A. Article IV Consultation: Inclusive Growth, Job Creation, and Social Protection

Revisiting the Legacy of Egypt’s Development Model

14. The efficient allocation of economic resources in Egypt is hampered by numerous distortions that are the legacy of the past. For decades, the Egyptian economy was characterized by an expansive welfare system and a preference for economic self-reliance. The former was manifested in a system of universal subsidies and a large public sector workforce, encouraging consumption that over time rose to over 90 percent of GDP—well-above levels in peer countries— and leaving little fiscal room for policies geared towards broad-based development. Economic self-reliance led to a preference for industrial and import substitution policies, which in combination with fuel subsidies resulted in over-investment in inefficient and capital-intensive industries, where the state played a dominant role, providing relatively low employment growth for the economy (Box 1). This made capital accumulation the primary driver of growth. At the same time, inward-looking policies, weak competition, and poorly-defined property rights dis-incentivized productivity growth, and weakened external competitiveness and dynamism of the private sector. This prevented Egypt from taking full advantage of the opportunities from globalization that helped lift living standards among many of its peers. The attempts to address the perceived weak dynamism and job creation by the private sector have resulted in creating further distortions to efficient resource allocation and further expanding the role of the state in economic activity. This was revealed in the tendency to over-regulate markets, provide preferential or subsidized access to resources to select sectors and industries, operate directly in product markets, and centralize commercial decisionmaking by suggesting what, where, and how to produce. The suboptimal allocation of economic resources became self-reinforcing, further weakening productivity growth and job creation.

Box 1.

Constraints to Growth and Private Sector Development

Egypt’s growth in the last two decades has been insufficient to improve the living standards. Real GDP growth averaged 4.2 percent per year over 1990-2017, but per capita GDP growth was more modest at 2 percent annually on the back of strong population growth. The national poverty rate was 27.8 percent in 2015/16.

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Decomposition of Real Per Capita GDP Growth

(Annual average, in percent)

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Sources: Dabla-Norriset al., 2013.Note: regional aggregates are weighted averages; the country-specific weights correspond to purchasing-power-parity-adjusted GDP.EM MENAP include Algeria, Bahrain, Iran, Iraq, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Pakistan, Qatar, Saudi Arabia, Syria, Tunisia and the United Arab Emirates.

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The growth model since mid-2000s has been inefficient. Capital deepening has been the main driver of growth, while the contributions of TFP and labor utilization have been small or negative. Egypt was unable to create enough jobs for its growing population.

Lack of competition, corruption, poor access to finance and land, and inadequate infrastructure are major obstacles to firms’ development and productivity improvement. The uneven playing field, and the time and cost of starting and operating businesses are cited by investors as key constraints. Energy subsidies benefit better connected firms and favor capital-intensive industries. Only 12 percent of Egyptian firms have a bank loan or a line of credit. Land allocation to the private sector is limited and inefficient (on a first-come-first-serve basis), and the lack of integrated multi-modal logistics constrains investment and trade. Regulatory bottlenecks and pervasive non-trade barriers, including burdensome customs procedures, increase the time and cost of trading across borders. (See the Selected Issues Paper).

15. These economic inefficiencies and a persistent shortage of fiscal space to support inclusive growth have placed undue burden on the otherwise sound financial sector. To meet the financing needs of the budget and increase financial inclusion, the CBE had to assume certain fiscal functions that go beyond the central bank’s mandate and are inconsistent with the objective of price stability. The government’s large borrowing needs were partly met through the CBE’s direct lending, fueling inflation, while the crowding out of private credit by the public sector prompted the central bank to provide subsidized loans to small and medium enterprises (SMEs) and mortgages to low-income households, which otherwise had little access to finance. To maintain financial stability, the central bank also had to assume the function of financing public bank recapitalization and bank resolution, which normally resides with the treasury. As a result, the CBE had to pursue multiple and sometimes competing objectives, as the treasury had limited resources to fulfil some of these objectives.

16. A new growth paradigm is needed to lift Egypt’s potential growth rate and meet the needs of its growing population. Creating around 700,000 jobs annually and sustainably lifting the living standards can be achieved if the private sector takes the lead in investment and employment. This will require reorienting the policy framework to support a more efficient allocation of resources across all sectors through market mechanisms. It will also require the role of the public sector to be guided by hard budget constraints, and transparency and accountability in the fulfilment of the respective obligations of various parts of the state—including importantly the separation of fiscal and monetary policy functions.

Reforms to Achieve Higher and Sustained Growth

17. The state continues to play a prominent role in the Egyptian economy. Given the large informal sector, the state remains the employer of choice for many, offering attractive wages and working conditions (benefits, job security), and competes with the formal private sector. The share of the public sector in total employment is estimated at close to 30 percent, almost twice as high as formal private sector employment (ELMPS, 2012). The state also provides extensive subsidies and owns a large number of public enterprises, including in the sectors that compete directly with the private sector, in areas such as banking, the energy sector, manufacturing, agriculture, transport, tourism, and services. Moreover, state-owned enterprises are not subject to the same criteria of transparency and accountability to shareholders as private entities. The state also owns most land for investment purposes, which is not readily accessible to the private sector through a transparent and market-driven allocation process. This large role of the state imposes large public outlays, limits the fiscal space for productive investments in infrastructure and human capital, and marginalizes the private sector. The result is limited scope for higher growth and job creation, especially for youth and women.

