Arab Republic of Egypt: Staff Report for the 2006 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Arab Republic of Egypt

Economic conditions in Egypt are favorable, and the economic reform is moving forward. The discussions focused on the elements of a macroeconomic policy. IMF staff discussed the following with authorities: a multiyear fiscal consolidation plan, the monetary policy stance and strategy appropriate for maintaining inflation in low single digits, the exchange rate policy, and progress in financial sector reform. Executive Directors recommended the reforms that are needed to support central bank operational autonomy and strengthen policy formulation, and they also stressed the need to enhance the flexibility of labor and improve education.


Economic conditions in Egypt are favorable, and the economic reform is moving forward. The discussions focused on the elements of a macroeconomic policy. IMF staff discussed the following with authorities: a multiyear fiscal consolidation plan, the monetary policy stance and strategy appropriate for maintaining inflation in low single digits, the exchange rate policy, and progress in financial sector reform. Executive Directors recommended the reforms that are needed to support central bank operational autonomy and strengthen policy formulation, and they also stressed the need to enhance the flexibility of labor and improve education.

I. Introduction

1. Economic conditions in Egypt are favorable and the economic reform program is moving forward. A new cabinet led by Prime Minister Ahmed Nazif, first appointed in 2004, was reappointed in December 2005 following parliamentary elections. The economic team was also reinstated, reaffirming the government’s commitment to economic reform. The election resulted in a parliamentary majority for the ruling National Democratic Party, with members of the Muslim Brotherhood—who ran as independents—winning about 20 percent of the seats in parliament.

2. The government’s reform program since 2004 has been addressing most of the areas regarded as critical in recent Article IV consultations, often involving Fund technical assistance. During 2005, the authorities made substantial progress in the areas of tax reform, public finance management, monetary policy, privatization, and financial sector restructuring. However, the Fund has stressed the need for ambitious fiscal adjustment, which the authorities recognize and accept.

3. Investor confidence in the direction of economic policy remains high. The reform progress achieved to date has raised and improved Egypt’s profile in international capital markets. Foreign direct investment and inward portfolio flows have risen sharply. Economic growth has accelerated and the balance of payments remains robust. Intermittent security incidents add some downside risk to the economic outlook, but their impact so far has been relatively minor and short-lived.

4. Increasing growth on a sustained basis is the biggest priority for policymakers. In this regard, the government is moving ahead with the next phase of reforms intended to address the structural impediments to higher growth and job creation, notably, large fiscal deficits, unproductive public expenditure, red tape, deficiencies in financial intermediation, and labor market rigidities. These reforms pose difficult socio-political challenges, and will require broad political consensus to implement.

5. While the authorities face a broad range of policy challenges and have developed a comprehensive reform agenda to tackle them, the Article IV discussions focused on the elements of a macroeconomic policy mix that would best support the authorities' main policy objectives. Specifically, staff discussed with the authorities: (i) a multi-year fiscal consolidation plan; (ii) the monetary policy stance and strategy appropriate for maintaining inflation in low single-digits; (iii) exchange rate policy; and (iv) progress in financial sector reform.

II. Recent Economic Developments and Outlook

6. Recent economic developments are chronicled in charts on the following pages.1 The external sector remains an important engine of growth, but the expansion has become more broad-based, with construction and services now increasing at a healthy rate. Privatization in 2005/06 (fiscal year ending June 30) has exceeded expectations (Box 1), and reforms in the fiscal area have prepared the groundwork for fiscal consolidation going forward.


After a slowdown from 2000-03, economic growth has been rising towards regional average rates.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


Employment has expanded with output, but not by as much as the labor force, which increased rapidly in 2005.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


After a recovery in the late 1990s, credit and investment remain weak.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


Confidence in economic policy contributed to a bull stock market. The regional correction in 2006 has affected Egypt, but less severely than in other countries.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


The real exchange rate began appreciating in January 2004....

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


… and the trade deficit has widened.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


But service receipts remain strong, including tourism ....

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


… and worker remittances from the Gulf have risen with the oil boom.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


As large capital inflows and FDI have boosted the capital account …

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


… the country’ NFA position has improved.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


Inflation fell sharply in 2005 and …

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


… the CBE lowered interest rates; the overnight rate stayed near the corridor floor.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


NFA has been the main source of broad money (M2) growth since early 2005.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001


M2D surged in 2005, but has decelerated since.

