE and the MOF signed a protocol on limiting direct CBE financing of the budget through overdrafts to prevent injection of new liquidity.

Box 1.

Prospects for Medium-Term Growth

During the last years, Egypt’s growth suffered from worsening fiscal and external imbalances which added to the long-term structural constraints of high unemployment, low labor force participation and an unfavorable business environment. Growth fell to 2.7 percent on average in 2011–2016, sustained by domestic consumption, which resulted in a widening fiscal deficit. The external sector deteriorated sharply, in a context of low investment, a less favorable global environment and security concerns.

The authorities’ program, supported by the three-year EFF arrangement, addresses macroeconomic and structural constraints. With a sound implementation of planned policies, Egypt’s growth could rise to 6 percent over the medium term, which would be comparable to the period 2005–2010 when annual growth averaged 5.9 percent.

On the demand side, growth will be driven by higher investment and improvement of the net external sector. Fiscal consolidation and reforms to improve business climate will help promote private sector development by crowding in private sector’s access to finance and by removing constraints to starting and doing business. Better macro-economic stability will improve market confidence and attract foreign investment, in particular FDI. Greater exchange rate flexibility will strengthen external competitiveness and support exports. The energy subsidy reform will remove the bias towards energy and capital-intensive industries.

It will encourage investment in labor-intensive activities and foster job creation to absorb Egypt’s growing labor force. The energy subsidy reform will also allow the authorities to increase growth-enhancing investments and spending in social sectors (notably health and education).

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Contributions to GDP growth

(percent)

Citation: IMF Staff Country Reports 2017, 017; 10.5089/9781475566901.002.A001

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On the supply side, manufacturing is projected to recover, while construction and services will remain buoyant. A unified and better functioning foreign exchange market and a gradual increase in Egypt’s electricity production resulting from investments since 2014/15 will remove two major constraints that weighted on manufacturing activity in recent years. Construction and services should continue to expand at dynamic rates while new opportunities such as recently discovered gas fields and the enlarged Suez Canal could also boost medium-term growth.

Lower than projected medium-term growth would have important implications for medium-term public debt sustainability. Under the baseline forecasts, the interest rate-growth differential and improved primary balances will reduce public debt to below 80 percent by 2020/21. Debt projections are particularly sensitive to growth assumptions, and slower GDP growth could weigh significantly on debt sustainability (Annex I). In this context, implementation of the fiscal consolidation plan and the structural reform agenda is important in containing this risk.

18. In the medium term monetary policy will focus on bringing inflation down to mid-single digits. The depreciation, VAT, and the energy subsidy reform are estimated to contribute to average inflation rising to 18 percent in 2016/17. The CBE will accommodate these first-round effects, but will maintain adequately tight monetary policy to contain secondary pressures and reduce inflation to single digits in the next three years. To signal its policy intentions and anchor inflation expectations, the CBE will maintain short-term interest rates at levels that ensure tight liquidity conditions. This will contain domestic demand and allow commercial banks and the CBE rebuild their foreign assets that have been depleted. In 2017/18 and beyond, as inflation declines interest rates will also come down to permit credit recovery. However, the CBE will be prepared to tighten the monetary stance again should demand pressures reemerge.

19. Monetary policy will rely on money targeting. The program sets a tight reserve money path for 2016/17, which will be achieved by controlling credit to government and banks. This will require improved liquidity forecasting and management, and strengthening of CBE independence by removal of fiscal dominance. The Ministry of Finance (MoF) and the CBE have agreed to bring budget overdrafts below EGP75 billion in 2016/17 by securitizing about EGP250 billion and minimizing new issuances. The CBE will closely monitor banks’ excess reserves and rely primarily on indirect policy tools, such as deposit auctions and repo/reverse repo transactions, to achieve its targets, but if warranted may also change reserve requirements. In the process, it will ensure that solvent and viable banks retain access to liquidity to operate uninterrupted.

20. The authorities plan to maintain a flexible exchange rate regime and accumulate significant international reserves. These will serve as buffers against external shocks, strengthen credibility of the CBE, and preserve competitiveness. The program targets the accumulation of about $5 billion in 2016/17, which would raise reserves to above 100 percent of the ARA metric for floating regimes. By the end of the program, gross international reserves are expected to reach almost $33 billion, equivalent to 5 months of prospective imports of goods and services. Once the market regains confidence and the supply of foreign exchange increases the CBE will operate mainly on the buy-side, but occasional FX sales might still be needed to prevent excessive short-term exchange rate fluctuations. The CBE is committed to meeting its program objectives, and will consult the Fund on the needed policy adjustments in the event of excessive FX sales (including direct sales to SOEs and the government).

