Arab Republic of Egypt: Staff Report for the 2014 Article IV Consultation
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
11 Feb 2015
eISBN:
9781484337769
ISBN:
9781484337769
Language:
English
Keywords:
ISCR; CR; exchange rate; debt; government; economy; trade balance; Egyptian pound; private sector; monetary policy; balance of payments; banking sector; Government debt management; Global
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KEY ISSUESThe 2014 Article IV consultation takes place when the authorities have started to address longstanding economic challenges. For a number of years Egypt has suffered from low and non-inclusive growth and from high unemployment. Since 2011 these problems have been compounded by large fiscal deficits and rising public debt and by external fragility evidenced by loss of foreign exchange reserves. In 2014, Egypt adopted a new constitution and elected a new president who was candid with the electorate on the need to reform the economy. The government has developed a plan centered on structural reform and investment promotion to raise growth and create jobs, and fiscal adjustment to bring the budget deficit and public debt under control. Crucially, the authorities have already begun to implement fuel subsidy reform, raising prices by 40–80 percent in July 2014. They have also begun the reforms needed to raise tax revenue and to make Egypt a more attractive destination for investment.There was agreement that the authorities’ objectives are ambitious but are broadly within reach with steady policy implementation. The authorities aim to raise growth to 6 percent per annum, reduce annual inflation to 7 percent, bring down the fiscal deficit to8 percent of GDP and debt to 80–85 percent of GDP, and increase foreign exchange reserves to 3½ months of imports, all within the next five years. Staff considers these objectives appropriately ambitious, although targeting a higher level of reserves would be prudent. It believes that the authorities’ policies, if followed steadfastly, are broadly consistent with these objectives, but noted that a number of policies—including the details of some fiscal measures and structural measures to improve the business environment—are still being formulated.The authorities and the staff differed somewhat on the extent of vulnerabilities and risks. The authorities are confident that they will be able to follow through on their policies and that improved confidence will lead to a surge in foreign investment, a pickup in tourism, and strong economic growth. Staff emphasized that the authorities’ policies would still leave significant vulnerabilities, namely high public debt and large financing gaps, which would need to be covered by greater adjustment or financing, or a combination of the two. Staff also pointed to the difficulty of maintaining tight fiscal and monetary policies over a long period, the risks of dilution of structural reform efforts, and the uncertain regional security environment. To contain these vulnerabilities and risks, staff recommended developing contingency measures in the budget, taking steps to build up reserves buffers, and greater exchange rate flexibility to restore competitiveness. However, staff also agreed that with steadfast commitment to reform, Egypt’s prospects could be stronger than assumed in staff’sprojections. In particular, the recovery in investment could exceed expectations.

Abstract

KEY ISSUESThe 2014 Article IV consultation takes place when the authorities have started to address longstanding economic challenges. For a number of years Egypt has suffered from low and non-inclusive growth and from high unemployment. Since 2011 these problems have been compounded by large fiscal deficits and rising public debt and by external fragility evidenced by loss of foreign exchange reserves. In 2014, Egypt adopted a new constitution and elected a new president who was candid with the electorate on the need to reform the economy. The government has developed a plan centered on structural reform and investment promotion to raise growth and create jobs, and fiscal adjustment to bring the budget deficit and public debt under control. Crucially, the authorities have already begun to implement fuel subsidy reform, raising prices by 40–80 percent in July 2014. They have also begun the reforms needed to raise tax revenue and to make Egypt a more attractive destination for investment.There was agreement that the authorities’ objectives are ambitious but are broadly within reach with steady policy implementation. The authorities aim to raise growth to 6 percent per annum, reduce annual inflation to 7 percent, bring down the fiscal deficit to8 percent of GDP and debt to 80–85 percent of GDP, and increase foreign exchange reserves to 3½ months of imports, all within the next five years. Staff considers these objectives appropriately ambitious, although targeting a higher level of reserves would be prudent. It believes that the authorities’ policies, if followed steadfastly, are broadly consistent with these objectives, but noted that a number of policies—including the details of some fiscal measures and structural measures to improve the business environment—are still being formulated.The authorities and the staff differed somewhat on the extent of vulnerabilities and risks. The authorities are confident that they will be able to follow through on their policies and that improved confidence will lead to a surge in foreign investment, a pickup in tourism, and strong economic growth. Staff emphasized that the authorities’ policies would still leave significant vulnerabilities, namely high public debt and large financing gaps, which would need to be covered by greater adjustment or financing, or a combination of the two. Staff also pointed to the difficulty of maintaining tight fiscal and monetary policies over a long period, the risks of dilution of structural reform efforts, and the uncertain regional security environment. To contain these vulnerabilities and risks, staff recommended developing contingency measures in the budget, taking steps to build up reserves buffers, and greater exchange rate flexibility to restore competitiveness. However, staff also agreed that with steadfast commitment to reform, Egypt’s prospects could be stronger than assumed in staff’sprojections. In particular, the recovery in investment could exceed expectations.

