II A Historical Examination of Growth, Investment, and Saving
- Howard Handy
- Published Date:
- May 1998
Egypt’s growth performance has been uneven. After growing rapidly during the 1970s and first half of the 1980s, output decelerated and generally fell short of population growth rates. Economic growth has recently picked up and is estimated at about 5 percent in 1996/97. Sustaining this trend over the medium term with the aim of improving living standards and creating job opportunities for a rapidly growing labor force has emerged as the central objective of the Egyptian Government’s recently intensified reform effort.
The key to meeting the growth challenge is to raise investment levels, improve investment efficiency, and ensure that investment is financed in a sustainable manner. To this end, this section examines the nexus of growth, investment, and savings in Egypt over the past three decades.
The Growth Record
From the early 1950s, the government adopted an import substitution, state-led growth development policy. Initially, the strategy produced modest growth rates averaging 3.5 percent a year during 1952–73.3 The twin oil shocks (1973 and 1979) created a regional boom that had direct effects on Egypt (through higher oil revenues), as well as indirect effects (through workers’ remittances, foreign aid, and tourism), resulting in abundant financing for investment. Growth was also fueled by the “injitah” (open-door) reform policies starting in 1975, in which the private sector was accorded wider scope for operations, and by a series of laws encouraging investment, inter alia, through incentives.4 As a result of these factors, real GDP grew sharply, averaging 8.4 percent a year between 1974/75 and 1984/85 (see Figure 1).
Figure 1.Real GDP Growth
Sources: Data provided by the Egyptian authorities; and IMF staff estimates.
By the mid-1980s, growth was stagnating and macroeconomic imbalances were widening. Inflation was in excess of 20 percent a year, the current account deficit was more than 10 percent of GDP, and external arrears were accumulating. These imbalances reflected substantial fiscal deficits and expansionary monetary policy. Market inefficiencies were fostered by administrative restrictions: administered prices, interest rate ceilings, multiple (and overvalued) official exchange rates, administrative allocations of foreign exchange, and restrictions on the private and foreign sectors. The financial sector suffered from segmentation, limits on competition, mandatory and subsidized credit allocations, and negative real rates of interest. The private sector was “crowded out” by a development strategy that relied on large–scale public ownership combined with import substitution and a limited focus on export promotion. Also, investment in human capital was low as evidenced by relatively weak social indicators.
The collapse of world oil prices in the mid-1980s had negative spillover effects on Egypt, including lower remittances and aid. At the same time, the economic slowdown was exacerbated by the above distortions. As a consequence, real activity decelerated and real GDP growth averaged 3 percent during 1985/86–1992/93, with only a 1 percent annual rate between 1989/90 and 1992/93.
The impact of Egypt’s faltering growth was accentuated by high population growth (see Figure 2). While real per capita GDP initially grew faster than the average for all developing countries, its level was surpassed by the Asian countries in 1986/87, and eventually by the average for all developing countries. Put differently, while Egypt’s real per capita GDP was a third higher in the early 1990s than a decade earlier, the real per capita GDP of the Asian region had grown (during the same period) by more than 80 percent.
Figure 2.Real Per Capita GDP Growth
Sources: Data provided by the Egyptian authorities; IMF, World Economic Outlook database.
Egypt entered a new phase of economic growth in the early 1990s. Following the successful implementation of a macroeconomic adjustment program, the government embarked on an ambitious program of structural reforms aiming at revitalizing the economy, integrating it globally, and ensuring that the private sector would play the key role. Favorable results are in evidence with real GDP growth estimated to have accelerated to 5 percent during 1996/97.
The Investment Record
Capital accumulation is a key contributor to growth. In tandem with GDP growth, investment rates in Egypt rose sharply until the early 1980s (see Figure 3).5 The latter reflected the passage of a number of pro-investment laws, as well as an intensification of petroleum exploration activities. Moreover, investment opportunities during that period benefited from abundant financing linked to the regional boom. During the high investment period (1974/75–1981/82), the investment rate more than doubled from 12 percent of GDP (during the earlier five-year period) to just under 25 percent of GDP.
Figure 3.Investment Rates
Source: Data provided by the Egyptian authorities.
