Abstract
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.
1. In many respects, economic developments in Egypt since last year's consultation attest to the authorities' vigorous implementation of a bold and far-reaching reform agenda introduced since mid-2004. The range of measures instituted so far, in particular the fiscal and financial sector reforms, are successfully tackling deep-seated structural impediments and injecting dynamism into the economy. In addition to important tax policy and administrative reforms, tariff rates were substantially reduced, privatization of state assets was accelerated, and measurable progress was accomplished in the divestiture of state ownership in the banking sector. Improvements in the monetary policy framework continue to be implemented, building up toward a formal inflation targeting regime in the medium-term, and coordination between fiscal and monetary policies is being strengthened, contributing to improved economic management. The impulse from these reforms was reflected in a solid economic growth in 2004/05, amidst an environment of modest inflation and stable market-determined exchange rate. The expansion was supported by a strong external sector, and with the reforms currently underway, is expected to accelerate further in 2005/06 and become even broader-based. Market sentiment remains strong, reflected in the upward revision of the long-term outlook from negative to stable last year by credit rating agencies, the continued tight spreads on sovereign debt, and the surge in equity and foreign direct investment flows.
2. The authorities are well aware of the ground they still need to cover to generate growth rates of 6–7 percent and the required increase in investment levels to attain this goal. They also recognize, however, that the next generation of structural reforms are inherently more difficult to implement, and will therefore need to be mindful of political economy considerations and calibrated so as to ensure broad public consensus for their implementation. In the period ahead, the reform effort will focus on fiscal consolidation to reduce the high levels of deficit and remove economic distortions induced by subsidies, persevering with financial sector reforms to enhance financial intermediation in support of higher investment, and strengthening of the business climate to promote corporate activity. Indeed, 2006/07 could well mark a turning point for the Egyptian economy, with the benefits of the recently implemented fiscal and structural reforms fully coming to fruition and laying the foundation for a stronger expansion going forward.
Fiscal Policy and Reforms
3. Fiscal consolidation remains a major pillar of the reform program. Measures to this end have also focused on improving the structure and transparency of the budget, as well as strengthening public expenditure management. An important accomplishment in this regard, with Fund technical assistance, is the preparation of a set of consolidated fiscal accounts for the 2005/06 budget using the GFSM 2001 classification. Under the new standard, many budget lines were reclassified, including operations that were previously treated ‘below the line’, and for the first time, the indirect petroleum subsidies provided by the state-owned oil company were rendered explicit. Although the reclassification process revealed a weaker fiscal position, the increased transparency and consistency that it brings to the budget will allow stronger control over resources and expenditures. At 9.1 percent of GDP in 2004/05, the fiscal deficit is admittedly large and unsustainable. While projected to decline to 8.3 percent in 2005/06, the improvement in the fiscal position largely reflects the exceptional revenues from the partial privatization of Egypt Telecom, and the settlement of tax arrears by the national oil company, which have more than offset the initial losses from the income tax reforms.
4. The authorities are fully committed to lowering the budget deficit by at least one percentage point annually over the coming five years, effectively halving the deficit by 2011, through a range of well-identified and detailed measures to be gradually phased in beginning 2006/07. On the revenue side, the recent reforms to the income tax law have begun to bear fruit, with preliminary estimates showing higher revenue intake, reflecting an increased number of taxpayers (due to reduced tax evasion) and larger average per-tax receipts (due to stronger economic activity). In addition, efforts are underway to broaden the tax base and improve tax buoyancy, by transforming the GST into a unified VAT with a single rate and streamlining of property and stamp taxes, and reinforce expenditure control through the institution of a Treasury Single Account (TSA).
