Statement by Hazem Beblawi, Executive Director for the Arab Republic of Egypt Executive Board Meeting, January 28, 2015

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.

1. This is a moment of opportunity for Egypt. With relative political stability restored Egypt is moving resolutely to invigorate the economy. While recognizing the full range of socio-economic challenges, the authorities are keen to strengthen economic prospects and improve the well being of all Egyptians. Accordingly, steps were immediately undertaken by the new government to begin structural reforms and promote investment, starting with a 2014/15 budget that aims to adjust spending allocations, contains the fiscal deficit to eventually bring down public debt, and is supported by monetary policies to contain inflation. Investment promotion and job creation are key priorities, to be anchored in fundamental economic reforms and a predictable and competitive investment environment. To this end, the March Conference in Sharm El Sheikh will bring together investors to participate in projects that aim to reinvigorate the Egyptian economy.

2. The authorities broadly share staff’s overall assessment of long-standing challenges facing the Egyptian economy. However, they differ on specific areas of the assessment related to the prospects, risks, and resilience of the Egyptian economy. They anticipate a stronger turnaround in business confidence and a larger role for investment flows. The authorities appreciate the diligent work of the team, constructive spirit of the discussions, and their openness to different perspectives and to adjusting some of their assumptions and previous perceptions.

Outlook

3. A turnaround in growth is clearly visible, helped by an improved sense of security, and a return to normalcy on the streets and in everyday life. Following four years of growth averaging 2 percent, the pace of economic activity is expected to double in 2014/15, and to further increase thereafter. Growth rebounded to 6.8 percent y-o-y in Q3 of 2014 with a strong pickup in manufacturing and tourism. The authorities recognize the merits of starting from conservative growth projections. However, they see scope for a stronger growth rebound from the energy sector, new project investments, tourism, communications, and construction. They also anticipate a more positive spillover from the impact of lower oil prices on economic activity in Egypt’s trading partners.

4. The authorities are well aware of the challenges and risks. They see limited risks from policy delays, given the stakes at hand and the current social and political acceptance of the necessity of reforms. Indeed, for the first time in Egypt, there is a clear national consensus on the need to implement reforms that would achieve more inclusive growth and strengthen the economy’s resilience to external shocks. The authorities anticipate a boost to medium-term growth from investment in industrial projects, energy generation, superhighways, social sectors, as well as regulatory reforms to facilitate startups, and support to small and medium enterprises. The Suez Canal Regional Development project, the flagship of the government’s investment recovery program, will provide many opportunities for investors as it sets the stage to enlarge and cement Egypt’s role as a global trading and logistics hub. Plans include four new seaports in the three provinces surrounding the canal, a new airport, a new industrial zone west of the Gulf of Suez and a “technology valley” in Ismailia.

Fiscal Policy

5. The authorities’ commitment to restoring fiscal sustainability is unwavering as they see the planned large fiscal consolidation as unavoidable. All the gains that were made in reducing the large fiscal deficits in the years prior to the global financial crisis have since been reversed. Debt has increased by one third and the budget sector’s gross financing needs have nearly tripled. In 2013/14, the budget deficit peaked due to revenue shortfalls associated with the petroleum sector, and two stimulus packages that raised infrastructure and social spending. This included allocations for increases in cash transfers, low income housing, and public transport. Additional fiscal savings will be needed to accommodate the floor on public spending on health and education, as mandated in the new constitution.

6. This year’s budget targets a deficit of 10 percent of GDP. They agree with staff’s assessment that the budget strikes the right balance between moving toward fiscal sustainability, supporting the recovery, and improving social conditions. The budget incorporates subsidy cuts through the fuel price increases of 40-80 percent that were implemented last July, gas price increases to households by over 200 percent, as well as tax measures on dividends and capital gains, implementation of a new property tax, income taxes at the higher income brackets, and excises on tobacco and alcohol, which together yield 2½ percent of GDP. Measures were also introduced to contain the public wage bill, and an overhaul of the public pay system is under consideration. Additional measures are planned for later this year and in next year’s budget with a view to reduce the deficit to 8 percent of GDP and to bring government debt to a declining path, reaching 80-85 percent of GDP within five years. The pace of fiscal consolidation is calibrated to limit the adverse impact on growth and on lower income groups, as recognized in the staff report.