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001

7. Notwithstanding the continued economic recovery, labor force growth exceeded employment growth in 2005. The official unemployment rate peaked in September 2005 near 12 percent, before falling slightly in December. The labor market is characterized by an excess supply of labor, particularly among the youth, a serious mismatch between the skills required and those furnished by the public education system, and significant restrictions on hiring and firing. However, in investor and business surveys, labor market constraints are typically not perceived as the main obstacles to doing business.

8. Inflation during 2005 fell sharply from the high levels of 2004. The high inflation rate in 2004 appears to have reflected lagged pass-through pressures from the large nominal depreciation of the pound and lax monetary policy during 2003. The subsequent stabilization of the exchange rate and the tightening of monetary conditions led to a fairly sharp decline in inflation in 2005.2

Privatization in Egypt

Asset sales in 2005/06 have surpassed expectations and have attracted international investors. In the first nine months of 2005/06, 49 state assets were sold for a total of US$2.5 billion, including seven joint venture banks and 20 percent of the government’s stake in Egypt Telecom. As of April 2006, 97 entities were listed for sale by the government comprising 42 companies (or stakes in companies) and 55 joint ventures (

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Source: Ministry of Investment

Buyer origin, by sale value

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001

The proceeds are being allocated to the original owners (line ministries, public holding companies, the Treasury) and are being used mostly to restructure remaining state enterprises; in 2004/05, about 20 percent of the proceeds went to the Treasury. About 5 percent of the proceeds help finance employee compensation packages at entities being privatized. Employees not retained are compensated, retrained, or shifted to “sister” entities under the same state holding company.

According to the Ministry of Investment, the performance of privatized companies has been good. Specifically, about 70 percent of the privatized companies surveyed had increased sales and profits, 90 percent had raised salaries or increased staff, and nearly 80 percent had strengthened their balance sheets.

9. The authorities implemented a range of structural reforms in the fiscal area in 2005. On the revenue side, the government reduced and streamlined corporate and individual income taxes, moved to self-assessment procedures, and established a large taxpayer center (Box 2). On the expenditure side, the budget for 2005/06 made explicit for the first time the large fuel subsidy provided by the state-owned oil company, Egyptian General Petroleum Corporation (EGPC). While not involving cash payments through the budget (the cash impact is reflected in foregone tax/dividend payments by EGPC), this has contributed to a wider public debate on subsidies.

Reforms in Tax Policy and Revenue Administration

As part of an ongoing overhaul of the tax regime supported by Fund technical assistance, the authorities:

  • Adopted a new customs tariff in 2004 that simplified the tariff structure and reduced the weighted average tariff rate from 14 to 9 percent, and the unweighted average from 27 to 20 percent.

  • Passed a new income tax law in mid-2005 that reduced the top marginal tax rates on income and profits from 32 to 20 percent for individuals and from 40 to 20 percent for corporations and partnerships (EGPC, the Suez Canal authority, and the central bank were left at 40 percent). The reform increased the exemption threshold, provided for more generous depreciation allowances, broadened the tax base by eliminating deductions, and provided for the phasing out of tax holidays while grandfathering current beneficiaries.

  • Began modernizing tax administration with (i) the successful introduction of self-assessment, (ii) the creation of a Large Taxpayer Office in 2005, and (iii) preparation for integration of the Income Tax and Sales Tax Departments with the appointment of a single tax commissioner.

10. Another accomplishment was the preparation in 2006 of a set of consolidated fiscal accounts under the GFSM 2001 budget classification. This has increased the transparency and consistency of the fiscal accounts. The authorities are in the process of addressing a number of remaining issues, notably, fully harmonizing the coverage of the fiscal accounts “above” and “below the line” and reconciling financing flows with debt stocks (Table 3).

11. Historical data revisions and the reclassification of accounts revealed a weaker fiscal position in recent years than what had been depicted earlier (Table 4). In the process of migrating to the new budget classification (NBC) in 2005, the authorities made significant revisions to the historical series, and also reclassified some operations as above-the-line items (an adjustment Fund staff made to get the augmented fiscal balance presented in recent Article IV staff reports based on the old budget classification). These revisions, starting in 2001/02, resulted in a large upward adjustment of the previous deficit estimates for 2001/02–03/04. Adoption of the NBC and the move to a cash basis explain a smaller part of the upward revision in the deficit estimates.

Table 3.

