Background

1. Reflecting steady implementation of wide-ranging reforms since 2004, Egypt’s economy was well-positioned to withstand the global financial crisis and associated economic downturn. In the years immediately prior to the crisis, macroeconomic reforms were aimed at reducing fiscal and financial vulnerabilities, while far-reaching structural reforms substantially improved the investment climate as highlighted in previous staff reports. Looking forward, the authorities remain firmly committed to continue with fiscal and growth-promoting reforms to strengthen the economy’s dynamism, boost productivity, and place the country on a strong footing in the post-crisis global environment.

Recent performance and policy response

2. Crisis-related spillovers to Egypt were mild, particularly when compared with similar countries, demonstrating the financial sector’s renewed resilience and the authorities’ swift policy responses. Growth declined to 4.7 percent in 2008/09 from an average of 7 percent in the previous three years. The magnitude of this decline, by 2½ percentage points, represented about one half of the impact in comparable countries. Foreign direct investment flows continued albeit at a slower rate, equity markets have rebounded and so far regained about half of their losses, and the bout of capital outflows of late 2008 has since begun to reverse. Egypt’s diversified export receipts (tourism, fertilizers, and clothing) were less sensitive to the downturn in global economic activity, as shown in Box 1 of the staff report, reflecting a sound competitive edge. Household demand also remained buoyant, attesting to public confidence in future growth prospects and aided by a sizeable fiscal stimulus and supportive monetary policies. The fiscal stimulus was focused on accelerating investment projects to lay the ground for further private sector activity and postponing some tax measures, notably the VAT. Meanwhile, the Central Bank of Egypt (CBE) reiterated its 100 percent deposit guarantee of local banks, cut overnight rates six times by a over 300 cumulative basis points, and allowed the exchange rate to depreciate by about 6 percent in the six months following the Lehman incident.

Outlook and medium term policies

3. The authorities consider the key medium-term objective is to persist with reforms aimed at solidifying macroeconomic stability while raising productivity and competitiveness of the economy. Fiscal consolidation will continue to aim at strengthening the system’s sustainability, controls, and efficiency. In addition to the ongoing fiscal adjustment, the aim is to further develop infrastructure and boost private sector and foreign direct investment to raise employment opportunities. Meanwhile further financial deepening is viewed as key to mobilize savings needed to finance private sector-led growth. The authorities believe that continuation of such policies may allow for a more rapid recovery in potential growth back to around 6 percent, well ahead of 2014 as staff projects in Box II. It could also allow resumption of the upward trend in potential growth that has occurred since the 2004 reforms (from around 3½ percent to around 6 percent within three years).

Fiscal Policy

4. With vigilant monitoring and cautious fiscal management, the budget outcome is expected to remain within the 2009/10 fiscal target of 8.4 percent of GDP, in spite of a substantial drop in tax proceeds. As the global recovery takes firm hold, the authorities intend to resume fiscal consolidation measures that were interrupted by the onset of the crisis. For the remainder of this year and in 2010/11, options are being explored such as rationalizing the consumption of subsidized butane, and bolstering tax administration to contain evasion. They remain committed to containing the ratio of gross public debt to GDP, which has so far been held in check to below pre-crisis levels.

5. The authorities’ medium-term strategy of reducing the fiscal deficit to 3 percent of GDP aims to maintain investor confidence, preserve macroeconomic stability and create fiscal scope for future counter-cyclical policies. The strategy involves a balanced adjustment, encompassing both revenue and spending measures. On the revenue side, the proposal for replacing the sales tax by a comprehensive VAT is to be submitted to parliament in 2011, and further measures to close loopholes in the income tax legislation are under consideration. On the expenditure side, the reform of fuel subsidies will also be resumed as soon as the crisis has fully abated. Moreover, the cabinet is discussing pension and health care reforms to improve efficiency and sustainability.

Monetary and exchange rate policies

6. The CBE has gradually strengthened the monetary policy framework and enhanced its transparency. During the transition toward an eventual inflation-targeting regime, the central bank meets its inflation objectives by steering the interest rate corridor, keeping in view developments of monetary aggregates, as well as a host of other factors that may influence the underlying rate of inflation. A core inflation index has been used by the central bank to supplement the CPI published by the statistical authorities, and the public launching of the core inflation index in October 2009 was well-received. Monetary policy notes will soon be published to enhance the understanding of CBE’s monetary policy decisions and its effectiveness.

7. Headline and core inflation declined in February 2010. After peaking at 23.7 percent in August 2008, headline inflation declined to around 9 percent in August 2009, but subsequently rose in October and remained elevated at above 13 percent until January 2010 due to a series of one-off factors. These factors did not spill over to underlying inflation, as core inflation remained subdued at around 7 percent throughout the period. The February 2010 CPI, released on March 10 after issuance of the staff report, dropped to 12.8 percent, while core inflation declined to 6.9 percent. The authorities expect inflation to continue to trend downward during the year, but remain watchful of developments and start ready to adjust policies as needed to keep inflationary expectations in check.

8. The authorities view the current exchange regime as appropriately flexible, taking into account market forces while avoiding disruptive fluctuations due to speculative forces. The exchange rate depreciated by 6 percent in the few months following Lehman Brothers’ collapse, and while it has since recovered, it fluctuates daily in response to market demand. Service and remittance receipts are expected strengthen as the global recovery takes hold, reducing the current account deficit to below the 2½ percent of GDP that emerged in 08/09. As staff rightly points out, there is no evidence of competitiveness concerns and non-oil export performance has been impressive. Once the temporary factors driving headline inflation have abated, price developments are expected to become more aligned with trading partners, reversing the temporary real appreciation, which in any case is relatively small and within the possible margin of error in the calculations.

Financial sector reforms

9. Building on the tangible results observed from Phase I financial sector reforms, the authorities have now embarked on the Phase II agenda to further modernize prudential oversight and facilitate intermediation and increase access to credit. As highlighted in Box V, a comprehensive restructuring has forged a solid foundation for the Egyptian banking system. Nonperforming loans have been significantly resolved, the supervisory framework has been updated, and mandatory reporting of risk and performance is being enforced. A new Law 10/2009 was introduced to regulate the growing non-bank financial markets and instruments and the Egyptian Financial Supervisory Authority was established to oversee the sector. Increased competition among banks in retail banking activity will help improve access to credit, but the authorities are under no illusion that this will be a rapid process. For example, compared to only two banks offering mortgage finance in 2004/05, now 10 companies and 19 banks are offering mortgages, the total value of which remains relatively small at less than 1 percent of GDP.

Other structural reforms

10. The authorities intend to proceed with their broad-based structural reform agenda aimed at attracting FDI, and boosting productivity, employment, and potential growth. Recent improvements in infrastructure, as well as the regulatory framework and access to credit, have propelled FDI from below $1 billion annually pre-2004 to $13 billion in 2007/08 (around 8 percent of GDP). A bill is before congress to launch a Public Private Partnership program, under the auspices of the Ministry of Finance, aiming to attract private resources for infrastructure investment with cautious pricing of risks, and while limiting contingent liabilities.

11. The authorities thank the staff for a valuable and constructive exchange of views, including during the useful presentations on selected issues of current policy relevance. They also wish to express their appreciation for the continued provision of timely and effective technical assistance and look forward to working together to further strengthen the statistical framework.