Text Table 1.

Egypt: Framework of Policy Priorities

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18. Corruption is perceived as high and widespread. Perceptions-based corruption indices show high levels of perceived corruption in Egypt compared to most regional peers and other emerging market economies. Literature suggests that a reduction in the perception of corruption could have very strong economic effects. Ugur and Dasgupta (2011)⁴ find that a one-unit improvement in the perceived corruption is associated with an increase of 0.59-0.86 percentage point in per capita GDP growth. In this vein, the perception of corruption might have mitigated to some extent the i to estimate the precise effect.

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Perceptions-based Corruption Indicators, 2016

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Sources: Transparency International, The Worldwide Governance Indicators, Verisk Maplecroft, and IMF staff calculations.1/ Worldwide Governance Indicators’ control of corruption percentile rank, measuring perceptions of the extent to which public power is exercised for private gain; with 0 corresponding to lowest rank and 100 to highest rank.2/ Transparency International corruption perception index, measured on a scale of 0 (highest level of perceived corruption) to 100 (lowest level of perceived corruption).3/ Verisk Maplecroft corruption risk index, measured on a scale of 0 (highest corruption risk) to 100 (lowest corruption risk); rescaled from the original 0-10 scale for comparability with the other indices.

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19. Capitalizing on its initial successes, the reform agenda needs to be broadened. A dynamic private sector and market-driven resource allocation were essential preconditions for the growth transformations enjoyed by emerging economies over the past five decades. It requires a reorientation of the state to focus on the provision of a stable macroeconomic environment and the efficient delivery of public goods. This needs to be complemented with reforms that improve the business environment and promote private sector development.

20. A limited set of reforms has high potential to alleviate the key bottlenecks to growth in a relatively short time. These include: a modernized regulatory framework to create a level playing field for all; enhanced competition in input and product markets; greater trade integration and the removal of non-tariff barriers; improved access to finance and land; strengthened governance, transparency, and accountability of SOEs; and labor market reforms (See the Selected Issues Paper). Progress in these key areas could unlock higher growth and also generate positive spillovers for the region.

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Business Environment and Governance Indicators

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Sources: Global Competitiveness Report (2017-18); World Bank Doing Business Report (2018)

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21. The authorities broadly shared the mission’s view of the medium-term objectives. They agreed that the private sector needs to be the primary engine of growth and job creation. They concurred with the key reform areas proposed by staff, while noting that a proper pacing of reforms was essential to build domestic consensus and generate buy-in from all stakeholders, given the extensive reforms already undertaken and the sacrifices already made by the population in the context of the reform program. The authorities considered that the private sector in Egypt was still insufficiently dynamic with a large level of informality, and the state may need to provide guidance and occasional support until it had matured. The authorities also noted that there is a role for the state to overcome market failures, especially in an environment when important macroeconomic policy changes are being introduced. This was demonstrated by occasional shortages of food and other essential goods last year, when the state had to intervene in the public interest.

Better Integrating Youth and Women into the Labor Market

22. Egypt would benefit from better integrating women in the labor market and supporting youth employment. For these groups, unemployment is particularly high and labor force participation low. About one-third of young Egyptians in the labor force are unemployed and more than ¾ of women are outside the labor force. Staff analysis indicates that skills mismatches are among key obstacles for youth in finding jobs. Inadequate working arrangements in private sector, including the safety of transportation and inflexible working conditions, prevent many women from entering the job market. The authorities and staff shared the view that targeted reforms are needed for these groups to raise Egypt’s growth potential. For the young, improving the quality of education is critical to equip new entrants with the knowledge and skills demanded by employers. Integration of women in the labor market can be fostered by: improving the safety of public transportation; improving the availability of childcare; and adopting more flexible policies for maternity leave, and parental services; promoting entrepreneurship among women; and improving access to finance (see the Selected Issues Paper).

Box 2.

Women’s Participation in the Labor Market

Female labor force participation is particularly low in Egypt, with only 23 percent of Egyptian women in the active labor force despite Egypt’s success in promoting gender equality in primary and secondary education. Women are nearly three times less likely to be in the labor force, and more than twice as likely to be unemployed than men. One in two young women is not in either education, the labor force, or training, and about half of unemployed young women have tertiary education. Women’s labor force participation also drops as they get married, highlighting the difficulty for women to balance a job and a family.

