Abstract
Egypt's underlying structural weaknesses and the prolonged political transition have led to the build-up of macroeconomic imbalances. A significantly overvalued exchange rate has undermined competitiveness and depleted international reserves. Weak revenue combined with poorly targeted subsidies and a growing public sector wage bill have resulted in persistent large fiscal deficits and a high level of public debt. Real and potential growth have slowed since 2011 as foreign exchange shortages and the weak business climate deterred investment and impeded productivity improvement and job creation. Regional instability and security concerns have also taken a toll on the economy, especially on tourism. Risks of economic distress increased.
The Egyptian authorities are undertaking momentous reforms. Egypt’s economy faced multiple headwinds that led to a significant growth slowdown from previously high levels, rising unemployment, acute balance of payments challenges, and inflated fiscal deficits – all of which coincided with rising public aspirations. The economy was subjected to successive shocks, including the effects of the political transition, a heightened regional security situation that severely impacted investment and tourism, and unfavorable global economic conditions which have taken a toll on confidence and investment and triggered capital outflows. As the situation became untenable, the authorities initiated wide-ranging and bold reforms to restore macroeconomic stability, ensure robust inclusive growth, build confidence, and rebuild reserves.
The government is implementing a comprehensive and well-balanced program for which they have requested a three-year extended arrangement. Specifically, the program aims to restore a healthy foreign exchange market, reduce the fiscal deficit and high debt, remove internal supply bottlenecks to achieve the growth potential, and create jobs as laid out in the MEFP. A paramount objective is to carry out these reforms, which entail short-term pain, while safeguarding social cohesion; which will be difficult to balance and all the more challenging when there are high expectations of immediate results. Some reforms were already initiated in 2014, and the adjustment as agreed with the Fund is significantly front-loaded, which underscores the tremendous resolve for reform at all levels of government.
Monetary and Exchange Rate Policies
An important component of the program is the decisive reform of the foreign exchange system by the Central Bank of Egypt (CBE) on November 3, 2016 with the goal of eliminating persistent foreign currency shortages. A preemptive tightening that includes a 300 bp rate hike, as well the ongoing substantial fiscal tightening, were both considered necessary conditions for successful exchange rate reform. Following an initial devaluation from 8.8 to 13, which CBE has announced as a nonbinding foreign exchange rate to serve as soft guidance to jumpstart the market, banks were free to set buy and sell rates for trading among themselves and with clients; operating hours for banks’ foreign exchange units were extended to 12 hours a day including weekends; and the priority import list was abolished. Initial results are encouraging, although there has been a larger devaluation of the Egyptian pound relative to what was initially envisaged or suggested by fundamentals. Banks are competing to attract foreign exchange deposits and this pent up demand is expected to lead to initial over-shooting. The pound traded at an average of 14.65 at the central bank’s initial auction on November 3, and traded in the interbank market the following three business days at buy rates of 15.7-17.8 and sell rates of 16.3-18.25 to the U.S. dollar.
The move was widely welcomed domestically and abroad. It is expected to improve Egypt’s external competitiveness, support exports and attract foreign investment and rebuild CBE international reserves. The CBE stands ready to adjust monetary policy as needed to stave off excess pound liquidity in order to limit pressure on the pound and contain the inflationary impact of the devaluation. The CBE expects the situation to stabilize as banks gain experience and trading volumes improve, both with clients and on the interbank market. Initial indications suggest that transactions on the parallel market have diminished considerably and are likely to disappear as more dollar liquidity is diverted to banks.
Monetary policy remains focused on reducing inflation back to single digits within two years, especially to contain the second round impact of the energy price increases, VAT introduction, and devaluation. CBE hiked policy rates and introduced longer maturity deposit auctions in early November to tighten the monetary stance and sterilize excess liquidity. Inflation had reached 14 percent prior to the devaluation and is expected to rise further this fiscal year before coming down. In addition to the indirect policy instruments, disinflation will be supported by minimizing liquidity injection through direct credit to government from the overdraft facility by applying strict limits; the overdraft has recently accounted for one third of deficit financing. CBE will begin to publish its quarterly inflation and monetary policy report in 2017.
Fiscal Policy and Public Financial Management
A significant fiscal consolidation is concurrently under way. Financing of the fiscal deficit has contributed to exchange rate pressures, pushed up interest rates, and crowded out the private sector. With deficits averaging 12.5 percent of GDP in the past four years, debt approaching 100 percent of GDP, the interest bill at 30 percent of government expenditure, and gross financing needs exceeding 55 percent of GDP annually (including rollover of domestic debt), action to contain fiscal deficits could no longer be postponed. To address this, the government’s 2016/17 budget as approved by the newly- appointed Parliament, reduces the primary fiscal deficit by 2½ percentage points of GDP.1 The budget target ensures that budget sector debt will be on a declining path starting this year.
Fiscal-reducing measures that have already been implemented include a third increase in electricity prices by an average 40 percent; adoption of a long-awaited modern VAT system at an initial rate of 13 percent; a simplified business tax regime; increases in tobacco excises; and an increase in fuel and natural gas prices between 35 to 87 percent on November 4, 2016. The public wage bill is projected to decline by nearly 1 percent of GDP. Thus, the gross deficit-reducing measures undertaken this year are quite substantial and amount to 5½ percent of GDP2 on an annualized basis.