Egypt: Summary of the General Government Operations, 2001/02–2006/07 1/

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Sources: Egyptian authorities; and IMF staff estimates and projections.

General government comprises the budget sector, National Investment Bank (NIB), and the Social Insurance Funds (SIF).

In 2005/06, includes a 1.2 percent of GDP payment of tax arrears by EGPC.

From 2005/06, fuel subsidies are explicitly recorded as a notional expenditure item. An equivalent amount is recorded as notional revenues from EGPC and foreign partners under “other revenue”.

In 2005/06, includes a 0.8 percent of GDP inflow due to the partial sale of Egypt Telecom.

Fund staff estimates, derived from changes in the stock of gross external debt.

Refers to adjustments to the net financing flows denominated in foreign currency related to exchange rate movements.

Refers to revenue minus expenditure (approximation of net lending/borrowing under GFSM-2001).

Refers to the general government debt, including government guaranteed external debt.

Gross debt minus deposits with banks. Deposits include the “blocked accounts” on rescheduled Paris Club debt held at the CBE.

Table 4.

Egypt: Comparison of Old Budget Classification (OBC) and New Budget Classification (NBC) 1/ General Government Operations, 2001/02–2003/04

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Sources: Egyptian authorities; and IMF staff estimates.

New budget classification (NBC) is based on GFSM 2001.

Includes net lending in the old budget classification (OBC), and net acquisition of financial assets in the NBC series.

Augmented fiscal balance as presented in 2005 Article IV Staff report (Country Report No. 05/177). These estimates were based on the OBC, adjusted for financing operations that had been recorded officially “below the line”.

12. Under the NBC-based fiscal accounts, the consolidated general government deficit in 2005/06 is projected at 8.3 percent of GDP, down from 9.1 percent of GDP in 2004/05. The improvement reflects exceptional receipts related to: (i) the partial sale of Egypt Telecom (0.8 percent of GDP), and (ii) the payment of tax arrears by EGPC (1.2 percent of GDP).3 The latter was financed by incurring an external liability of US$1.55 billion secured by a forward sale of oil. Revenue losses from the income tax reform (involving steep rate cuts) in 2005 are estimated at 1 percent of GDP. These losses are expected to be short-lived because the tax reform should broaden the base, lead to greater compliance (there is already some evidence of a surge in tax filings), and eventually generate a higher yield. Domestic fuel subsidies are set to increase by 2.6 percent of GDP to 6.9 percent of GDP.

III. Key Issues and Views of the Authorities

Overview and reform objectives

13. In order to lower unemployment, the government agreed with staff that the economy will need to grow on a sustained basis by at least 6–7 percent, and that total investment will need to reach about 25 percent of GDP, well above recent levels of around 18 percent of GDP. In the authorities' view, the main constraints to private investment and higher growth are inefficiencies in financial intermediation and bureaucratic barriers to business development. The high level of unproductive government spending (i.e., subsidies) and distortions in relative prices, particularly energy prices, have also hindered growth.

Macro framework and balance of payments outlook

14. The discussions were framed in a macroeconomic scenario based on moderate fiscal adjustment (baseline scenario discussed below) and continued structural reforms. Under this scenario, staff expects increased government savings and the supply impulse driven by structural reforms to gradually raise productivity and boost private investment as a share of GDP to 20 percent by 2011 (Table 5), along with a small increase in government investment to 5 percent of GDP.4 Real GDP growth is projected to increase over time to 6.5 percent by 2010/11, and structural unemployment to be reduced by about 2 percentage points over the period. The external current account would move from a surplus of 2 percent of GDP in 2005/06 to a deficit of 2 percent of GDP by 2011, financed largely by non-debt-creating capital inflows. Egypt’s external debt is expected to decline gradually over the medium term, even in the face of external shocks (Tables 8 and 9), and external vulnerabilities will remain low.

Table 5.

Egypt: Medium-Term Macroeconomic Framework, 2001/02–2010/11

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Source: Egyptian authorities; and IMF staff estimates and projections.
Table 8.

Egypt: Medium-Term Balance of Payments, 2001/02–2010/11

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Sources: Central Bank of Egypt; IMF staff estimates and projections.

Includes multilateral and bilateral public sector borrowing and private borrowing.

Data before 2004/05 are the CBE data on non-oil FDI augmented by estimates of FDI in the oil and gas sector derived from EGPC annual reports.