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Unemployed by Level of Educational Attainment and Gender

(Percent)

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

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Mobility constraints, lack of connections, high wage gaps with men, and lack of child care services appear important factors behind women’s low participation and high unemployment rates, especially in the private sector. Public sector jobs tend to offer better employment conditions, including more flexible hours, better commute, better benefits, and a lower wage gap. World Bank (2014) estimates the overall wage gap between women and men at about 12 percent, and this rises to 40 percent in the private sector. With very limited employment opportunities in the public sector, many women remain unemployed or get discouraged and withdraw from the labor force. 30 percent of working women took more than a year to find a job against 12 percent for men._

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Unoccupied by Level of Educational Attainment and Gender

(Percent)

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Source: 2014 ILO School-to-Work Transition Survey.

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Creating Fiscal Space

23. In the medium term, Egypt needs to create fiscal space for its significant spending needs. The spending priorities include upgrading infrastructure, investing in health and education, and building a sustainable social safety net. Egypt could create more fiscal space through tax policy reforms and better tax administration. Egypt’s tax revenue is under 13 percent of GDP, which is low by international standards. The current tax system is complex with multiple tax rates and tariffs, creating an uneven playing field.

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Tax Revenues, 2016

(percent of GDP)

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Note: EDM stands for the average tax revenue from Emerging and Developing Markets consistent with the WEO classification.

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24. Egypt could raise revenue by about 4 percent of GDP. Staff analysis suggests this can be achieved by tax policy reforms and improving revenue administration. While significant progress was achieved in recent years on multiple fronts, including the introduction of the VAT, there is still significant scope for further policy measures. Staff recommended: (1) broadening the VAT base by reducing exemptions; (2) increasing progressivity of the personal income tax and strengthening compliance through administrative reforms, especially for professionals (lawyers, doctors, accountants); (3) improving corporate income tax performance by addressing base erosion and profit shifting, and reviewing tax incentive schemes for FDI and free economic zones (Box 3); (4) simplifying the tax regime for small and micro enterprises; and (5) streamlining the tariff structure and removing discretionary exemptions in customs duties. To improve efficiency of revenue mobilization, there is scope for modernization of tax and customs administration, including by integrating direct and indirect tax management, creating a large and medium taxpayers’ unit, and rationalizing staff accordingly and building risk-assessment programs by segment. The authorities appreciated staff’s recommendations, and welcomed closer cooperation with the Fund on these issues (see the Selected Issues Paper).

Box 3.

Strengthening International Tax Rules for Development

Egypt’s international tax rules are important drivers of foreign direct investment (FDI). Evidence suggest that a 1 percentage point higher effective tax rate on companies reduces FDI on average by 3 percent. With a corporate rate of 22.5 percent, several tax incentives, and a wide network of double tax treaties (DTTs), the Egyptian international tax system is seemingly conducive to foreign investors (for detailed analysis, see the Selected Issues Paper).

International tax rules should also ensure that FDI contributes to a broader domestic revenue base. With a very low tax-to-GDP ratio, Egypt lags behind both its regional and global peers; and its corporate tax revenue has been declining sharply in recent years, in part due to lower revenue from the petroleum sector. FDI inflows could help expand the domestic tax base, but will require careful tax policy design that limits base erosion, e.g. through implementing effective anti-avoidance policies, negotiating appropriate terms in DTTs, and limited use of ineffective and expensive tax incentives.

Egypt’s international tax rules could strike a better balance between encouraging FDI and safeguarding domestic revenue. Some reforms could improve revenue performance, without creating adverse effects on investment:

• Phasing out the use of tax incentives in free zones. International evidence suggests that tax exemptions and tax holidays are often ineffective in attracting investors but carry significant fiscal costs.

• Adopting more effective anti-avoidance measures. Egypt should strengthen anti-avoidance rules regarding e.g. interest deductibility and the enforcement of transfer pricing rules.

• Reconsidering DTTs. While Egypt adopts withholding taxes on outgoing payments to protect against base erosion, several DTTs limit the right to levy withholding taxes and open opportunities for treaty shopping.

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Strengthening International Tax Rules for Development

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Source: The authorities

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Fiscal Incidence of Reforms and Social Protection

25. The authorities have strengthened social protection measures to mitigate the impact of reforms. The World Bank’s recent poverty impact analysis suggests that the welfare loss from recent energy price increase is around 5½ percent of household expenditure on average before any mitigating measures. The poorest households have been particularly impacted by the increase in LPG prices. Monthly food subsidies were more than doubled in 2017/18 from EGP21 to EG50 per beneficiary, which given their almost universal coverage broadly compensates these losses for the bottom 40 percent, and half of the losses for the third and fourth quintiles. The impact of reforms on household budgets has been mitigated further by expanding the coverage and increasing the benefits of the targeted cash transfer programs of Takafol and Karama⁵ which in combination with the other measures is likely to have fully compensated the negative effects of the reforms implemented in 2015/16-2016/17 for the beneficiaries of these programs. In addition, the impact of the reforms is mitigated for other households by raising tax credits for low incomes, granting wage bonuses of 7-10 percent to public sector employees, and increasing the social insurance pensions by 15 percent. Despite the significant progress made in reducing leakages by cleaning databases and moving to semi-cash transfers, the food subsidy program remains poorly targeted and inefficient. Improving targeting could free up resources and reduce poverty among the low and middle income groups.