Collapsing international oil prices in the mid-1980s sharply curtailed investment financing. At the same time, remaining market distortions eventually became too important for investors to ignore. Indeed, while real GDP growth rates decelerated starting in the mid-1980s, the decline in investment expenditures began a few years earlier. The contraction continued through the early 1990s with the rate averaging only 18 percent of GDP during 1982/83–1992/93 consistent with a real contraction of–0.8 percent a year. Moreover, the decline was progressive with the investment rate reaching less than 15 percent of GDP by the early 1990s. As with growth, the consolidation of macroeconomic stability and the implementation of a comprehensive structural reform program during the past few years have had a positive effect on investment expenditures, which appear to have regained momentum.
Egypt’s investment record can be better understood by examining its various components.
The boom/bust behavior of Egyptian investment was largely a public sector phenomenon. At its peak in the late 1970s, public investment reached 22 percent of GDP, of which half was accounted for by public enterprise investment. About 80 percent of public investment was spent on “economic sectors” that competed with the private sector. These expenditures contributed to unsustainable fiscal deficits, rising external indebtedness, and mounting public enterprise losses. A financing crisis emerged in the late 1980s that led to a sharp contraction in public investment; the latter has recently stood at less than 10 percent of GDP.6
The prevalence of economic distortions and crowding out by the public sector translated into low private investment rates. Even during the high-investment and high-growth period, private investment averaged only 5 percent of GDP. Moreover, the private sector did not compensate for the contraction in public investment starting in the late 1980s. Although private investment has gathered strength more recently (Figure 4), its level (12 percent of GDP in 1996/97) remains well below that prevailing in the fast-growing Asian economies (24 percent of GDP in 1996).
Egypt’s investment rate has been significantly lower than in other developing country regions. In particular, after initially outperforming comparator regions (including the Asian region), Egypt’s investment rate lagged since the late 1980s. Moreover, despite the momentum of the past few years, the rate remains below the developing country average.
Figure 4.Private Investment
Source: Data provided by the Egyptian authorities.
The dynamics of investment behavior have been studied by Bisat, El-Erian, El-Gamal, and Mongelli (1996). They estimate the speed at which investment adjusts to changes in the optimal capital stock using panel data for Middle Eastern and North African countries over the period 1980–94. The underlying model is the flexible accelerator model, according to which an increase in output spurs future streams of investment as firms gradually adjust toward an optimal capital-output ratio. For Egypt (grouped with Algeria, Israel, Jordan, and Tunisia) investment was found to adjust relatively quickly to gaps between desired and actual capital stock. Moreover, the conclusions suggest a high capital output ratio that is, capita] intensive investment, and a relatively low depreciation rate.
Bisat, El-Erian, and EI-Gamai (forthcoming) estimate the same model for Egypt over two partially overlapping sample periods: 1970/71–1985/86 and 1981/82–1996/97. They Find that the speed of investment adjustment was much smaller in the earlier period (about 44 percent) than in the later period (119 percent). The conclusion is consistent with the observation that during the early period, investment was mostly of public origin, and hence less likely to respond to economic factors.
The previous analysis illustrates the association between investment and growth rates in Egypt. The framework of growth accounting distinguishes between (1) growth that is accounted for by increases in the quantities of factor inputs, typically capital and labor, and (2) growth that is accounted for by increases in the efficiency in the use of inputs or total factor productivity growth. Often referred to as technology, total factor productivity (TFP) encompasses all methods used to produce goods and services with factors of production. Improvements in technology increase the productivity of all factors of production, and thus also raise total output. Growth based on increases in factor inputs is sometimes called extensive growth, whereas growth based on TFP is called intensive growth.
For the period as a whole, the average Egyptian TFP growth rate was estimated at 2.4 percent a year. Evidence suggests a structural break in the behavior of TFP: for the early sub-period (1970/71–1985/86), the average TFP growth rate was estimated at 5 percent while for the later sub-period (1981/821996/97), it was estimated at 1.8 percent. In terms of contribution to growth, the econometric estimates indicate that, for the period as a whole, TFP growth accounted for nearly two–thirds of output growth. For the early period, it accounted for all of the growth, while for the later period, it accounted for approximately half the growth.