In addition to the revisions to the FDI data (see footnote 2), IMF staff make three other adjustments to the official balance of payments data. First, the CBE estimates record the difference between a headcount-based estimate of tourism-related inflows and the estimates obtained from the International Transactions Recording System as an outflow in the capital account. The Staff estimates here record only the flows based on direct estimates of tourist arrivals with the errors and omissions line offsetting any upward bias implicit in these estimates. Second, because of large discrepancies between the annual flows of net short-term suppliers credits and changes in end-of-period stocks in the official data, net flows of short-term suppliers credits are not identified here and are instead absorbed in errors and omissions. Third, unlike in the official data, and in order to preserve symmetry with unrecorded capital outflows on account of currency substitution in earlier years, reverse currency substitution in 2004/05 is not recorded under other capital inflows, but instead reflected in errors and omissions.

The official data on external debt do not include non-resident holdings of domestic currency-denominated Treasury Bills (about US$1.6 billion at end-2005). BIS data for non-bank private sector external debt suggest that the official data on external debt underestimate the former by US$1.3 billion and the latter by more than US$3 billion.

Table 9.

Egypt: External Debt Sustainability Framework, 2000/01–2010/11

(In percent of GDP, unless otherwise indicated)

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Sources: IMF staff estimates and projections.

Derived as [r − g − p(l +g) + εα(l+r)]/(l+g+p+gp) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(l+g) + sa(l+r)]/(l+g+p+gp) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Fiscal Policy

15. The authorities outlined a range of measures aimed at bringing the deficit down by at least 1 percent of GDP annually for five years. The plan involves the following mix of measures—to be phased in gradually starting in 2006/07:

  • i) reforming domestic fuel subsidies by targeting them more effectively on the poor and providing incentives to switch to natural gas;

  • ii) streamlining and improving the product targeting of food subsidies;

  • iii) instituting wage and employment measures designed to contain the wage bill, including a partial hiring freeze and measures to slow wage drift; the authorities plan to submit to parliament in 2006 a comprehensive reform of the civil service expected to contribute to fiscal consolidation;

  • iv) reforming the GST into a unified VAT with a broader base, a single rate, and a higher threshold, with a presumptive tax regime for small businesses;

  • v) broadening the base and streamlining rates for the property tax and stamp taxes;

  • vi) introducing a Treasury Single Account (TSA) to help improve cash management and increase control over off-budget resources kept by budget entities in the banking system;

  • vii) reorganizing the institutional layout and streamlining the flow of funds between the budget, the National Investment Bank (NIB), and the Social Insurance Funds (SIFs);

  • viii) tightening controls on operating flows with state enterprises to increase the transparency and control of expenditures;

  • ix) improving debt management; and

  • x) launching public private partnerships (PPPs) to finance the provision of much-needed public investment, particularly for schools and health clinics.

16. Possible sources of fiscal pressure in the coming years include pension reform and bank restructuring. A public pension reform plan is currently being formulated with assistance from the World Bank, and could have sizeable transition costs, depending on the final design. The main features of the plan comprise closing the current system to new entrants, establishing a fully funded contributory system for new entrants, and adding a noncontributory minimum pension plan (integrating various existing schemes). As for bank restructuring, the authorities intend to finance the rest of their restructuring program with privatization proceeds. If privatization progresses at the current pace, proceeds should cover bank recapitalization costs over time.

Subsidies in Egypt

Public spending on subsidies has increased dramatically in recent years and now far exceeds outlays on education and health. While subsidies have been motivated by social concerns, preliminary data indicate that the share of the population living below the poverty line (headcount ratio) has nevertheless increased since 2000.

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Source: Ministry of Finance, World Bank (for poverty), and Fund staff estimates

The benefits are not well targeted. Recent studies (World Bank, USAID, World Food Program) show that fuel subsidies benefit mostly the production sector, as households account directly for less than 20 percent of energy consumption. The richest quintile of households reaps 93 percent of the gasoline subsidy and 65 percent of the natural gas subsidy, while many poor households do not have access to the required food ration cards. A recent World Bank simulation estimated that the poverty headcount ratio would drop by 6.1 points to 13.5 percent if subsidies were reduced by 50 percent and the savings allocated to households as cash transfers.

Subsidies have contributed to a misallocation of resources. Retail prices of petroleum products are among the lowest in the world. By increasing the profitability of fuel-intensive sectors, investments are likely to be channeled into activities with sub-optimal social returns. Per unit of output, Egypt’s energy use in 2000 was close to that of the United States, and CO2 emissions were among the highest in the world (WDI 2000).