Moving to Inflation Targeting

26. The authorities plan to adopt inflation targeting (IT) in the medium term. This will help achieve low and stable inflation and safeguard the central bank from assuming responsibilities outside its mandate. The discussions focused on the main intermediate steps for a smooth and predictable transition. To this end, the adoption of the flexible exchange rate regime was a critical step. In addition, Egypt needs to develop adequate institutional, operational, and governance structures that are essential for successful implementation of IT. Some of the key institutional pre-requisites include: (1) defining price stability as the primary objective of monetary policy; (2) enhancing flexibility of the exchange rate; (3) strengthening autonomy of the central bank; and (4) strengthening the financial stability framework consistent with independent monetary policy. The authorities and staff agreed that to support credibility of the new monetary policy framework the transition should take place after macroeconomic stabilization is entrenched and inflation is durably reduced to single digits. Meanwhile, the CBE’s efforts will be focused on building analytical capacity to forecast inflation, strengthening the liquidity management framework, developing money markets to improve monetary transmission, and developing an efficient communications’ strategy (see the Selected Issues Paper; MEFP ¶11).

B. Program Discussions

Monetary and Exchange Rate Policies

27. The current monetary policy stance is appropriately geared to reducing inflation. The mission and the authorities agreed that policy interest rates should not react to the favorable base effects, which are projected to reduce y-o-y inflation significantly in the coming months. Instead, the CBE will need focus on seasonally-adjusted monthly inflation trends, and consider gradual monetary easing only if inflation expectations and key macroeconomic indicators (GDP growth, the CA balance, credit, real interest rates, banking liquidity, real wage growth) consistently point to the absence of demand pressures and second-round effects (MEFP ¶5). The CBE will continue to strengthen its communication to inform the markets about its assessments of inflation expectations and macroeconomic developments, and send consistent signals about its objectives and policy decisions. It will continue to regularly publish its monetary policy reports.

Box 4.

Building Blocks for Modernizing the Monetary Policy Framework: Toward Inflation Targeting

Best Practice	Objective
Institutional Building Block
Price stability defined in the law as the primary objective of monetary policy.	The price stability objective takes precedence over all other objectives such as growth, employment, and the exchange rate, among others.
De-jure and de-facto independence of the central bank with matching levels of transparency and accountability.	Political, financial and operational autonomy of the central bank to ensure that policy rates serve the single objective. Independence, transparency and accountability are pillars of good governance.
Macro Financial Building Block
Clear separation between monetary and fiscal policies, while ensuring complementarity.	Curtail fiscal dominance and monetary financing of the fiscal deficit. A strong fiscal position to strengthen potency of monetary policy.
A flexible exchange rate regime.	The exchange rate does not constrain freedom of the central bank in setting interest rates. Inflation targeting is incompatible with a fixed exchange rate regime under free capital movements
Stable, sound, and deep financial sector.	Financial stability considerations do not influence monetary policy decisions.
Technical and Organizational Building Block
Effective liquidity management with a set of monetary policy instruments aligned with the level of money market development.	Ability of the central bank to effectively steer money market interest rates in the desired direction and minimize undue interest rate volatility
Forecasting and policy analysis systems	Strong analytical and forecasting capacity of the central bank to base its monetary policy decisions on sound economic judgement.
A well-defined organizational structure of the central bank and a clear decision-making process.	A rigorous process for monetary policy decisions which accounts for all relevant and available information.
Efficient communication of monetary policy objective and actions.	Anchor inflation expectations with a transparent communication strategy.

View Table

Best Practice	Objective
Institutional Building Block
Price stability defined in the law as the primary objective of monetary policy.	The price stability objective takes precedence over all other objectives such as growth, employment, and the exchange rate, among others.
De-jure and de-facto independence of the central bank with matching levels of transparency and accountability.	Political, financial and operational autonomy of the central bank to ensure that policy rates serve the single objective. Independence, transparency and accountability are pillars of good governance.
Macro Financial Building Block
Clear separation between monetary and fiscal policies, while ensuring complementarity.	Curtail fiscal dominance and monetary financing of the fiscal deficit. A strong fiscal position to strengthen potency of monetary policy.
A flexible exchange rate regime.	The exchange rate does not constrain freedom of the central bank in setting interest rates. Inflation targeting is incompatible with a fixed exchange rate regime under free capital movements
Stable, sound, and deep financial sector.	Financial stability considerations do not influence monetary policy decisions.
Technical and Organizational Building Block
Effective liquidity management with a set of monetary policy instruments aligned with the level of money market development.	Ability of the central bank to effectively steer money market interest rates in the desired direction and minimize undue interest rate volatility
Forecasting and policy analysis systems	Strong analytical and forecasting capacity of the central bank to base its monetary policy decisions on sound economic judgement.
A well-defined organizational structure of the central bank and a clear decision-making process.	A rigorous process for monetary policy decisions which accounts for all relevant and available information.
Efficient communication of monetary policy objective and actions.	Anchor inflation expectations with a transparent communication strategy.

