Egypt

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Highlights

• Continued political and security turmoil has led to a worsening of macroeconomic fundamentals. Growth has stagnated, inflation has reached double-digit levels and the country faces rising public debt and a worsening fiscal position.
  
• Some steps have been taken to reform energy subsidies. Over the past year fuel prices were increased for both industry and consumers. However, the current complexity of the political and security situation may constrain the government’s ability to implement much-needed reforms for restoring macroeconomic stability.
  
• Structural reforms have not progressed, owing to the protracted period of political transition. Economic policy-making and the undertaking of politically sensitive reforms have been undermined by domestic turmoil, lack of political consensus and the high turnover of governments.

Key priorities for 2014

• The principal and immediate challenges are to restore macroeconomic stability and confidence. Some degree of political stability is necessary for normal business activity to resume and for investor confidence to be restored. Building constituencies for these reforms will be the key to their success.
  
• Further reforms to the universal subsidy system are needed. Subsidies represent a substantial burden on the budget and are not well targeted, with only 13 per cent of subsidies reaching people in the bottom quintile income bracket.
  
• Reforms are needed in order to improve the business environment. Enforcement of contracts remains weak, regulatory functions and state operations are still not fully separated and better enforcement of competition policy is needed in order to ensure a level playing field for all businesses. The extensive bureaucratic process is burdensome and leads to substantive delays for all transaction types.

Macroeconomic performance

Adverse political and security developments have weighed on the economy. The army-backed ousting of Mohamed Morsi in July 2013 and the worsening security situation have disrupted business activity and weakened investor confidence. Real GDP growth slowed to an average of 2.6 per cent in the second half of the 2012-13 fiscal year (which runs from July to June), down from 4.3 per cent in the same period last year. This economic performance falls well below the estimated growth rate of 6-7 per cent that Egypt needs to achieve in order to keep the unemployment rate stable. Unemployment has risen by more than 4 percentage points since 2010 to reach 13.2 per cent in the third quarter of the 2012-13 fiscal year.

Pressures remain high on Egypt’s fiscal deficit and balance of payments. The fiscal deficit widened to 14 per cent of GDP in the 2012-13 fiscal year, which was up from 10.7 per cent in the 2011-12 fiscal year, largely on the back of increases in public sector wages and higher interest payments, and at the expense of much-needed public investment. Spending on food subsidies increased, as the depreciating currency pushed up import costs. In August 2013 the government announced plans to reschedule its energy debts, preparing a timetable for repaying arrears on debts owed to foreign oil companies. The government has continued to rely heavily on domestic borrowing at a high cost, increasing banks’ exposure to sovereign credit risk and significantly crowding out private sector credit. Meanwhile, pressures on the balance of payments remain elevated, on the back of weak tourism and Suez Canal receipts, along with meagre foreign direct investment flows and continued portfolio outflows, albeit at a slower pace compared with 2011.

The authorities announced a combination of monetary easing and fiscal stimulus in response to worsening economic conditions. These measures were made possible by a massive US$ 12 billion financial support package from the Gulf countries. In August 2013 the government announced US$ 3.2 billion of spending on investment projects, which was further increased in October 2013 to US$ 4.3 billion, equivalent to 1.6 per cent of GDP. In parallel, in August and September the Central Bank of Egypt made successive cuts to its main policy rates by a cumulative 100 basis points, in an effort to boost economic growth, while announcing that the downside risks to the economic outlook outweighed the upside risk to inflation. Inflation reached a two-year high of 10 per cent in September, mostly on account of increasing food prices, and partly reflecting earlier currency depreciation. However, inflationary pressures could ease given the recent exchange rate stability brought about by the financial assistance provided by the Gulf countries, which has helped to bolster reserves.

Egypt’s growth outlook hinges on restoring macroeconomic stability. In the short term, the US$ 12 billion financial assistance package from the Gulf countries will give the government some breathing space as it grapples with the deteriorating economic situation. Nevertheless, it is likely that the current complexity of the political and security situation will constrain the government’s ability to implement much-needed reforms. In addition, Egypt’s sovereign credit rating was repeatedly downgraded this year by all three credit rating agencies (with the latest downgrade being in July 2013) in response to deteriorating fiscal metrics and political uncertainty, which is likely to keep investor confidence depressed.