17. In the absence of any reform measures, and assuming one-off receipts are not repeated, the general government deficit would reach about 10 percent of GDP in 2006/07 (“passive” scenario, below). While the central government budget for 2006/07 approved by parliament did not include any of the new measures specified above, the authorities plan to start phasing them in this year, particularly the fuel subsidy reform, which would translate into higher cash tax payments from EGPC (up to several percentage points of GDP); the GST/VAT reform, which would, depending on the unified rate chosen, yield a half year impact of at least 0.5 percent of GDP; and further measures, such as the TSA (0.5 percent of GDP from savings on interest payments) and better expenditure control. Based on these indications from the authorities—i.e., adjustment equivalent to about 2 percent of GDP— during 2006/07, staff estimate that the general government deficit could be reduced to 8.1 percent of GDP.

18. Outlook: Under the “baseline” scenario (deficit 8.1 percent of GDP in 2006/07 and a 1 percent of GDP annual adjustment thereafter), net public debt would decline after five years to 65 percent of GDP—the June 2004 level. A gradual decline in the debt/GDP ratio would still occur under various shocks (Table 7). A more ambitious adjustment path (“ambitious” scenario) of an additional 0.5 percent adjustment of GDP annually would lower debt to 58 percent of GDP by June 2011. If the underlying deficit were maintained at 10 percent of GDP (“passive” scenario), public debt would continue rising along recent trends and reach 83 percent of GDP in 2011. It is important to note, however, that the investor base, structure, and composition of Egypt’s domestic public debt stock help to limit near-term vulnerabilities normally associated with debt levels of this magnitude (see Country Report No. 05/177, Staff Report, Box 1).

Table 7.
Table 7.

Egypt: Public Debt Sustainability - Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001

Sources: IMF staff estimates and projections.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. The four-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Monetary and Exchange Rate Policy

19. The CBE is modernizing monetary policy formulation and operations, and confirmed its plans to adopt a formal inflation targeting (IT) framework over the medium-term. In this context, the CBE has established a corridor for the interbank overnight rate and significantly enhanced communications with the publication of a monetary policy statement and releases following regular Monetary Policy Committee meetings. The central bank is also developing its macroeconomic analysis and forecasting capacity.

20. In the transition to inflation targeting, the CBE has adopted a monetary policy framework relying on broad indicative guidance from monetary aggregates and various inflation measures in the context of a managed float. The authorities attributed the decline in inflation through March 2006 to the secular decline of broad money (M2) growth since early 2004 and the appreciation and subsequent stability of the LE/US$ exchange rate during 2005. In their view, the surge in 2005 in the growth of domestic currency broad money (M2D) above indicative “target” zones of around 12–13 percent was caused by portfolio shifts related to increased confidence in the Egyptian pound, with no inflationary consequences. The CBE considers the current stance of monetary policy to be broadly consistent with stabilizing inflation at current low levels of 4–6 percent, assuming money demand continues to grow somewhat faster than GDP. However, it stands ready to tighten policies should signs of inflationary pressures re-emerge. The authorities expressed concern about continued weak credit growth. This can be explained by the fact that central bank rate cuts have not been fully passed through to bank lending rates, commercial banks remain overly cautious following the bad loan build-up of earlier years, and commercial banks have preferred alternative assets (government securities, foreign assets) with more favorable risk/return characteristics.

21. The interbank foreign exchange market is operating smoothly and market participants expressed satisfaction with its efficient functioning. In the context of the recent large balance of payments surpluses, the CBE has used the abundance of foreign exchange liquidity over the past year as an opportunity to strengthen its international reserve position, both through purchases outside the market on behalf of the government (e.g., converting Suez Canal proceeds), and by buying on the market to help banks respect regulatory limits on open positions. These actions by the CBE have influenced the LE/$ exchange rate, keeping it in a narrow range (LE/US$5.72–5.78) over the past 15 months, implying a de facto peg during that period.

22. While reaffirming their commitment to a managed float, the authorities expressed concern about the effect of a nominal appreciation, driven in part by temporary capital inflows, on competitiveness. They pointed in particular to stagnation in the growth of non-oil exports during the second half of 2005 and to the importance of supporting the tourism sector. Going forward, the CBE believes that the trade deficit is likely to widen as growth rises, while portfolio inflows should weaken as interest rate differentials narrow; both developments should put downward pressure on the currency.