5. Revenue measures would be complemented by decisive action on the expenditure side. Measures on this front focus on rationalizing the wage bill through reforms that would slow the drift in wages, and on streamlining the subsidy bill, particularly the fuel subsidies, which are poorly targeted. The authorities recognize that this basket of expenditure reforms is politically sensitive and would require broad public consensus for successful implementation. As such, while the non-inclusion of the adjustment measures in the 2006/07 budget was motivated by political economy considerations, a targeted fuel price increase is contemplated, along with the streamlining of the food subsidy bill. Progress with subsidy reforms, however, would need to coincide with measures to strengthen the social safety net and institute adequate compensatory schemes. In this respect, the authorities are planning to expand coverage of the social safety net and improve its targeting of low-income households through a means-tested system.
6. The authorities are in agreement with staff on the importance of fiscal adjustment to firmly reduce government debt and create the fiscal space for growth-enhancing investments. It is important to note, however, that the ‘baseline’ scenario of a one percent adjustment per year up to 2011 reflects the authorities' conservative estimate of the impact of the ongoing and contemplated reform measures. Should the envisaged full package of measures outlined by staff be introduced, the adjustment could very well approximate the 1.5 percent predicated in the ‘ambitious’ scenario. In fact, accounting for the absence of exceptional revenues in 2006/07, the projected deficit of 8.1 percent implies an even larger adjustment effort compared to 2005/06. Nonetheless, and as staff point out, even in the baseline scenario, the level of external debt would pursue a declining trajectory still in the face of shocks. Moreover, the structure of the domestic public debt, with its longer term maturity and its investor base, mitigates any potential vulnerabilities.
Monetary, Exchange Rate, and External Sector Issues
7. The authorities are committed to a monetary policy framework that promotes price stability, and are intent on adopting a formal inflation targeting framework once the requisite institutional and analytical infrastructures are in place. In the meantime, monetary policy formulation continues to improve, underpinned by a more proactive interest rate policy, to render it more forward-looking and provide better guidance to the market. In this connection, the Central Bank of Egypt (CBE) launched an interest rate corridor in June 2005, with the overnight interbank rate as the operational target. With the width narrowed from 300 bps at inception to 200 bps in October 2005, the corridor has been effective in significantly reducing interest volatility and guiding market expectations. Predictability and transparency of monetary policy have improved, with interest rate decisions being determined by the Monetary Policy Committee (MPC), which meets regularly every six weeks. These meetings are followed by a monetary policy statement communicated to the public. Moreover, the CBE liquidity management toolkit was expanded with the issuance of its own securities (CBE notes) in August 2005.
8. Monetary policy throughout 2005 and early 2006 remained attuned to developments in indicative monetary aggregates and inflation indicators, as well as developments in credit growth. With inflation stabilizing at around 4–5 percent, in part induced by the appreciation of the exchange rate, real interest rates turned highly positive. Partly reflecting concerns over the sluggish growth in private sector credit, the CBE lowered its policy rates successively until April 2006. These rates, however, were not immediately reflected in bank lending rates, where spreads remained high and credit growth timid. This may suggest an excessively cautious lending stance by commercial banks following the credit excesses of the late 1990s, which is expected to be mitigated by the wide-ranging structural reforms currently ongoing in the banking sector. In the last MPC meeting in May 2006, interest rates were left unchanged, with the CBE adopting a vigilant stance regarding the course of key indicative targets.
9. Since its introduction in December 2004, the interbank foreign exchange market has been operating smoothly and efficiently, without any intervention from the CBE. Reflecting increased confidence in CBE's management, as well as significant capital inflows, the Egyptian pound appreciated against the US dollar by over 7 percent in 2005, following a period of overshooting in the previous year, and stabilized within a narrow range. With the sizable surpluses on the balance of payments, the CBE further bolstered its reserve position, which has risen to US$23 billion (equivalent to more than seven months of imports). However, it is important to underscore that the CBE is not seeking to stabilize the rate. In large measure, the apparent stability reflects the underlying structure of the market, where traditionally Suez Canal and hydrocarbon foreign exchange receipts are transacted outside of the market, whereas excesses in banks are mopped up by the CBE to help them conform with regulatory ceilings on their open positions. Moreover, the authorities have indicated their willingness to tolerate fluctuations in the exchange rate, provided these are induced by fundamentals and not by one-time factors, such as portfolio shifts related to increased confidence in the domestic currency, and volatile capital flows associated with activity in asset markets. As underscored by staff, tempering exchange rate fluctuations of a temporary nature is a legitimate policy concern to help protect the exportable sectors, until the structural shifts currently underway in the economy take hold. Going forward, upward pressure on the exchange rate is likely to dissipate, as the accelerated growth erodes the surplus on the current account, and the compressed interest rate differentials soothe portfolio flows.