Major structural reform developments

Structural reform has not progressed over the past year, owing to the protracted period of political transition. Economic policy-making has been undermined by the political turmoil and the high turnover of governments. Successive governments have not been able to commit to a coherent economic vision for the country. It remains difficult to implement politically sensitive reforms. A degree of political consensus is required that has so far remained elusive. Some fiscal reforms have been undertaken, such as an easing of some fuel subsidies and the approval of a new income tax law, but more efforts are needed to address the structural nature of the country’s large and growing fiscal imbalances.

Continued economic policy uncertainty poses a serious impediment to the business environment. Egypt ranked one hundred and twenty-eighth of 189 countries in the World Bank 2014 Doing Business report, as the business environment is hindered by the difficulties encountered in enforcing contracts, dealing with construction permits and paying taxes. Enforcement of contracts remains weak, as judicial procedures tend to be long and costly, and often subject to political pressure. Additionally, the cost of doing business in Egypt has increased as the corporate income tax rate has risen by 5 per cent to 25 per cent in 2013. In many sectors, large reform gaps persist, and regulatory functions and state operations are not fully separated. Competition policy needs to be reinforced in order to level the playing field for all businesses. The Competition Authority is not fully independent, and the extent of its enforcement authority and mechanisms is unclear. The extensive bureaucratic process is burdensome, posing a major issue for investors, who are faced with substantial delays for all types of transactions. However, the authorities have taken some steps towards improving the investment climate and attracting foreign capital. For example, towards the end of 2012, among a series of measures to make public-private partnerships (PPPs) more attractive to investors, Egypt amended the rules governing PPPs to allow for disputes to be resolved through arbitration rather than through Egyptian courts.

Steps have been taken to reform the energy subsidy system. Some energy prices have been increased since the end of 2012. In particular, fuel prices for heavy industry have been raised, along with a 50 per cent increase in the price of natural gas. Additional measures aim to bring fuel prices in line with international levels within three years. The main industries affected by the increases are those producing cement and bricks, with exemptions for power stations and food manufacturers. Subsidies for 95-octane petrol were removed, and the price of subsidised cooking gas was raised in April 2013 for the first time in two decades. However, plans for further energy subsidy reforms have not materialised. A smart card system for purchasing subsidised fuel, which was due to be launched in July 2013, has been postponed.

Despite modest improvements in the infrastructure sector, key challenges remain. Although it is relatively better developed than its peers, the infrastructure sector in Egypt is in urgent need of investment and upgrading to provide better access and improve quality. Nevertheless, foreign and domestic investment is still impeded by an uncertain political environment, a lack of widespread financing solutions (especially at the municipal level) and by tariffs that are too low to recover costs, especially in the utilities sector. The transport and power sectors remain heavily state-dominated and highly subsidised.

Competition in the telecommunications sector has improved marginally. In December 2012 the National Telecommunications Regulatory Authority approved the issue of a fourth mobile services licence for the state-controlled incumbent (Telecom Egypt), which will not acquire any frequencies but will be permitted to lease and resell capacity from the three other mobile operators. This will allow Telecom Egypt to diversify its product range to include mobile services and to ease the pressure from declining fixed line subscriptions. This comes in the context of a broader plan by the government to strengthen competition within the sector. Although a date has yet to be set, it is expected that the unified licence will be extended to the other three: Etisalat Egypt, Mobinil and Vodafone Egypt.

There is a growing need for deeper financial intermediation. While the banking sector in Egypt is relatively developed compared with those of its peers, the past year saw a deterioration in asset quality in Egyptian banks, as their purchases of government securities increased sharply, raising their sovereign exposures and leading to repeated downgrades of their credit ratings. The knock-on impact of this has been to crowd out lending to the private sector. Expanding access to finance for wider segments of the population, in particular micro, small and medium-sized enterprises (MSMEs), is one of the key challenges in the reform of the financial sector, in addition to deepening financial intermediation. Poorly developed credit bureaus and weak contract enforcement are among the principal obstacles to the further development of MSME finance. In January 2013 the Egyptian Cabinet approved a new draft law for the issue of Islamic bonds, or sukuk, which was approved by the Shura Council in May. The Ministry of Finance expects that this new financial instrument, which is intended for use in financing both private and public projects, will help to attract new investment to Egypt.

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