In order to mitigate the impact of policy tightening on the vulnerable, the authorities plan to increase budget spending by an additional 1 percent of GDP, over and above normal allocations, to expand social assistance programs. Nevertheless, they remain concerned about the social implications of the adjustment and the potential need for further resources and measures to strengthen the social safety net. In this regard, we call on staff to carry out analysis of the distributional impact of the full package of reforms and to collaborate with the World Bank as needed on this issue. The authorities would greatly appreciate if staff would update and expand the 2013-2014 incidence analysis, by the first review, to better assess the social cost of adjustment and the need for further pro-poor mitigating measures.
Additional fiscal reforms are necessary to sharply reduce debt. Even with these significant measures the fiscal deficit would remain high at 10 percent of GDP. Future consolidation will deliver a primary surplus exceeding 1 percent of GDP next year and 2 percent of GDP in 2018/19—which would deliver a swing in the primary deficit by 5½ percent of GDP in three years. Further reducing fuel subsidies, which disproportionately benefit the rich remains a high priority not only to reduce the deficit but also to free up more resources for spending in priority areas such as health, education and public infrastructure. The subsidy bill has already declined from a peak of 6½ percent of GDP in 2012/13 to 1¾ this year; and will be further reduced to below ½ percent of GDP. Public debt is forecast to decline by close to 20 percentage points of GDP within 5 years.
Strengthening institutions and the policy framework is a priority. In July 2016, the Ministry of Finance established a new unit in charge of modernizing public financial management with a mandate to support good governance and accountability and the efficient use of fiscal resources. Medium-term budgeting will be introduced and a pre-budget statement provided to Parliament. Attention will be given to reviewing the operational performance of economic authorities and identifying those that are providing public functions and should be incorporated within the budget. A list of all state guarantees will be compiled, ceilings on future guarantees proposed, and the framework for issuing state guarantees will be reviewed with a view to limit unnecessary fiscal risks. The finances of the Social Insurance Fund will be reviewed with external technical assistance. In addition, a comprehensive statement of fiscal risks will be prepared in the first quarter of 2017 covering all areas including contingent liabilities, pensions and public enterprises.
Energy Sector Reforms
Egypt has considerable prospects as a supplier of natural gas and substantial scope to improve the supply of electricity and efficiency of the petroleum sector. A comprehensive reform of the energy sector was launched in 2014. The first priority has been to increase capacity to ensure more reliable electricity supply. In the second step, an independent energy regulator will be created to ensure transparent pricing on the basis of an energy sector strategy to be prepared by March 2017. Based on recent discoveries, gas production will exceed Egypt’s domestic needs within 2017, while ongoing exploration could further increase Egypt’s gas potential. With respect to the petroleum sector, the near term focus is to place the Egyptian General Petroleum Corporation on a financially sound footing by implementing the action plan to be prepared by external consultants, and by the removal of fuel subsidies. The plan will suggest ways to strengthen corporate governance, optimize operating costs and provide avenues to involve the private sector.
Financial Sector
The financial system is strong, well capitalized, liquid and profitable. The CBE’s supervision department has conducted rigorous bank-by bank stress tests and found the system resilient to severe exchange rate and interest rate shocks; it continues to monitor the stability of the system. In addition to continued strengthening of the regulatory and supervisory framework, the CBE will promote effective competition, improve access to financial services, and strengthen the crisis management and resolution framework. The CBE will publish its financial stability report starting in December 2016.
Private Sector Growth and Export Potential
To unlock Egypt’s growth and export potential, the authorities are launching a wide-ranging structural reform program. Key among the measures is a new licensing regime, which will include a one-stop shop. The bankruptcy and liquidation procedures will be simplified and a new insolvency law adopted. An efficient collateral registry will be developed to facilitate access to finance. To improve export performance, the authorities will develop an action plan to address bottlenecks to the growth of nonoil exports. To address high unemployment, they are developing specialized training programs for youth and intermediation programs, and will increase spending on public nurseries to support higher female labor force participation. To support export growth, an action plan will be developed in early 2017 to look into the current export promotion regime. Moreover, a five-year IPO program aims to diversify investment sources by attracting investments worth $5 billion over three years. The program will initially focus on a small number of viable public companies in the financial services and banking, oil and gas, petrochemicals, and real estate development.
Growth Outlook and Inclusion
Reviving Egypt’s economy is the best way to meet the aspirations of the Egyptian people. Egypt expects a return to higher growth over the medium-term, building on the inherent strength of the economy represented in its human and natural resources. The policy reforms mark a significant turning point to achieve the authorities’ ambitious goals. Notwithstanding the potential near-term contractionary effects, the authorities also see a potential for a higher-than-currently-projected investment response to the strong package of reforms and the credibility gains associated with approval of a Fund program. H.E. President el-Sisi repeatedly underscored the importance of protecting low income groups while undertaking necessary reforms. To better support this objective, the authorities will accelerate ongoing work to develop a database of vulnerable groups, enhance social safety net programs, and better target assistance to reach deserving households. It is expected that the macroeconomic and structural reforms will revitalize the economy and be supplemented by measures to improve human capital, including through better health and education, in order to reap benefits for all.
To conclude, the authorities are undertaking an extraordinary effort and appreciate the broad support of the Fund and the international community. They wish to thank the Executive Board for considering this request on such a short notice. They appreciate staff–s hard work and management’s efforts in bringing this program to fruition.
The program targets change in the primary fiscal deficit given the uncertainty surrounding interest rates.
This figure is higher than the 3.9 percent of GDP shown in the staff report, as it (i) annualizes the fiscal yield from the VAT and fuel price increase that became effective in September and November, respectively; and (ii) includes 0.9 percent of GDP as the decline in the wage bill this year as described in paragraph 15 of the MEFP.