Financial Sector Reforms
10. Perhaps one of the most significant achievements in 2005 relates to the financial sector in general, and the banking sector in particular. The cornerstone of the Financial Sector Reform Program, to be implemented over 2005–08, rests on a major public sector restructuring in the banking and non-banking sectors. The program aims to build a more competitive financial sector, able in the medium-term to provide modern and efficient financial intermediation, including by strengthening the enabling environment for resource mobilization to support greater corporate activity. The program continues to be on track, and in some cases, even ahead of schedule. In the banking sector, consolidation has advanced with the number of banks reduced from 57 in 2004 to 43, through 7 merger operations involving 14 banks. The plan is to further reduce the number of banks to 34 by end-2007. In addition, shares in 12 of 17 shareholdings of state-owned banks in joint-venture banks have been divested, representing 94 percent of total market value in joint-venture ownership. The privatization of Bank of Alexandria (Egypt's fourth largest bank with 7 percent of system deposits) is almost complete, with the invitation for expression of interest published in the international press in March 2006. More importantly, the authorities recognize that the resolution of the large stock of non-performing loans (NPL) would considerably strengthen the system's capacity for financial intermediation. In this respect, settlement agreements representing 46 percent of private sector NPL have been reached, and a scheme to deal with state-owned enterprises NPL was outlined, with defined resources from privatization proceeds earmarked to this effect.
Privatization and Structural Reform Issues
11. The government has considerably stepped up the pace of its privatization program. Since the adoption of the Asset Management Program (AMP) by the Ministry of Investment in July 2004, state ownership in 77 assets was transferred to the private sector. Of these, 49 transactions took place between July 2005 and March 2006 alone, yielding proceeds of US$2.5 billion that are well in excess of those recorded in the preceding five years combined. The pick up in privatization involved a series of IPOs which were positively received by the markets, and contributed to an increased diversification of the investor base. In December 2005, the IPO for Egypt Telecom was launched on the Cairo Stock and London Stock Exchanges, offering 20 percent of the state's stake in the landline operator. Ten percent of the stake was made available to institutional investors and was 45 times oversubscribed, while the remaining 10 percent was offered to small investors and witnessed a three-fold oversubscription. The Egypt Telecom IPO is the largest for the Middle East and North Africa region to be listed on an international exchange in 2005. Other important privatization transactions in the pipeline include the sale of the state's stake in one of its major oil refineries, Middle East for Oil Refinement (MEDOR), expected within year-end. As also noted by staff, the allocation of the privatization proceeds is transparent, with a good portion being retained by line and functional ministries to restructure remaining enterprises.
12. The government is actively pursuing reforms to strengthen the business climate, by addressing the bottlenecks caused by red tape and cumbersome taxation. Recognizing the scope of the customs reforms introduced last year, Egypt has been ranked first by the World Bank's Global Competitiveness Report in customs procedures reform. This reflects the facilitation of commercial documentation procedures and the reduction in the number of customs approvals from 26 to only 5. Moreover, legislation is currently being drafted to set up specialized economic courts, to circumvent bureaucratic hurdles and streamline the judicial framework governing business contracts. In the same vein, a ministerial committee has also been established to expedite dispute settlement procedures with the private sector.
13. Finally, the Egyptian authorities are committed to the vigorous pursuit of their reform agenda to achieve a structurally higher growth. They would like to express their appreciation for the extensive and highly valuable technical assistance they are receiving from the Fund in support of their reform efforts, and thank staff for a productive consultation and well-balanced report. They look forward to continued close collaboration with the Fund in the period ahead.