21. The authorities are committed to eliminate the multiple currency practice (MCP), which has been kept in place not for the BoP purposes. The multiple price currency auctions, which give rise to the MCP, will help develop a well-functioning FX market. The authorities have requested temporary approval of this measure given that that it does not discriminate against other members, does not harm the interests of other members, does not impede the member’s balance of payment adjustment, and is temporary.³ The MCP will be eliminated once the interbank market is well developed. The current limit of $100,000 on transfers abroad by individuals without an underlying commercial transaction and a cap of $50,000 on cash deposits for importing non-priority goods will also be lifted by June 30, 2017. With the unification of the exchange rate, the large parallel market premium is expected to disappear. However, it will take time to assess whether the policy has succeeded. A full analysis of the exchange system will be conducted by the staff prior to the first review to verify Egypt’s compliance with Article VIII.

22. The CBE will strengthen its operations and transparency. Specifically, it will bring its investment regulations for reserve management in conformity with best international practices to ensure that reserves are invested in low risk and highly liquid instruments. Reserve allocation to foreign subsidiaries and branches of Egyptian banks will be capped at the current stock of $5.6 billion. The CBE will develop a new communications strategy to better inform the markets of its policy objectives and to explain its actions. This will include publishing of the financial stability reports (from December 2016) and quarterly reports on monetary policy and inflation (from March 2017), and engaging with media more actively.

C. Fiscal Policy and Public Finance Management

23. Fiscal policy will be anchored to restoring debt sustainability and setting public debt on a clearly declining path. Staff and the authorities shared the view that under unchanged policies public debt would have become unsustainable. The program was designed to balance the debt stabilization objective with the political and economic feasibility of fiscal consolidation. Therefore, the program targets a fiscal consolidation path, which the authorities view as politically feasible and aims at reducing general government debt from 95 percent of GDP in 2015/16 to 86 percent of GDP in 2018/19, and further to 78 percent of GDP by 2020/21. The debt sustainability analysis (Annex 3) shows that under the proposed adjustment scenario public debt is sustainable, though not with a high probability.

24. Consistent with the debt objective, the program targets an adjustment in the primary balance of 5½ percent of GDP over three years. The mission and the authorities discussed whether more ambitious fiscal consolidation would have been appropriate, but the program adjustment is large compared to peers and significant additional adjustment would not be advisable due to its contractionary impact and potentially negative social implications. The primary balance rather than the overall balance is targeted because it better reflects the government’s policy stance by excluding interest payments which are difficult to control given the uncertainty about interest rates during the transition. The overall deficit is also expected to fall during the program from 12.1 percent of GDP to 4.7 percent. Tax revenues are projected to increase by 2.5 percent of GDP during the program mainly because of VAT, which was passed by Parliament in August, and primary expenditure is projected to decline by 3.5 percent of GDP owing to the reductions in wages and subsidies. As public debt declines with the fiscal consolidation, so does the interest bill. This will free up fiscal space for higher spending in the authorities’ priority areas of health, education, R&D, investment and social protection.

25. The 2016/17 budget was approved by Parliament in late June and is consistent with the program objectives. It targets the primary deficit of 0.8 percent of GDP, which corresponds to fiscal consolidation of 2.6 percent of GDP. The new VAT, which was passed by Parliament on August 29, will be introduced at a rate of 13 percent in 2016/17 (compared to 10 percent for the previous General Sales Tax), to be increased to 14 percent in 2017/18. There are exemptions for most staple foods consumed by the poor. The higher tax rate, combined with base broadening and improved compliance, will yield an additional 1 percent of GDP in 2016/17 compared to the GST. On the expenditure side, the elimination in the budget law of indexation of public sector employees’ bonuses and allowances will contain the wage bill increase to below the projected inflation, and generate 0.9 percent of GDP in fiscal savings. The projected net reduction in public employment through the new strict hiring rules, and the streamlined public employment framework under the new Civil Service Law adopted by Parliament in October, are expected to yield additional medium-term savings. Energy subsidies are budgeted to decline by 0.4 percent of GDP in 2016/17 (see ¶27).