Non-oil Merchandise Exports

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Sources: Central Bank of Egypt and DOTS

23. The slow-down in growth and the decline in reserves suggest that the Egyptian pound was substantially overvalued in 2000. The large depreciation that occurred between 2001 and 2004 appears to have broadly restored equilibrium. However, major structural breaks and data shortcomings (notably regarding the CPI series and data on unit labor costs) impede a more quantitative appraisal of Egypt’s competitiveness. The string of current account surpluses after 2000 could suggest an undervalued exchange rate, although the surplus has dropped sharply in 2005/06 and is forecasted to turn into a deficit by 2008, while the real exchange rate has been appreciating since 2004.

Financial sector restructuring

24. The authorities have achieved significant progress in strengthening the banking sector. The government sold its stake in most joint venture banks, thereby transferring nearly 20 percent of the banking system (measured by deposits) from de facto public control to the private sector. The sale of Bank of Alexandria (BoA) is on track to be completed in late 2006. The authorities are merging two of the remaining three state banks, and intend to restructure and recapitalize the resulting two state banks over the next three years. While the current reform would still leave more than 40 percent of the banking system (based on current shares in deposits) under state ownership by 2008, the authorities expect this share to decline rapidly, given the much faster growth in private sector banks.

25. The soundness of the financial sector has been improving. Capital adequacy ratios have been rising since 2001, the rates of return on assets and on capital have trended upwards, and nonperforming loans (NPLs) recently started to decline as a share of total loans (Table 11). Workout units in the state banks, supported by CBE-led arbitration, have restructured about one half of outstanding private sector NPLs. All public sector NPLs of BoA were settled in cash in early 2006, and the planned clearance of public sector NPLs of other state banks should further improve the NPL/loan and provisioning/NPL ratios. Exposure of the banking system to exchange rate risk remains low, although sustained large exposure to the public sector will be incompatible with a vibrant growth-enhancing financial system (Box 4).

Table 11.

Egypt: Selected Vulnerability Indicators, 2001/02–2005/06

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Sources: Egyptian authorities; and IMF staff estimates and projections.

Debt at remaining maturity is defined as external short-term debt plus maturing medium- and long-term external debt.

Current account deficit plus amortization of external debt.

Public sector covers the general government.

The financial sector includes commercial banks (public and private), business and investment banks, and specialized banks.

Projections for 2005/06 reflect the actual value as of December 2005.

Balance Sheet Analysis of the Banking Sector

From 2002 to 2005, the banking sector (excluding the CBE) has more than doubled its net exposure in local currency to the government sector (including the CBE), from 10 to 25 percent of GDP, while sharply reducing net claims on the business sector. Net exposure to the government surpassed that to businesses at end-2005.

The increase in claims on the government arises from past large fiscal deficits and an increase in deposits with the CBE, which reflects the recent strong NFA growth. Declining exposure to the private sector is due in part to the recent loan portfolio clean-up and to the portfolio choices of banks in favor of government securities and central bank deposits over corporate loans. This is likely to have reduced credit and interest maturity risks in the banking sector.


Net Claims of the Banking Sector

(percent of GDP)

Citation: IMF Staff Country Reports 2006, 253; 10.5089/9781451811872.002.A001

However, stagnating credit to business may amplify macro volatility because it reduces the financial sector’s ability to efficiently reallocate financial resources across firms. This would be more critical during bad times when profitable firms experiencing temporary cash shortages might face financing constraints. More generally, sustained large government borrowing can harm the depth and quality of financial development, as banks have lesser incentives to improve efficiency.

Net foreign currency-denominated claims on the government and business sectors have declined since 2002, while claims on the rest of the world (mainly deposits with correspondents) increased from about US$4 billion at end-2002 to US$13 billion in early 2006. Banks' net open positions are not large, and the aggregate net open position is negligible, implying a low overall foreign exchange risk. The decline in foreign currency exposure to entities with revenues mostly in local currency (government and local businesses) has further reduced exchange rate risk.