28. Reserve money targeting under the program will rely on active liquidity management. The interest rate corridor and open market operations using deposit auctions will aim at containing banks’ excess reserves at levels consistent with the program’s monetary objectives. A joint Cash Coordination Committee will be established by end-March 2018 to improve collaboration between the CBE and the Ministry of Finance (MoF), and develop a comprehensive liquidity forecasting framework including capacity to analyze high frequency patterns of fiscal revenues, expenditures, and financing needs. Government overdrafts will be contained to the legal limits. CBE lending to banks will primarily serve short-term liquidity management needs, while the subsidized lending programs in support of SMEs and social housing programs will be capped (EGP45 billion for SMEs and EGP20 billion for social housing) and will not be expanded. Instead, to improve access to finance by these groups of borrowers, the MoF and the CBE will explore options for funding these initiatives from the budget. They will also develop microfinance to support lending to SMEs (MEFP ¶9).

29. The authorities will maintain and further enhance flexibility of the exchange rate.⁶ The floating of the pound in November 2016 was a critical step in resolving FX shortages in Egypt. It also serves as a buffer against external shocks and helps preserve competitiveness. The CBE plans to continue to refrain from interventions in the interbank FX market except to mitigate disorderly conditions. The mission and the authorities discussed the role of the repatriation mechanism, which in early days of the FX market liberalization served as a cushion for potentially disruptive short-term capital flows related to carry trade. The mechanism impedes the deepening of the interbank FX market, results in unwarranted injection of liquidity, and weakens monetary transmission. As the new exchange rate regime gained credibility and the convertibility risks dissipated, it was agreed that the usefulness of the repatriation mechanism may have run its course and its gradual and orderly winding down would strengthen the role of the policy rate as the main monetary policy tool. For this purpose, effective December 3, 2017 the CBE introduced a mandatory fee of 100 basis points for investors, who still wish to use the repatriation mechanism as insurance against the convertibility risk. The fee of 50 basis points for exercising the option of buying FX from the CBE at exit will remain in place. In parallel, to allow deepening of the interbank market and help it absorb greater FX inflows, the CBE increased the banks’ long net open position (NOP) limit to 10 percent from the previous 1 percent. The CBE will monitor market developments in the coming months and make further modifications to the repatriation mechanism, as needed.

30. The CBE’s international reserves are adequate to support macroeconomic stability, and the program’s NIR targets remain appropriate. The CBE’s official reserves reached $36 billion in October, or about 150 percent of the Fund’s ARA metric for floating regimes (Annex 3). It also has about $8.5 billion in deposits with local banks. To align the current reserve allocation with its new investment guidelines for reserve management, the CBE will reduce its FX deposits in foreign branches of the Egyptian banks to $4 billion by end-December, and to $3 billion by end-June 2018 (structural benchmark). These deposits will be eliminated by end-June 2019 (MEFP ¶10).

31. The authorities are undertaking a comprehensive review of the Law of the Central Bank and the Banking System. The current banking legislation needs to be aligned with the authorities’ medium-term objectives to adopt a forward-looking monetary policy framework with inflation as a nominal anchor. To assist in this endeavor, the authorities intend to request Fund technical assistance. Given the much broader coverage of the amendments than initially envisaged, they are requesting to modify the end-December structural benchmark and delay the submission of the draft law to Cabinet to end-June 2018 (structural benchmark). The mission supported this request (MEFP ¶12).

Financial Sector Policies

32. Depreciation of the pound and higher interest rates had a moderate impact on the capital adequacy, asset quality, and profitability of Egyptian banks. The aggregate capital adequacy ratio (CAR) improved from 14.1 percent in December 2016 to 14.5 in June 2017, helped by the CBE decision to allow banks to include current-year profits in the CAR calculation and prohibit dividend payments for all banks. The stock of nonperforming loans (NPLs) increased by only 2.3 percent in the first half of 2017, with the NPL ratio improving to 5.5 percent due to strong credit growth during this period. As of June 2017, bank profitability remained strong, with return on equity at 30.9 percent and return on assets at 2 percent. Despite a small decline in the banks’ high net interest margin, pre-provision income was supported by fees and commissions and higher loan volumes.

33. In the absence of new shocks loan quality is expected to remain sound. The main reasons include: (i) the CBE restrictions on FX lending to borrowers without sufficient FX revenues; (ii) the cash collateral requirement for import-related trade finance loans in the same currency; (iii) the focus of banks on multinational corporates, local blue chips, and wealthy retail clients; (iv) the relatively low debt levels of Egyptian corporates and households; (v) resilient revenues of large corporate borrowers in most sectors; and (vi) the generally favorable growth outlook.

