Outlook for Egypt’s economy looks promising, but challenges remain

Program focuses on cutting budget deficit through gradual subsidies cut, tax reform, and floating the currency

EReport prepared by NBK

gypt has great potential, including an abundant labor force, a well-diversified economic base and an important geographic location that provides easy access to vital foreign markets. Yet, economic development was constrained by the legacy of a large role for the state in economic activity, weak governance and inward-oriented economic policies. This prevented Egypt from taking full advantage of the opportunities provided by globalization that helped lift living standards among many of its peers. To reverse these trends, the Egyptian economy has undergone major changes over the past couple of years, in the context of an ambitious economic reform program. Much progress has been made under the program, which ushers in a new era with great opportunities, but Egypt continues to face a host of economic challenges and vulnerabilities.

Legacy of Egypt’s Development Model

For decades, the Egyptian economy was characterized by its dependence on government subsidies and by a large public sector workforce, leaving little fiscal room for policies that would boost private sector activity and economic development. The dominant role of the state made government spending the primary driver of economic growth, which led to weak productivity growth and slow job creation.

Egypt’s growth in the last two decades has been insufficient to improve living standards and reduce poverty. Growth averaged 4.2% over 1990-2017, reaching an all-time high of 7.5% in 1997/98, but GDP per capita growth was modest at around 1.9%. The labor force stagnated at around 44% of the active population and the unemployment rate remained close to 10%, with much higher rates among women and the youth. Thus, while Egypt’s economy appeared to grow, inequalities and poverty were increasing. According to the World Bank, the national poverty rate has been creeping up, reaching 27.8% in 2015, compared to 26.3% in 2012 and 19.6% in 2004.

Due to a combination of political instability since 2011 and poor economic management, economic conditions deteriorated resulting in severe macroeconomic imbalances. GDP growth slowed to 3.3% during 201117, the exchange rate became overvalued, foreign exchange reserves dropped substantially, and fiscal deficits and public debt increased to record highs. These problems were also a manifestation of the weak economic governance over the past decades. The economic reform program Faced with dire economic conditions, the Egyptian government recognized the seriousness of the situation and adopted in late 2016 an ambitious and politically difficult economic reform program, supported by $12 billion loan from the IMF, with the aim of addressing macroeconomic vulnerabilities and promoting inclusive growth and job creation. The program involved mainly a gradual phasing out of state subsidies, a tax reform and the flotation of the Egyptian Pound (EGP). Besides recalibrating the economy, the difficult measures undertaken aim to attract foreign direct investment and to demonstrate to Egypt’s regional and international partners that the government is very much committed to the success of the adjustment program. Subsidy reforms Subsidies served as a key policy tool and a social safety net to support low-income households and maintain political stability. However, the subsidies were not well targeted, benefiting all regardless of their income and wealth and imposing a heavy burden on public finances. Rising international oil prices and growing domestic demand for energy products led to a dramatic increase in energy subsidies, reaching 22% of total government spending in 2011/12, compared with 9% a decade earlier.

With fuel subsidies being a major contributor to the increasing budget deficit, energy subsidy reform was a strategic priority for the government. In fact, Egypt started reforming its subsidy system slowly in 2012 by increasing gasoline prices and raising electricity prices in 2013. These reforms were not sufficient to reduce the fiscal deficit to a sustainable level. Therefore, the government adopted deeper reforms of public expenditure in July 2014, with the goal of reducing fuel subsidies to 0.5% of GDP by 2019 from 7% in 2013, through periodic rises of fuel and electricity prices. These price hikes, combined with lower global oil prices, have helped the Egyptian government lower spending on subsidies. More recently, energy and domestic water tariffs were increased by up to 50 % in August 2017. Moreover, the government tightened eligibility rules for food subsidy cards, and at the same time increased rations for remaining subsidy cardholders, in an effort to cushion the most vulnerable against soaring prices. However, the government partially reversed an earlier decision to lower subsidies on bread in March 2017, given that bread is a key food staple that directly affects millions of people.