26. Egypt’s stock market was one of the top performers in 2005. The bull market, which started in late 2003, was driven by increased confidence in economic policies, but was also fueled by ample domestic and regional liquidity related to the oil boom. The market experienced a sharp correction in early 2006, falling by 33 percent between the January peak and late May. However, this was less than most Gulf markets, mainly because the rise in valuations in Egypt in 2005 was much less than experienced in the Gulf (or during the 2000 dotcom bubble in the United States). The price/earnings ratio hit 27 in January, before falling to 15 in May. The correction has so far had little visible impact on the economy, in part because market capitalization is still relatively low, and trading is concentrated in a few big stocks. The value of the biggest five (ten) companies account for 62 percent (80) percent of the market. While information on the makeup of the investor base is limited, the correction was reportedly driven more by retail investors who entered the market in 2005. Anecdotal evidence suggests that potential risks to the banking system as a result of margin lending to retail investors is likely to be limited, consistent with the observed weak credit growth.

27. Outside the banking sector, state-owned insurance companies are also being restructured, with a view to privatization. Capital market regulation is well advanced in adopting best practices, and the stock market is enforcing higher standards of corporate governance. The authorities are also in the process of bringing supervision in banking and insurance into compliance with international best practices. However, the tax-free treatment of interest on government securities appears to be undermining the development of broader capital markets, and the secondary market in government securities remains small. The authorities are interested in an FSAP update in 2007 to assess progress in the financial restructuring program and take stock of the changes wrought by the recent reforms.

Other structural reforms and data issues

28. The authorities are contemplating further tariff reductions to build on the gains achieved in September 2004, when the government restructured and lowered tariff rates by 7 percentage points to 20 percent (unweighted average). These are still considerably higher than the current average of 11.2 percent for countries in the Middle-East and Central Asia. Egypt’s weighted average tariff rate is 9 percent.

29. The government recently submitted draft legislation to parliament to establish specialized economic courts. These are designed to reduce red tape and to improve the judicial framework underlying business contracts. This approach is based on previous positive experiences reforming institutions by developing improved processes on a parallel track. In addition, disputes between private sector operators and the government are increasingly being resolved by a ministerial committee.

30. The authorities are giving data quality problems greater attention. A high level inter-ministerial committee has been established to address weaknesses in statistics, notably the CPI and FDI data, where shortcomings include the quality of coverage and sampling and limited cooperation between the relevant agencies.

31. A high-level ministerial committee has been established to coordinate Egypt’s response to the avian flu threat. Avian flu has so far affected only the poultry sector and the authorities have not prepared a specific program for the financial sector. They do not expect the avian flu to pose a problem for the functioning of the financial system. However, they expressed interest in understanding the best-practice measures being developed elsewhere and plan to participate in international seminars for bank supervisors on the topic.

IV. Staff Appraisal

32. The staff essentially concurs with the authorities' economic objectives and policy priorities. Under the authorities' strategy, fixed investment will need to rise considerably, and private sector growth will need to drive employment creation. Staff welcomes the authorities' decision to place fiscal consolidation at the center of Egypt’s macroeconomic policy agenda, which will imply difficult policy choices and require strong efforts at consensus building. However, favorable global economic conditions make the timing ripe for tackling tough issues, which will have long-term positive effects on the economy. Staff appreciates the authorities' active participation in elaborating a technical assistance strategy that ties TA priorities closely to the government’s reform agenda, and will help guide the Fund’s technical assistance to Egypt over the coming years.

33. Fiscal consolidation is central to achieving the authorities' growth objectives. In this regard, absent the “one-time receipts” of 2 percent of GDP, the general government fiscal deficit in 2005/06 would rise. Public debt needs to be put on a firmly declining path to ensure macroeconomic stability over the long run, reduce uncertainty for investors, and avoid debt overhang effects. In addition, growing public debt, which already limits the authorities' budget flexibility, will further squeeze their ability to use countercyclical fiscal policy to cope with exogenous shocks. Finally, a large share of government spending is unproductive and has encouraged a misallocation of resources, with fuel subsidies being the most obvious example.

34. The government’s multi-year fiscal consolidation plan is welcome. However, a more ambitious medium-term fiscal adjustment, on the order of 1.5 percent of GDP annually over five years, would more decisively reverse the debt dynamics in the coming years. Even then, debt levels would remain high for many years, particularly relative to other high-growth emerging markets. The fiscal consolidation program should be based on a comprehensive and appropriately prioritized strategy, and should be centered on subsidy reduction and early introduction of a modern VAT. Medium-term expenditure rationalization should be guided by the relative efficiency of major spending categories in terms of performance outcomes, rather than relying on ad hoc or across-the-board cuts. Social assistance should be targeted more directly at low-income households.