34. The banking sector is resilient to moderate shocks. A bank-by-bank assessment suggests that capital and operating profits are sufficient to absorb possible loan impairments. Banks maintain solid liquidity buffers and execute active balance sheet management, to mitigate the interest rate and liquidity risks from large holdings of government securities. However, several smaller banks, whose capital adequacy, asset quality, and profitability are below the sector averages, remain vulnerable. Solvency pressures in these banks are often explained by the CBE’s stringent capital requirements for excessive loan concentrations. CBE supervision closely monitors implementation of these banks’ remediation plans. They do not pose significant risks to financial stability, considering their small market share. Going forward, the CBE will continue to enhance systemic risk oversight and prudential supervision.

35. The CBE is upgrading their early intervention and resolution frameworks. It is developing a new regulation with clear differentiation between the early intervention and resolution triggers, matrix of enforcement actions, and provisions of the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes). The authorities and staff agreed that implementation of the resolution framework required incorporation of the Key Attributes in the Law of the Central Bank and the Banking System, and that the use of public funds for systemic bank resolutions and public bank recapitalization should be transferred from the CBE to the MoF, once the budget gains further strength.

36. Staff recommended developing a clearly articulated and rules-based emergency liquidity (ELA) assistance framework that is consistent with independent monetary policy. The CBE should have full discretion over ELA provision to solvent and viable banks. ELA should be provided at penal rates on secured basis, with pre-defined ‘haircuts’ for eligible collateral classes. The CBE could only provide ELA to a systemic bank against the government guarantee, when solvency, viability, or collateral quality are in doubt. ELA provision should be accompanied with enhanced supervisory oversight and early intervention measures, if necessary. Staff recommended developing clear operational structures and workflows to ensure that conflicts of interest for ELA provision are avoided, and offered Fund technical assistance for operationalizing the ELA framework.

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Egypt: Financial Sector Trends

Citation: IMF Staff Country Reports 2018, 014; 10.5089/9781484338117.007.A001

Source: The Egyptians authorities.

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Fiscal Policy

37. Placing public debt on a clearly downward path will remain the program’s fiscal anchor. Egypt has limited fiscal space, reflecting the sizeable stock of debt and high gross financing needs. The authorities’ fiscal consolidation path aims to improve the primary balance by about 4 percent of GDP over the next two years, which in combination with strong growth in nominal GDP will reduce general government debt from 103 percent of GDP in 2016/17 to 87 percent of GDP in 2018/19. Beyond the program period, the authorities intend to maintain primary surpluses of about 2 percent of GDP to bring debt further down to about 72 percent of GDP by 2021/22. The updated DSA suggests that Egypt’s public debt is sustainable under program policies, but is subject to significant risks. A combination of policy slippages, reform slowdown, and a realization of contingent liabilities would undermine debt dynamics (Annex 1). To limit the potential for unanticipated increases in government debt from outside the budget sector, an indicative target on budget sector debt is proposed going forward.

38. The 2017/18 budget is facing significant risks. The shortfalls in the CBE profit transfer⁷ and dividends from public banks, net of compensatory measures, are estimated at 0.2 percent of GDP. In view of these shortfalls, the mission supports the authorities’ request to modify the primary surplus target and reduce it from 0.4 percent of GDP to 0.2 percent of GDP. Additional risks could come from higher oil prices, and possible revenue shortfalls and spending pressures in the run-up to the elections. Realization of these risks would require additional fiscal measures to preserve the targeted fiscal consolidation. The projections for the wage bill and fuel subsidies remain consistent with the program. The increase in food subsidies in 2017/18 of about 0.5 percent of GDP to mitigate the impact of the increase in energy prices will be covered from the contingency reserved in the budget. The interest bill will also be higher than budgeted by about 0.5 percent of GDP due to the rise in interest rates, resulting in an overall fiscal deficit of the budget sector of 9 percent of GDP. This is slightly weaker than programmed, but still constitutes a significant fiscal consolidation of 1.7 percent of GDP compared to 2016/17 (MEFP ¶14).

39. The ongoing energy subsidy reform will continue to play a key role in fiscal consolidation. The fuel subsidy bill has decreased from a peak of 5.9 percent of GDP in 2013/14 to 3.3 percent of GDP in 2016/17. It is expected to decline further to 2.4 percent of GDP in 2017/18. The price-to-cost ratios are estimated at 59 percent for gasoline and diesel, and 64 percent for other products as of end-June 2017. The authorities plan to eliminate all fuel subsidies (excluding LPG) by the end of the program. The Ministry of Petroleum and the MoF are planning to prepare follow-up recommendations for the automatic fuel price indexation. This will include the specification of a fuel product price formula, a rule determining the frequency and magnitude of price changes (such as caps or smoothing mechanism), and the institutional framework of price setting. The mechanism will be discussed with Fund staff and approved by the Prime Minister by end-February 2018 (structural benchmark). The authorities have committed to implement the next fuel price increase and the indexation mechanism by December 2018. The exact timing of implementing the indexation mechanism will be discussed at the time of the third program review. The authorities have also started to publish regularly the costs of fiscal subsidies in fuel products to create greater awareness of the drain on public resources (MEFP ¶18).