Context

1. Egypt has been going through a period of dramatic change. The momentous events of January 2011 ushered in a period of great hope but also great challenges. The political transition entered a new phase with the change of government in July 2013. This was followed by the approval of a new constitution in January 2014 and the election of a new president in May. The political process is still continuing: parliamentary elections are scheduled for March-April 2015. Underlying political and social tensions also remain. As recently as last month demonstrators and security officers were killed during protests. Many protesters have been jailed and terrorist attacks against security personnel and civilians are still taking place.

2. The past four years of political instability have taken a toll on confidence, economic activity, investment, and tourism. Amidst political turmoil, chronic economic problems were left unaddressed and new problems became acute. Fiscal revenue and foreign exchange earnings collapsed while expenditure rose sharply, causing persistent inflation, large budget deficits, sizable external imbalances, and reserve loss.

3. The restoration of relative political stability has given the authorities an opportunity—which they have seized—to address Egypt’s longstanding economic challenges. The economic reform agenda is a long one. The authorities’ policies to achieve inclusive growth and job creation focus on pursuing structural reforms, promoting investment, and protecting the poor. They are seeking to restore macroeconomic stability through fiscal adjustment, supported by a tight monetary policy to contain inflation. Measures implemented so far, along with some recovery in confidence, are starting to produce a turnaround. But the authorities’ success in meeting their goals will depend on their steady efforts, willingness to take additional actions as needed, and continued external support.

4. The authorities see this Article IV consultation as an important step on the road to recovery. They hope that their policies will resonate with the international community and with investors who they will invite to an economic conference in March 2015, and see the views of the Fund as an important contribution to their planning.

Recent Economic Developments

5. Egypt is facing major economic challenges, some of them longstanding. Recent difficulties—especially low growth and high unemployment—should be seen in the context of structural weaknesses which largely predate 2011. These stem mainly from large macroeconomic imbalances, microeconomic distortions, low human capital, poor infrastructure, low access to finance, and poor external competitiveness (Box 1). Structural challenges are exemplified by poor rankings in business climate and competitiveness indicators. Egypt ranked 112 out of 189 in the World Bank 2015 Doing Business survey, reflecting considerable red tape, cumbersome regulations, and poor enforcement of contracts and minority investors. The country ranked only 119 out of 144 in the World Economic Forum 2014–15 Global Competitiveness Index due to a deteriorated macroeconomic environment and particularly poor scores on labor and goods market efficiency, financial market development, and education.

Growth Diagnostic and Constraints to Growth

Growth was buoyant during 2004–10 (5½ percent annually on average) but did not generate jobs sufficiently to absorb the young and growing population and to ensure inclusiveness. Growth was driven mainly by consumption while investment lagged behind and the external sector contributed negatively. Growth remained constrained by the insufficient quality of employed labor and lackluster gains in productivity, with total factor productivity growing by a mere 0.8 percent per year.

Staff analysis suggests that the most binding constraints to growth and job creation in Egypt are macroeconomic risks, microeconomic distortions, low productivity, low access to finance, and poor external competitiveness.

  • Macroeconomic risks are reflected in fiscal and external vulnerabilities which affect confidence and investment.

  • Microeconomic distortions stem from still high subsidies, inefficient labor markets, weak governance, perceived corruption, and constraints to doing business. High energy subsidies generate a bias in favor of capital and energy-intensive industries and divert resources, including FDI, toward these sectors at the expense of more efficient or labor-intensive industries. Inefficient labor markets push firms and workers into the informal sector. Poor enforcement of contracts and an unpredictable judicial system are major impediments to doing business. The public sector is large, generating 39 percent of formal GDP in 2013/14. Despite privatization operations in the past decade, public institutions still control the majority of assets in the banking and insurance sectors; are important players in the telecom and transportation sectors; and are dominant in sectors such as oil and gas, refining, and electricity. Anecdotal evidence suggests that the military exercises significant control over some public enterprises and land, although it is difficult to estimate the share of military ownership.

  • Low human capital, as evidenced by poor health and education indicators, and poor infrastructure—especially roads and electricity—weigh on productivity. Education is underfunded and does not prepare young people for productive employment, while public health services are subpar, limiting health outcomes and human capital formation. The rising infrastructure deficit has been reflected in poor transportation infrastructure, traffic congestion, distribution bottlenecks, and electricity, fuel, and water shortages.