26. The authorities’ program has a strong social spending component. To ease the adjustment process, about 1 percent of GDP in fiscal savings will be directed to additional food subsidies, cash transfers to the elderly and the poor families, and other targeted social programs. The aim is to replace poorly targeted energy subsidies with programs that directly support poor households. In addition, resources for programs protecting vulnerable groups, including school meals, subsidies for infant milk and children’s medicines, and vocational training for young people will be preserved or increased.

27. Energy subsidy reforms that begun in 2014 are continuing. The current subsidy scheme is not well targeted and benefits the well-off disproportionately rather than the poor. The staff considers that significant reductions in fuel subsidies during the program are essential. The authorities raised electricity tariffs by about 40 percent in July 2016. Gasoline and diesel prices have been increased on November 3 by 35 percent on average to achieve a pre-tax cost-recovery ratio of 56 percent and the budgeted reduction in the fuel subsidy bill. The authorities are prepared to further adjust fuel prices or take other measures as needed to offset any additional costs in the event of larger than projected depreciation of the pound or higher global oil prices. They have also committed to periodically increasing the pre-tax cost recovery ratio further on most fuel products to achieve 100 percent in 2018/19 and to eliminate electricity subsidies over the next five years.

28. The mission and the authorities discussed safeguards against fiscal slippages. Lower economic growth, higher interest rates, weaker than anticipated VAT performance, wage bill overruns and obligations to non-performing state-owned enterprises were identified as the main risks to the fiscal consolidation. To preserve the fiscal targets, the authorities will consider better targeting of food subsidies by improving the current smart card system; accelerating energy subsidy reforms; revisiting tax exemptions and other tax expenditures; and further cutting non-priority expenditures, as needed.

29. Egypt’s PFM reforms are aimed at strengthening the budgetary framework and improving monitoring of fiscal risks. As key measures, the authorities will: 1) review the classification of the economic authorities in fiscal accounts to identify those that serve public policy objectives and incorporate them in the state budget; 2) in view of potentially significant exposure to contingent liabilities, strengthen the framework that governs the issuance and monitoring of state guarantees and prepare by January 31, 2017 a report on all outstanding state guarantees; 3) develop by June 2017 a road map for pension reforms, including a plan to address the implicit liabilities of the budget sector to the Social Insurance Fund; 4) introduce a medium-term budgeting framework with multi-year rolling ceilings for major spending categories with greater emphasis on programmatic budgeting; 5) prepare and present to Parliament a pre-budget statement on economic and public finance developments; and 6) develop by March 31, 2017 a fiscal risks statements covering macroeconomic risks, public enterprises, debt management, contingent liabilities, pensions, and resource mobilization.

Egypt: Fiscal Measures^*

^*Measures show the difference between the program values and baseline “zero policy change” estimates by the authorities. Measures may exceed savings relative to 2015/16 due to increases in baseline costs.

Egypt: Fiscal Measures^*

			2016/2017
			(in percent of GDP)
Deficit reducing measures			3.9
	Revenue		2.2
		VAT	1.0
		Tobacco and other excise duties	0.5
		Tax administration and base broadening reforms	0.1
		Dividends from public banks	0.2
		Other tax and non tax	0.4
	Expenditure		1.8
		Electricity subsidy	0.6
		Fuel subsidy	0.6
		Other spending savings	0.5
Deficit increasing measures			−1.0
	Expenditure		−1.0
		Health, education, and research and development	−0.3
		Food subsidies	−0.2
		Takaful and Karama cash transfer programs	−0.1
		Social Solidarity Pension	0.0
		Social safety nets	−0.3
Net impact of measures on deficit			2.9

^*Measures show the difference between the program values and baseline “zero policy change” estimates by the authorities. Measures may exceed savings relative to 2015/16 due to increases in baseline costs.

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Egypt: Fiscal Measures^*

			2016/2017
			(in percent of GDP)
Deficit reducing measures			3.9
	Revenue		2.2
		VAT	1.0
		Tobacco and other excise duties	0.5
		Tax administration and base broadening reforms	0.1
		Dividends from public banks	0.2
		Other tax and non tax	0.4
	Expenditure		1.8
		Electricity subsidy	0.6
		Fuel subsidy	0.6
		Other spending savings	0.5
Deficit increasing measures			−1.0
	Expenditure		−1.0
		Health, education, and research and development	−0.3
		Food subsidies	−0.2
		Takaful and Karama cash transfer programs	−0.1
		Social Solidarity Pension	0.0
		Social safety nets	−0.3
Net impact of measures on deficit			2.9

^*Measures show the difference between the program values and baseline “zero policy change” estimates by the authorities. Measures may exceed savings relative to 2015/16 due to increases in baseline costs.