40. PFM reforms will remain an important priority. With the assistance of Fund TA, the authorities are planning to submit to Cabinet their first Fiscal Strategy Paper in December, which outlines the government’s medium-term fiscal objectives, and sets expenditure ceilings reflecting policy priorities. This paper should guide the preparation of the Budget Circular for the next fiscal year, including entity-specific spending limits and key assumptions for budgeting. The fiscal risks statement and the guidance note on broad principles governing issuance of new state guarantees will help manage and contain fiscal risks, especially those related to contingent liabilities. They also intend to improve management, transparency, and accountability to taxpayers of state-owned enterprises. To this end, the authorities intend to prepare and publish by end-December, 2018 a comprehensive report on public enterprises, which will include: a full list of the companies owned by the government, broken down by industry, policy objectives, and the ownership structure; their financial statements and indicators of financial performance; the governance structure; and their impact on government finances (MEFP ¶16).

Structural Reforms to Support Private Sector-led Growth

41. Strengthening competition and addressing corruption are key to achieving greater economic efficiency. Work is also advancing on modifying the Public Procurement law to ensure transparency. The new law is in Parliament and is expected to be approved by end-November 2018. A dedicated online portal for government procurement will be launched by December 2018. As part of the broader government policy to separate regulatory authorities from line ministries and improve the quality of service, by end-June 2018 the authorities are planning to create an independent regulator for public transportation (structural benchmark; MEFP ¶26).

42. Access to land continues to be one of the main hurdles for the private sector. At present, a limited amount of industrial land is offered by the government at a fixed price on a ‘first-come-first serve’ basis. The absence of a market mechanism for land distribution results in misallocation of this critical factor of production and foregone revenue for the state. Land allocation could benefit from a more open and transparent process. The authorities and staff agreed to review the current practice and to explore policy recommendations that would help improve allocational efficiency (MEFP ¶26).

43. There is a need to build on recent efforts to better integrate women in the labor force. The authorities have doubled the budget allocation for public nurseries and other facilities to support women from EGP250 million in 2016/17 to EGP500 million in 2017/18 (structural benchmark). They are also exploring ways to simplify registration of home nurseries, expand job opportunities for women, and child care for working mothers. In addition, the women’s council is working to identify measures that can address barriers to women participation in the labor force, and the authorities have engaged with UN Women to develop and implement gender budgeting (MEFP ¶26).

44. The authorities announced a five-year program to divest minority shares in select state-owned enterprises. The objective is to attract private investment, reduce the role of the state in the economy, and deploy public assets to their most productive use. Private ownership is expected to improve transparency and corporate governance, bring in know-how, and support economic development. The initial step is to sell shares in five or six viable state companies in banking and financial services, oil and gas, petrochemicals, building materials, and real estate. The divestment plan will be announced in January 2018 (structural benchmark) and the shares will be brought to the market by end-June 2019 (MEFP ¶26).

Financing and Program Issues

45. The program is financed through December 2018. This includes $1 billion from the World Banks’s third DPF, $500 million from the African Development Bank, $425 million from the G7, and $1.1 billion from international banks. The financing gap for the remaining period of the program is about $1.5 billion, and is expected to be covered from bilateral, gross reserves, and commercial sources.

46. The authorities request modifications of the quantitative performance criteria for the primary fiscal balance and NDA. The marginal reduction in the primary fiscal balance reflects a shortfall in the CBE profit transfer because of higher than expected sterilization costs and does not materially affect program objectives. The change in NDA is a result of reclassification of 7-day deposits from reserve money to NDA and has no policy implication. The change in the classification is reflected in the definitions of NDA and reserve money in the TMU.

47. The authorities have taken action that eliminated the multiple currency practice (MCP) maintained for non-BoP reasons, which was temporarily approved by the Fund until November 2017. A MCP was found to arise from the multiple price auction system established by the CBE, as the exchange rates for spot transactions in an auction could differ by more than two percent. This MCP was temporarily approved by the Fund until November 2017. In November 2017, the CBE introduced a mechanism eliminating this MCP. The multiple-price auction remains in place and the authorities have not used it since November 2016.

48. Egypt’s capacity to repay is adequate, but risks remain. Fund credit outstanding as a share of gross reserves is projected to peak at 39 percent by 2019/20, and debt service to the Fund as a ratio of exports of goods and services would reach 0.6 percent in the same year (Table 11). The CBE’s reserve position is strong, fiscal balances are improving, and the memorandum of understanding between the CBE and MoF on respective responsibilities for servicing Fund credit should ensure uninterrupted repayments.

Table 11.

Egypt: Capacity to Repay the Fund, 2015/16-2020/21 ^{1/ 2/}

Source: IMF staff calculations.

^1/Fiscal year starts on July 1 and ends on June 30.

^2/Assumes repurchases are made on obligations schedule.

^3/Debt service includes interest on the entire debt stock and amortization of medium- and long-term debt.

^4/Quota changed from 943.7 to 2037.1 millions SDRs effective as of February 2016

Table 11.