7. An important element of the fiscal strategy is to reform the subsidy system. In this connection, the new food ration cards were well-received and are already yielding substantial savings in food subsidy cost due to lower wheat consumption and better targeting. For subsidized fuel, smart cards have been distributed and used in five governorates so far and are being further extended to enable future targeting of fuel subsidies. The recent oil price decline has substantially reduced the budgetary cost of fuel subsidies for this fiscal year. However, the authorities recognize the possibility of a faster rebound of oil prices than is implicit in futures prices. They have every intention to seize this opportunity to continue with subsidy reforms and to further narrow the gap between retail prices and cost recovery. Moreover, the authorities paid $3.5 billion in amounts due to foreign oil companies since July which is leading to new investments. Power shortages will be addressed by new power projects as well as inviting private sector participation to invest in renewable energy based on a newly established feed-in tariff, which was three times over-subscribed.

Monetary, Exchange Rate, and Financial Sector Policies

8. The Central Bank of Egypt’s (CBE) monetary and exchange rate policies seek to gradually reduce inflation to maintain real incomes and enhance external competitiveness. The Monetary Policy Committee of the CBE raised interest rates by 100 basis points in July 2014 in a courageous step to help contain the second round effects of the increase in fuel prices as subsidies were cut. On January 15, 2015 the Committee cut the benchmark interest rate 50 basis points reflecting an improved inflation outlook on the back of the drop in international oil prices and the subsequent revision of food price forecasts. Monetary policy will continue to aim at reducing inflation and closing the competitiveness gap with Egypt’s trading partners.

9. The CBE’s medium-term objective is to anchor low and stable inflation expectations, while supporting growth and employment. Since inflation in Egypt has been partly due to domestic supply shocks and distribution problems, the CBE has highlighted the causes of inflation in goods and services, particularly food, and the need to undertake structural reforms to ease bottlenecks and improve competition.

10. The CBE’s foreign exchange rate policy is geared toward achieving a flexible exchange rate that reflects the underlying forces of supply and demand and is consistent with an adequate level of reserves, while avoiding excess volatility. The CBE has conducted the foreign exchange auctions with a view to maintain an orderly foreign exchange market. Following a period of stability, the exchange rate depreciated in the central bank auctions by 3½ percent in the week of January 18, 2015. The CBE expects to benefit from returning capital inflows, particularly in the form of foreign direct investment, given renewed confidence in the economy. FDI and tourism have already begun to recover and they expect a more positive impact on the balance of payments than assumed in staff’s projections. The authorities consider imports and exports relatively inelastic to the exchange rate as exports are constrained by non price factors and given the large share of wheat and intermediate inputs in imports. Indeed, the large depreciations of the REER in 2003 were not followed by a strong response in net exports, as seen in the fourth panel of Figure 1. The authorities are concerned that the exchange rate assessment, as presented in the staff appraisal and in the report and Appendix, could lead to undue pressures on the currency despite known problems with these methodologies.

11. The banking system’s resilience remains intact, in spite of the economic slowdown associated with a prolonged political transition, as confirmed by robust and improving financial soundness indicators. They welcome the staff’s confirmation of banking sector soundness and effective supervision. Building on the far-reaching reforms over the past decade, profitability continues to improve and nonperforming loans further decline, while provisioning coverage has reached 98 percent. The CBE’s regularly conducted stress tests indicate that plausible losses could be absorbed by banks’ profits and capital buffers.

Structural Reforms for Sustainable Growth

12. The authorities’ blueprint aims to raise Egypt’s growth potential and medium-term growth rates to levels that meaningfully lower unemployment and raise the standards of living of all Egyptians. They appreciate the staff report’s emphasis on the importance of these objectives. To complement measures to restore macroeconomic stability, the authorities’ initiatives give priority to enhancing financial inclusion and improving the business climate. A new microfinance law and plans to develop mobile banking will enhance access to financial services. Efforts are under way to tackle the regulatory and bureaucratic obstacles that stand in the way of domestic and foreign investors, as well as policies to ensure transparency and that the rule of law prevails. Accordingly, the authorities have recently introduced amendments to the competition and anti-monopoly laws. They have taken steps to remove legal hurdles facing private contracts with the government and will introduce amendments to the investment law that will further streamline processes for foreign investment. They are looking to the March conference as a landmark event to jumpstart investment flows.

Selected Issues Paper

13. The authorities welcome work that identifies the binding constraints to growth and advice that specifies and prioritizes structural reform recommendations, as intended by the “Growth Diagnostics” approach. They do not disagree with most of the views in the Selected Issues Paper. However, they would have welcomed more empirical evidence on some stated views, further prioritizing of reforms, and a clearer connection with paragraph 42 of the staff appraisal. In the table on the most problematic factors for doing business in Egypt, which is based on perceptions survey data from the World Economic Forum, the rankings fluctuate widely from year to year, with the exception of political stability and access to finance, making it difficult to draw conclusions.

Egypt is a founding member of the Fund and looks forward to continued close collaboration with the institution. The authorities value the professional work of the staff and appreciate the excellent and timely technical assistance.