  • Low access to finance is an important constraint to growth. Credit to the private sector has been on a declining trend as a share of GDP over the past decade. Low credit reflects crowding out from public sector borrowing, which pushes interest rates up and reduces incentives to lend to the private sector. Structural deficiencies are also significant, as reflected in low bank penetration and bank deposits. Credit to SMEs is very low.

  • The negative contribution of the external sector to growth reflects poor overall competitiveness. Nonoil merchandise exports were only 4.8 percent of GDP in 2013/14. Limited external linkages, real exchange rate appreciation, and the unfavorable business environment have been obstacles.

A01ufig1

Contributions to Real GDP Growth

(percent)

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

6. The political turmoil of January 2011 triggered a sharp capital account reversal and left growth depressed, while policy accommodation widened fiscal and external imbalances. The protracted political and institutional uncertainty, a perception of rising insecurity, and sporadic unrest dented confidence. Large capital outflows ensued, along with declining investment and tourism (Figures 1–4):

  • Real GDP dropped by 0.8 percent in calendar year 2011 and growth only recovered to about 2 percent annually in the following years, weighed by continued disruption of domestic production due to political turmoil, and widespread energy shortages and electricity blackouts.

  • The fiscal deficit and debt rollover needs soared, pushing up domestic borrowing costs. Delayed reforms, lower revenue, and rising wage, subsidy, and interest payments led to double-digit budget deficits reaching close to 14 percent of GDP in 2012/13.

  • Faced with capital outflows, weak foreign direct investment (FDI), and widening current account deficits, the Central Bank of Egypt (CBE) supplied large amounts of foreign currency to stabilize the exchange rate. While this provided an anchor to maintain confidence, it depleted international reserves from $35 billion (6.8 months of imports) at end-2010 to $14.5 billion (2.5 months) in June 2013. Exchange rate pressures were particularly strong in December 2012 and the first half of 2013, when reserves were only supported by sizable official financing from Gulf countries, rapid depreciation, and foreign exchange rationing, which compressed imports and generated a parallel market.

  • Social outcomes, which were already lagging, deteriorated further post-2011. Unemployment peaked at 13.4 percent in 2013/14, with the highest levels found among youth and women. Poverty rose to 26.3 percent in 2012/13, with another 20 percent of the population estimated to be close to the poverty line.

Thus, by June 2013, Egypt’s economy was in a precarious position with low growth, high unemployment, wide fiscal and external imbalances, and low reserves buffers.

Figure 1.
Figure 1.

Egypt: Real Sector Developments, 2002/03–2013/14

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Sources: Egyptian authorities; and IMF staff calculations and projections.
Figure 2.
Figure 2.

Egypt: Fiscal Sector Developments, 2007/08–2014/15

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Sources: Ministry of Finance; Central Bank of Egypt; and IMF staff calculations and projections.
Figure 3.
Figure 3.

Egypt: External Sector Developments, 2003–14

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Sources: Egyptian authorities; International Financial Statistics; Information Notice System; Bloomberg; and IMF staff calculations and projections.
Figure 4.
Figure 4.

Egypt: Monetary Sector Developments, 2008/09–2013/14

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

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

7. Growth remained slow in 2013/14, but the economy has now begun to recover. In 2013/14, GDP grew by 2.2 percent. Tourism and natural gas extraction were adversely affected by security concerns and some $6 billion in arrears to oil and gas investors. Unemployment remained stubbornly high at 13.1 percent in Q3 of 2014. However, growth rebounded to 6.8 percent y-o-y in Q3. The pick-up was particularly strong in manufacturing and tourism.

A01ufig2

Manufacturing Index

(January 2010=100, seasonally adjusted data)

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Source: Egyptian authorities.
A01ufig3

Monthly Tourist Arrivals

(In millions)

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Source: Egyptian authorities.

8. Inflation remains close to 10 percent, though core inflation is lower. Inflation was 10.1 percent on average in 2013/14. It then picked up in Q3 2014 due to fuel and tobacco price hikes implemented in July 2014 and increases in school tuition fees, reaching 11.8 percent in October. Interest rate action by the Central Bank of Egypt’s (CBE) helped contain second-round effects, and headline inflation receded to 10.1 percent in December. Core inflation was 7.7 percent.