In this context, it is possible to improve further the targeting of subsidies through the use of biometric data. India provides a good example. Like Egypt, India which has large population and high poverty rate was able to strengthen its social safety net and reduce inefficiency and corruption by adopting biometric data as a form of identification, and by creating a payment architecture based on the ID system to channel direct subsidies and benefits. Tax reforms: To reduce the large fiscal deficits and the debt-to-GDP ratio, the government had to resort not only to cutting spending but also to raising revenue. To this end, the government introduced a 14% value-added tax (replacing the 10% general sales tax) and a tax administration reform aimed at increasing tax revenues. While these steps are significant, the current tax system is still complex with multiple tax rates and tariffs, creating an uneven playing field. Egypt’s tax revenue is under 13% of GDP in 2016, which is still much lower than the average of its peers.

Egypt could still create more fiscal space through tax policy reforms and better tax administration, to invest in infrastructure, health, and education, as well as to build a sustainable social safety net. Floating the currency: The floating of the EGP in November 2016 entailed about 50%, depreciation, but was a critical step in resolving the shortage of foreign exchange and improving the economy competitiveness. This decision ended several months of tensions in the currency markets, which had fostered numerous restrictions on trade and financial transactions, and encouraged the development of a parallel exchange market. Moreover, it helped to narrow the current account deficit, with exports slightly increasing and imports moderating. There have also been improvements in foreign capital flows, as well as an increase in remittances and sharp increase in the number of tourists. However, the floating of the exchange rate combined with subsidies cut and tax reform pushed inflation to as high as 33% in July 2017. The impact of these measures started to wane and inflation started to come down although it edged up to 16% in September 2018 (from 14%) mainly on account of higher energy prices. Main achievements After several years of sluggish growth and weak economic performance, the Egyptian economy is showing signs of recovery, with growth reaching 5.3% in the fiscal year 2017/18, the fastest pace in a decade. Growth was supported mainly by a strong pick-up in government investment spending, an improved regulatory environment, an expansion of investment in the gas sector and a recovery in the tourism sector. As a result, unemployment rate fell to 9.9% in 2Q18 from 12% a year earlier, its lowest in eight years. In fiscal year 2018/19, despite higher oil prices and the recent decrease in appetite for emerging-market assets, economic growth is expected to increase further to reach about 5.5%. Egypt’s government is targeting a growth rate of 7.8%-8% by 2022, according to its economic reform program.

The tourism sector, a main driver of economic growth, staged a strong rebound thanks mainly to EGP float that made the country a relatively cheap destination for foreign visitors. Tourism revenues rose by 77% in the first half of 2018 to around $4.8 billion compared with the same period last year, due to an increase in the number of tourists by 41% to about 5 million during the same period. In addition, remittances from Egyptian expats increased by about $4.6 billion

(21.1%) during fiscal year 2017/2018, reaching a new record of about $26.5 billion compared to $21.9 billion in the previous fiscal year.

The external sector has also gained considerable strength since the depreciation of the EGP, supported by some export growth due to improved competitiveness as well as lower imports. The current account deficit in fiscal

year 2017/18 narrowed by 58.6% to $6 billion, falling to 2.5% of GDP from 6.1% of GDP ($14 billion) a year ago. The current account is projected to narrow further to about 2% of GDP in 2018/19. Larger capital inflows helped improve the overall balance of payments, which registered a surplus of more than $13 billion over the past couple of years.

FDI inflows were strong at $7.7 billion (3.2% of GDP) in the fiscal year 2017/18, driven by hydrocarbon investments, while portfolio investment declined recently, as emerging markets witnessed capital flight with some countries experiencing currency crisis (Turkey and Argentina).

As per inflation, the core inflation returned to single digits (8.6%) in September 2018, after reaching an alltime high of 35.26% in July of 2017. In 2018/19, headline Inflation is expected to stand around 14%, given that Egypt would continue to cut energy

subsidies to reduce government expenditures. While domestic inflation was tamed, imported inflation, mainly on account of high energy prices, could keep inflation relatively high.

Egypt’s fiscal position and debt dynamics have improved, driven mainly by the full year impact of the VAT increase, containment of the wage bill and cuts in energy subsidies. Indeed, the fiscal deficit narrowed from 12% of GDP in 2015/16 to 10.7% of GDP in 2016/17, and is estimated to reach 9.7% of GDP in 2017/18, while government debt is expected to reach 92% of GDP in the current fiscal year 2018-2019 down from 108% of GDP in 2016/2017. However, the high cost of debt service on account of higher global interest rates would potentially put pressure on fiscal deficits in the coming years, absent other compensatory measures.

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