35. For 2006/07, the budget approved by parliament needs to be complemented by specific fiscal measures. The measures outlined by the authorities look promising, and if fully implemented, could produce the desired adjustment. Since several of the measures require legislative action, staff urges prompt action to introduce the relevant laws to parliament and press for early adoption in order to contain the general government deficit for 2006/07 to 8 percent of GDP.

36. The authorities plan to rely partly on public private partnerships (PPPs) for financing much needed public investment, particularly in the social sectors. Staff believe that public investment should primarily be financed with resources freed up by cuts in inefficient current spending (e.g., subsidies). Use of PPPs would require that close attention be paid to the supporting legal and institutional framework underpinning contracts. Any contingencies arising from PPPs should be recorded explicitly in the budget in the interests of fiscal prudence and transparency. Similarly, staff encourages the authorities to carefully assess and contain any transitional fiscal costs from the planned pension reform.

37. The current stance of monetary policy appears appropriate for sustaining current low levels of inflation. Thus, additional interest rate reductions should wait until liquidity growth decelerates further and low inflation becomes firmly entrenched. The authorities need to monitor closely the rate of growth in broad money, and specifically domestic currency broad money. The large government deficit, financed in recent months mostly from nonbank sources, may eventually need more financing from the domestic banking system, which could put further pressure on monetary aggregates or crowd out private credit. Staff supports the CBE’s goal of moving to formal inflation targeting (IT), and recommends accelerating the reforms needed to support central bank operational autonomy and strengthen policy formulation. These include: revisiting the composition of the Monetary Policy Committee to ensure greater independence, preparing legislation prohibiting monetary financing of fiscal deficits, building up CBE forecasting and analytical capabilities, and further enhancing communication on monetary policy with the public.

38. Staff estimate that the real appreciation since 2004 reflects the appreciation of Egypt’s equilibrium real exchange rate stemming from (i) a large improvement in the country’s net external position and (ii) a surge in both the volume and the U.S. dollar value of proven hydrocarbon reserves. However, looking forward, it is doubtful that the non-oil export and tourism sectors could sustain a further real appreciation of the pound without losing market share. In the context of the ongoing gradual weakening of external balances, there may thus be a good case for the central bank to occasionally lean against nominal appreciation driven by transitional capital inflows (e.g. privatization receipts) until ongoing structural reforms translate into tangible productivity gains.

39. The CBE could, at the same time, allow market forces greater play in exchange rate developments. This would help discourage one way bets and encourage the development of risk management instruments, and more generally help in deepening the foreign exchange market. Furthermore, greater flexibility would be required if the CBE moved to a formal IT framework, and allowing some fluctuations in the rate would be helpful in getting the public accustomed to movements in the exchange rate.

40. The successful restructuring of the BoA highlights the useful influence that the goal of privatization can have on the process of bank modernization and reform. Completion of the audits of the remaining state banks, and their independent analysis, is essential for further progress in banking restructuring. Even at the end of the current financial reform program (2008), however, a large share of the banking system would remain under state ownership, raising concerns about the efficiency of financial intermediation and about a level playing field between public and private banks.

41. The results of the privatization program and near-term plans demonstrate the government’s commitment to reducing the role of the state in the productive sectors of the economy. Staff welcomes efforts to secure sustained support for the privatization program through the wide dissemination of relevant information on the distribution and use of the proceeds.

42. Further efforts are needed to improve the legal and institutional framework for the production of economic statistics and to increase inter-agency cooperation. This is necessary to support the work needed to improve statistics on prices, balance of payments, real indicators of economic activity, and the fiscal accounts.

43. The mission welcomes the government’s intentions to consider further tariff reductions. The system of exemptions and duty relief schemes not addressed by the 2004 reform should be phased out.

44. The ongoing review of Egypt’s exchange system, in connection with Egypt’s acceptance of the obligations under Article VIII, is expected to be concluded by the time of the 2006 Article IV consultation Executive Board meeting.

45. It is proposed that the next Article IV consultation with the Arab Republic of Egypt take place on the 12 month cycle.

Table 1.

Egypt: Selected Macroeconomic Indicators, 2001/02–2006/07 1/

Population (2005): 70.5 million; Per capita GDP (2005): $1,320

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Sources: Egyptian authorities; and IMF staff estimates and projections.

Fiscal year ends June 30.

Authorities' estimates based on revised source data and new budget cla