9. In 2013/14, two stimulus packages and revenue shortfalls widened the budget deficit to 13.8 percent of GDP, notwithstanding large external grants. To support domestic demand, the government raised infrastructure and social spending by 1.8 percent of GDP, increased the minimum wage for government workers by 70 percent, and raised wages of teachers and doctors. The budget sector deficit was contained only thanks to grants from Gulf countries of 3.8 percent of GDP.1 Budget sector debt rose to 95.5 percent of GDP, while general government debt rose to 90.5 percent of GDP (a lower level because of cross holdings of debt by social insurance funds).

10. The 2014/15 budget represents a policy shift as the authorities implemented bold energy price and tax hikes at the outset of the fiscal year to reduce the deficit. The adopted budget targets a deficit of 10 percent of GDP (including grants equivalent to 1 percent of GDP). The main measures already implemented include energy subsidy reforms (through price hikes for fuel products by 40–80 percent and electricity by 20 percent), introduction of taxes on dividends and capital gains, a 5 percent additional tax on high incomes, increases in excises on tobacco and alcohol, and a revamped property tax. These measures are expected to yield savings of 2½ percent of GDP. The introduction of a fully fledged value-added tax (VAT) conforming to international standards to replace the sales tax, the sale of a telecom license, and the adoption of a new mining law are planned later in the fiscal year, with an expected yield of about 1 percent of GDP.

11. The underlying current account deficit widened significantly in 2013/14 as tourism plummeted, but the imbalance was covered by support from Gulf countries. In 2013/14, a 50 percent drop in tourism receipts widened the current account balance to 5 percent of GDP (excluding grants), while nonoil exports dropped below 5 percent of GDP. Net FDI remained flat as political and judicial uncertainty (including court cases reversing past privatization deals) affected the investment climate. External financing gaps were covered by some $20 billion in Gulf aid (grants, deposits, and oil shipments). Reserves were $14.9 billion at end-December 2014 (2½ months of imports).

A01ufig4

Non-Oil Exports

(In percent of GDP, 2005-13 average)

Citation: IMF Staff Country Reports 2015, 033; 10.5089/9781484337769.002.A001

Sources: WEO; and IMF staff calculations.

12. The official exchange rate has remained broadly unchanged since June 2013, but this has generated a parallel market and a backlog of demand for foreign exchange. The pound depreciated by 13 percent in the six months following the introduction of the CBE’s tightly managed foreign exchange auctions in December 2012. However, since June 2013, large support from Gulf countries allowed the CBE to stabilize the official exchange rate, which depreciated by less than 2 percent against the U.S. dollar. This has led the real effective exchange rate to appreciate by 18 percent at end-November 2014, due to high inflation differentials with trading partners and the appreciation of the dollar against other major currencies. Restrictions in the auctions and on the interbank market prevented a market-clearing adjustment, with the parallel market premium fluctuating between 2–7 percent. Backlogs of foreign exchange requests from commercial banks were only partially cleared through occasional large auctions. In December 2014, the CBE increased the weekly auctioned amounts by 25 percent.

13. The CBE’s monetary policy sought to balance concerns over inflation and the need to support growth and finance the fiscal deficit. Overall, the monetary stance has remained broadly accommodative, as the central bank accommodated the government’s financing needs by allowing continuous use of the government overdraft facility. As a result, the CBE’s net credit to the government increased to 24.1 percent of GDP in November 2014 (against 18 percent in June 2013). However, the CBE acted decisively in July 2014 to keep inflation in check when it raised its policy rates by 100 bps to preempt second-round effects of regulated price hikes. Credit to the economy has remained subdued, growing at 8.5 percent in 2013/14 and falling in real terms. High nominal interest rates discouraged credit demand while compressed differentials between lending rates and earnings on government securities created little incentive for banks to lend to the private sector.

14. Aggregate financial soundness indicators point to the system’s resilience despite the prolonged economic difficulties. Banking sector reforms in the 2000s, including restructuring and consolidation, some privatization operations, and a cleanup of non-performing loans (NPL) meant that banks faced shocks from a relatively strong position. As a result, profitability remained high and system-wide NPLs declined further from 10.5 percent in 2011 to 9.1 percent in June 2014, with provisioning coverage reaching 98 percent. Forbearance measures benefitting the hard-hit tourism sector did not have a significant impact given the small share of such loans. Stress tests regularly performed by the CBE suggest that plausible losses could be absorbed by banks’ profits and capital buffers, and exchange rate exposure is not significant. However, despite ample domestic currency liquidity, limited availability of foreign exchange generates sizable backlogs for bank customers.

Egypt: Banking Sector Financial Soundness Indicators, 2011–14 1/

(In percent)

article image
Source: Central Bank of Egypt.

Fiscal year ends June 30 for public banks and Dec. 31 for other banks.

Basel II regulations introduced in Dec. 2012, except for banks whose fiscal year end in June.