Egypt: Capacity to Repay the Fund, 2015/16-2020/21 ^{1/ 2/}

	2016/17	2017/18	2018/19	2019/20	2020/21	2021/22
			Projections
Fund repurchases and charges
Millions of SDRs	22.6	83.5	184.3	244.7	408.0	762.2
Repurchases	0.0	0.0	0.0	0.0	164.2	522.4
Charges and fees	22.6	83.5	184.3	244.7	243.9	239.8
Millions of US$	31.6	116.6	257.2	341.6	569.6	1,063.9
Percent of exports of goods and nonfactor services	0.1	0.3	0.5	0.7	1.0	1.7
Percent of total debt service 3/	0.0	0.1	0.2	0.3	0.5	0.8
Percent of quota	1.1	4.1	9.0	12.0	20.0	37.4
Percent of gross international reserves	0.1	0.3	0.8	1.1	1.7	3.2
Fund credit outstanding
Millions of SDRs	1,970	5,731	8,597	8,597	8,432	7,910
Millions of US$	2,750	8,000	12,000	12,000	11,771	11,042
Percent of exports of goods and nonfactor services	7.2	18.8	25.2	23.1	20.7	17.9
Percent of quota	96.7	281.3	422.0	422.0	413.9	388.3
Percent of gross international reserves	9.0	23.2	36.3	39.0	34.4	33.5
Memorandum items:
Exports of goods and nonfactor services (in millions of US$)	38,284	42,446	47,663	51,927	56,806	61,699
Debt service (in millions of US$)	90,703	90,584	106,780	114,545	121,371	125,871
Quota (in millions of SDRs, end of period) 4/	2,037.1	2,037.1	2,037.1	2,037.1	2,037.1	2,037.1
Quota (millions of US$ at eop exchange rate)	1,459.3	1,459.3	1,459.3	1,459.3	1,459.3	1,459.3
Gross international reserves (in millions of US$)	30,652	34,515	33,015	30,764	34,183	32,963

Source: IMF staff calculations.

^1/Fiscal year starts on July 1 and ends on June 30.

^2/Assumes repurchases are made on obligations schedule.

^3/Debt service includes interest on the entire debt stock and amortization of medium- and long-term debt.

^4/Quota changed from 943.7 to 2037.1 millions SDRs effective as of February 2016

View Table

Table 11.

Egypt: Capacity to Repay the Fund, 2015/16-2020/21 ^{1/ 2/}

	2016/17	2017/18	2018/19	2019/20	2020/21	2021/22
			Projections
Fund repurchases and charges
Millions of SDRs	22.6	83.5	184.3	244.7	408.0	762.2
Repurchases	0.0	0.0	0.0	0.0	164.2	522.4
Charges and fees	22.6	83.5	184.3	244.7	243.9	239.8
Millions of US$	31.6	116.6	257.2	341.6	569.6	1,063.9
Percent of exports of goods and nonfactor services	0.1	0.3	0.5	0.7	1.0	1.7
Percent of total debt service 3/	0.0	0.1	0.2	0.3	0.5	0.8
Percent of quota	1.1	4.1	9.0	12.0	20.0	37.4
Percent of gross international reserves	0.1	0.3	0.8	1.1	1.7	3.2
Fund credit outstanding
Millions of SDRs	1,970	5,731	8,597	8,597	8,432	7,910
Millions of US$	2,750	8,000	12,000	12,000	11,771	11,042
Percent of exports of goods and nonfactor services	7.2	18.8	25.2	23.1	20.7	17.9
Percent of quota	96.7	281.3	422.0	422.0	413.9	388.3
Percent of gross international reserves	9.0	23.2	36.3	39.0	34.4	33.5
Memorandum items:
Exports of goods and nonfactor services (in millions of US$)	38,284	42,446	47,663	51,927	56,806	61,699
Debt service (in millions of US$)	90,703	90,584	106,780	114,545	121,371	125,871
Quota (in millions of SDRs, end of period) 4/	2,037.1	2,037.1	2,037.1	2,037.1	2,037.1	2,037.1
Quota (millions of US$ at eop exchange rate)	1,459.3	1,459.3	1,459.3	1,459.3	1,459.3	1,459.3
Gross international reserves (in millions of US$)	30,652	34,515	33,015	30,764	34,183	32,963

Source: IMF staff calculations.

^1/Fiscal year starts on July 1 and ends on June 30.

^2/Assumes repurchases are made on obligations schedule.

^3/Debt service includes interest on the entire debt stock and amortization of medium- and long-term debt.

^4/Quota changed from 943.7 to 2037.1 millions SDRs effective as of February 2016

49. The authorities are addressing key recommendations of the safeguards assessment. The CBE adopted a new policy on the selection and appointment of the central bank’s external auditor, which will be effective starting with the 2018 audit. It will gradually phase out its FX deposits in foreign branches of the Egyptian banks over the program period. In addition, it is undertaking a review of the CBE Law. Staff is closely monitoring the implementation of other recommendations from the 2017 safeguards assessment.