High TFP growth in the early period may reflect a number of economic and methodological factors. First, improvements in TFP may lag actual investment spending by a number of years: high TFP growth rates in the 1970s may be associated with large investment projects undertaken earlier (e.g., the Aswan Dam).
Second, during the early period, significant resources went into social sectors such as education, health, and nutrition, reflected in TFP rising owing to an improved quality of human capital. From their low base in the 1960s, social indicators such as illiteracy, school enrollment, and access to health services improved. As documented by a number of empirical studies, investment in human capital can have high returns in terms of improving productivity and growth.
Finally, there may also be a methodological explanation for the high TFP growth rates estimated for the early period. In particular, the effect of some capital projects (e.g., power plants) may have been underestimated owing to the use of overvalued exchange rates. At the same time, services rendered by such projects may have also been underpriced (e.g., electricity tariffs) due to subsidies; this would result in artificially higher value added from investments using such services. Consequently, the growth accounting estimates may underestimate the contribution of capital accumulation to growth during the early period and overestimate that of factor productivity.
Investment Financing: National and Foreign Savings
This section considers the composition and sustainability of patterns of investment financing, noting that investment should be financed in a stable and sustainable manner to minimize vulnerability to exogenous financing shocks.
By definition, investment can be financed through national or foreign saving (see Figure 5). A judgment as to the sustainability of investment financing sources requires an examination of its two components. First, sustained current account deficits—the counterpart of foreign savings—require offsetting capital inflows. In Egypt, those tended to be of a largely debt-creating nature, which eventually led to the debt crisis and to the need for exceptional debt relief. Moreover, Egypt has historically relied on foreign aid to cover its external needs. Throughout the period under investigation, foreign direct investment tended to be quite small.
Figure 5.Saving-Investment Balance
Source: Data provided by the Egyptian authorities.
Until 1991/92, Egypt’s investment rate continuously exceeded national saving rates. Consequently, Egypt relied heavily on foreign savings (i.e., current account deficits) to finance its investment needs: for the period 1969/70–1990/91, foreign savings accounted for more than a third of investment financing. By the early 1990s, the situation had changed significantly with the external balances registering either surpluses or very small deficits.
Nonetheless, national saving closely traced investment rates: it rose sharply during the high-investment and high-growth period (1974/75–1984/85) averaging 21 percent of GDP—a moderately high level by international standards—and fell equally sharply during the low investment and low growth period of 1985/86–1991/92, averaging only 13percent of GDP. Since then, as reliance on foreign saving declined and as investment rates rose, national saving became a more important source of investment financing.
The two main components of national saving are net factor income from abroad7 and domestic saving (see Figure 6). Until the mid-1970s, net factor income was negative; thereafter, it became a large contributor to investment financing (averaging 7.5 percent of GDP during 1975/76–1996/97, or the equivalent of a third of total investment during that period). The main factor behind the dramatic growth in net factor income is the surge in workers’ remittances following the twin oil shocks and the simultaneous labor movement from Egypt to the Gulf countries and Iraq. More recently, net factor income has been rising as debt–service payments have been reduced and as interest income on foreign reserves rose.
Figure 6.Components of National Saving
Source: Data provided by the Egyptian authorities.
The private sector is the driving force behind domestic saving, although fiscal consolidation has made the public sector a net contributor in the 1990s (see Figure 7).8 Until fiscal adjustment took hold, public saving averaged minus 0.3 percent of GDP, indeed, it was negative in 15 of the 22 years spanning 1969/1970–1990/91. Public saving rates have since averaged 4 percent of GDP. Private sector domestic saving has strongly traced investment and growth behavior. Private saving rose sharply during the high-investment and high-growth period essentially fueled by high economic growth rates, relative price stability, and the announcement of the infitah program with its promise of a larger private sector role. It fell sharply during the low-investment and low-growth period. The lackluster saving behavior during 1981/82–1990/91 reflected a number of factors including limited outlets for mobilizing and allocating higher private savings due to financial market imperfections, negative real interest rates, and incentives, biased by overvalued exchange rates in favor of current consumption. In addition, macro-economic instability created an uncertain environment that discouraged saving. With the reversal of the above factors in the past few years, private domestic saving has staged a comeback and has ranged between 5 percent and 6 percent of GDP.