15. Data provision is broadly adequate for surveillance, but quality, timeliness, and overall transparency could be improved. Government finance, monetary, and external sector statistics are adequate, and transparency and dissemination have improved recently. However, only aggregate banking data are available, and data on general government are available only with a lag.

Outlook and Risks

16. Starting from a difficult position, the authorities seek to achieve higher and more inclusive growth and job creation, while reducing inflation and the budget deficit. By 2018/19, they target 6 percent GDP growth and 7 percent inflation, a budget deficit reduced to 8–8½ percent of GDP and a budget sector debt down to 80–85 percent of GDP.

17. As the authorities further flesh out and implement their policy initiatives, prospects for growth, employment and macroeconomic stability will improve (Figures 5–6, Table 9). With consistent implementation of policy plans in the coming years, staff projects that actual and potential growth could reach 5 percent by 2018/19, due to structural reforms to raise investment and improve productivity. If this materializes, unemployment could fall to 10 percent. Fiscal and inflation objectives could be met, as lower domestic financing of the budget would support a deceleration of inflation. In the short term, growth is expected to pick up, from a low base, to 3.8 percent this fiscal year. However, despite an expected rebound in tourism, FDI, and portfolio investment, high domestic demand and limited competitiveness will keep the trade and current account deficits elevated. External financing gaps are expected to remain throughout the projection period, with part of the gaps associated with a limited buildup of reserves to 3½ months of imports. The authorities have somewhat more upbeat forecasts (see paragraph 34).

Table 1.

Egypt: Selected Macroeconomic Indicators, 2010/11–2015/16 1/

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

Fiscal year ends June 30.

General government includes the budget sector, the National Investment Bank (NIB), and social insurance funds.

Budget sector comprises central government, local governments, and some public corporations.

Includes multilateral and bilateral public sector borrowing, private borrowing and prospective financing (in 2011/12).

Debt at remaining maturity and stock of foreign holding of T-bills.

Table 2.

Egypt: Balance of Payments, 2009/10–2018/19

(In billions of U.S. dollars, unless otherwise indicated)

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

Includes the amortization of official external financing from Gulf Cooperation Council (GCC) countries and EGPC arrears.

In 2010/11 to 2012/13, includes accumulation of EGPC arrears.

EGPC arrears.

IMF’s Special Data Dissemination Standard definition.

Includes multilateral and bilateral public sector borrowing, private borrowing and prospective financing (in 2011/12).

Table 3.

Egypt: Balance of Payments, 2009/10–2018/19

(In percent of GDP, unless otherwise indicated)

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

Includes the amortization of official external financing from Gulf Cooperation Council (GCC) countries and EGPC arrears.

For FY 2010/11 to FY 2012/13, includes EGPC arrears.

EGPC arrears.

IMF’s Special Data Dissemination Standard definition.

Includes multilateral and bilateral public sector borrowing, private borrowing and prospective financing (in 2011/12).

Table 4.

Egypt: Budget Sector Operations, 2011/12–2018/19 1/

(In billions of Egyptian pounds, unless otherwise indicated)

article image
Sources: Ministry of Finance; and IMF staff estimates.

Budget sector comprises central and local governments, and some public corporations. Fiscal year ends June 30. Cash basis. Cash basis consistent with the GFS 2001 classification.

Projections exclude measures.

Food subsidies include subsidies paid to farmers.

The authorities accounted as grants in 2013/14 and 2014/15 the transfer to the budget of special deposits held at the CBE received from abroad following the 1991 Gulf War. Staff recorded these amounts as central bank financing below the line, consistent with GFSM principles.

Oil revenue minus fuel subsidies. Oil revenue includes corporate income tax receipts from EGPC and foreign partners, royalties, extraordinary payments, excise taxes on petrol products, and dividends collected from EGPC.

Table 5.

Egypt: Budget Sector Operations, 2011/12–2018/19 1/

(In percent of GDP)

article image
Sources: Ministry of Finance; and IMF staff estimates.

Budget sector comprises central and local governments, and some public corporations. Fiscal year ends June 30. Cash basis.

Projections exclude measures.

Food subsidies include subsidies paid to farmers.

The authorities accounted as grants in 2013/14 and 2014/15 the transfer to the budget of special deposits held at the CBE received from abroad following the 1991 Gulf War. Staff recorded these amounts as central bank financing below the line, consistent with GFSM principles.

Oil revenue minus fuel subsidies. Oil revenue includes corporate income tax receipts from EGPC and foreign partners, royalties, extraordinary payments, excise taxes on petrol products, and dividends collected from EGPC.