D. Energy Sector Reforms

30. In addition to reducing subsidies, the Egyptian authorities are developing a comprehensive reform agenda for the energy sector (petroleum, electricity and gas). The objective is to modernize the sector, including by improving the regulatory framework for enabling private investments, strengthening its finances, and promoting competition. This is particularly important in light of the ongoing development of new gas fields in the Nile delta and the Mediterranean. To this end the Ministry of Petroleum has retained an external consultant to conduct a diagnostic study. On the basis of this, by March 31, 2017 the authorities will develop a medium-term strategy for the energy sector reform.

31. An integrated plan for restoring the financial sustainability of the state-owned Egyptian General Petroleum Company (EGPC) will be finalized by March 31, 2017. EGPC’s finances have deteriorated considerably since 2011, partly because of lower revenues but also because of growing operating costs. This has led to accumulation of $3.6 billion in arrears to international oil companies, who are the main suppliers of fuel, and if left unaddressed could impose significant fiscal burden. The EGPC modernization plan will incorporate the fuel subsidy reform, measures to improve efficiency, transparency and accountability of its operations, and a strategy to deal with the existing stock of arrears. Meanwhile, the EGPC will gradually reduce existing arrears and not accumulate new net arrears.

E. Financial Stability

32. The authorities are confident that the banking system can weather the transition to the new exchange regime. The CBE has conducted extensive stress tests prior to the devaluation to confirm that banks’ capital and liquidity buffers were adequate to withstand devaluation and higher interest rates. The results of stress tests indicated that the banking system would remain sound, but also showed that in the event of a severe shock the capital adequacy ratio of a few small banks could fall below the Basel-recommended 10.5 percent. The implication of depreciation on banks’ credit risk is expected to be moderate in light of relatively small dollarization of balance sheets of corporates and households. However, in the absence of sufficiently detailed bank data for stress tests, the staff cannot assess fully the risks to banks that could arise from a combination of currency depreciation and higher market interest rates. The CBE will monitor developments in banks carefully during the adjustment process, share banks’ financial data with the Fund staff in the coming months and work closely with it to assess health of the banking sector and perform bank-by-bank stress tests as needed to mitigate any risks that may emerge. In this regard, the CBE’s recent request for Fund technical assistance on stress testing is encouraging.

33. The authorities are planning to further strengthen Egypt’s regulatory framework and the crisis response capacity. The CBE is reviewing its supervisory model with the view to implementing best international practices in line with Basel III principles, enhancing transparency, and promoting competition among banks. It is also planning to strengthen its capacity to monitor systemic risks, develop more sophisticated methods for stress-testing and early warning systems, and enhance governance, bank resolution, and emergency liquidity assistance frameworks.

F. Structural Reforms for Growth and Employment

34. There are long-standing challenges of high unemployment and structural impediments to growth. Unemployment has declined marginally in 2015/16, but at 12.7 percent remains high and is significantly higher for youth and women. Furthermore, historically labor force participation has been low by international standards and employment intensity of growth has been too weak to absorb Egypt’s young and growing population. Egypt ranks 122 out of 190 in the World Bank’s Doing Business Indicators, and excessive regulations and licensing requirements, barriers to trade, rigid labor markets, and lack of access to finance are among key structural impediments to growth, exports and employment that have been widely cited by businesses and external observers. They deter investment and depress potential output.

35. In its program, the government has proposed an ambitious and wide ranging set of measures. The government is planning a new licensing law, to be adopted by March 2017, which will: streamline industrial licensing for all businesses other than those serving vital public interests; make factory permitting risk-based and delegate the function to local authorities; and simplify and limit the need for Civil Defense and Fire pre-approvals. This will reduce the complexity and time needed to obtain industrial licenses, which have been identified as key impediments to the development of the sector. The government is also proposing a new insolvency law, to be adopted by June 30, 2017, to simplify the time-consuming bankruptcy procedures and to de-criminalize insolvency. Further, the government will develop: a collateral registry to facilitate access to finance, which is among top complaints of SMEs; an action plan to rationalize the export-promotion regime and minimize non-tariff barriers to trade; and job intermediation schemes and specialized training programs for youth. It will also support women’s labor force participation by spending about EGP250 million on improving the availability of public nurseries, and by studying how to improve the safety of public transportation.