Figure 7.Gross Domestic Saving
Source: Data provided by the Egyptian authorities.
In summary, the high-investment period in Egypt tended to be financed by unsustainable forms of financing: deficit financing (the counterpart of low public saving), and debt-generating foreign saving. Moreover, a large share of such financing originated from unstable sources over which the domestic policymakers had little control (foreign aid and workers’ remittances). Indeed, as the Egyptian economy faced strong financing constraints in the early 1980s, investment itself contracted and growth eventually suffered. Recently, the economy has started to rely on more stable forms of financing for example, foreign direct investment and private saving.
Egypt’s Medium-Term Growth Challenge
This last section assesses the requirements and likelihood of the Egyptian authorities’ achieving their objective of raising annual real GDP growth rate to about 7 percent over the medium term.
Two scenarios for GDP growth and investment rates are presented in Table 2 for the combinations of differing growth rates of TFP, and the capital elasticity of growth. At current (i.e., “late period”) TFP growth rates (1.8 percent a year) and under a conservative assumption on capital return (output elasticity of capital of 0.3), Egypt would have to raise its investment rate by over 8 percentage points of GDP over the next six years to achieve a growth rate of around 5 ½ percent a year. On the other hand, with an improvement in the growth rate of TFP to 2.25 percent combined with a slightly higher capital elasticity of growth (0.4), Egypt could reach a GDP growth rate of approximately 7 percent with the same investment rate path.
|Unchanged growth scenario||Capital elasticity of growth = 0.3; total factor productivity growth =1.8 1|
|Real GDP growth||5.0||5.0||5.1||5.2||5.4||5.5||5.6|
|Accelerated growth scenario||Capital elasticity of growth = 0.4; total factor productivity growth = 2.25 1|
|Real GDP growth||5.0||5.9||6.1||6.3||6.5||6.7||6.9|
The challenge of raising investment rates by up to 8 percentage points is clearly not easy. Moreover, the economy would have to find financing for such investment. The Egyptian Government is committed to a policy of fiscal prudence, which would eliminate recourse to deficit financing of investment. At the same time, reliance on net foreign income from abroad (mainly workers’ remittances) would be limited by projected lower demand for Egyptian labor from regional markets. The economy could tap foreign savings; however, in order to avoid past mistakes, it would be optimal for such foreign savings to be mainly associated with foreign direct investment rather than debt–creating flows. In addition, macro–economic stability implies a limit on how large current account deficits can be in a certain country. Therefore, if the Egyptian economy were to successfully generate higher investment rates, it appears that private domestic savings would have to rise simultaneously.
Nonetheless, from indications over the past few years, Egypt appears to have entered a high-growth, high-investment, and high saving trajectory. This is not the first time in its modern history that the economy was on such a path. The current trajectory should differ from earlier ones in at least four respects:
Investment should primarily originate from the private sector with the public sector focusing on infrastructure and social investment.
Private sector investment has to become more responsive to growth in output so that Egypt can enter into a virtuous cycle of high growth and high investment.
At the same time, the efficiency of private investment has to improve from the low levels recorded more recently.
Investment has to rely on stable and sustainable forms of financing.
What is necessary for these four conditions to materialize? Both theory and empirical evidence illustrate that four factors contribute to higher and more efficient investment as well as to higher levels of domestic saving: maintaining stable macroeconomic conditions; accelerating structural reforms; investing more effectively in the social sectors; and strengthening the institutional and information base. The recent stabilization and reform effort implemented in Egypt over the past few years clearly illustrates that the economy is on the right track for achieving these conditions and meeting the growth challenge. In this regard, after four years of economic stability, both the level and efficiency of investment are on an upward trend. This clearly reflects the expanded role of the private sector, including build-operate-transfer projects in the energy sector, cement and fertilizer projects, and other power-intensive sectors. The private sector has also been invited to invest in telecommunications and ports and is expected to play a central role in the New Valley development project.