What economic model is Egypt going to adopt?

Mohsin Khan, 8 November 2012

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The dramatic political developments since the Arab Spring have generated uncertainty and subsequent debate over the future of economic policies and economic reforms in the Arab world. This column asks:

  • Whether the political transition triggered by the Arab Spring will lead to a continuation of the market-oriented economic reforms that most Arab countries had embarked upon over the past decade.
  • Whether the more populist regimes that emerge will undo these reforms and adopt economic policies that cater primarily to the immediate demands of a restive public.
  • Whether countries will simply try to muddle through with some combination of reforms and populism.

Unfortunately, unlike the central and eastern European transition countries, Arab countries cannot aspire to the EU’s economic model. There is a distinct possibility that the Arab countries will seek their own economic model. However, it is not yet clear what this economic model would look like.

Egypt: Reform and good growth

Egypt is at the centre of this debate because it defines the Arab region: it is the bellwether country in the Middle East, it encompasses a quarter of the region’s population and has the Middle East’s largest non-oil GDP. During the last decade Egypt undertook an active program of economic reforms under the now-deposed President Hosni Mubarak. These reforms were in line with the so-called Washington Consensus (Williamson 1989). Thus, they included the removal of binding constraints on growth through restructuring the public and financial sectors; streamlining business regulations; enhancing trade liberalisation; and privatising state-owned enterprises and joint venture banks (cf. Enders 2007).

Effects of economic growth?

Many in Egypt believe that the benefits of these reforms failed to trickle down to the poorest Egyptians, instead leading to crony capitalism and corruption. Others – particularly in the Egyptian business sector – argue that more needs to be done. Further reform in taxation, banking, trade, and business regulations are deemed necessary if Egypt is to foster a healthy domestic and international investment climate that generates jobs1.

As a result of the reform efforts initiated in 2004, and coupled with a favourable external environment:

  • Egypt’s economic growth increased from 4.5% in 2004 to 7.2% in 2008.
  • Egypt was described by the IMF as an "emerging success story"
  • Egypt was listed as among the top performers in the World Bank’s "2010 Doing Business Report".
  • Growing at an average rate of 5% during 2008-10, Egypt also managed to largely withstand the impact of the global recession.

With recent rises in exports, larger amounts of workers’ remittances received from overseas, tourism revenues and Suez Canal receipts, as well large inflows of foreign direct investment and portfolio capital, Egypt’s foreign currency reserves also increased from $14.8 billion in 2004 to $36 billion in 2010.

Post-Arab Spring growth struggles

But the Egyptian economy is now struggling in the wake of the Arab Spring. Within the transitional military-appointed government, political issues were prioritised over economic considerations, so much so that:

  • In 2011, growth fell to 1.8% and inflation remained around 11%
  • The official unemployment rate was at its highest in ten years, reaching over 12%
  • The fiscal deficit increased to 8.6% of GDP just as the transitional government continued to finance populist measures such as increasing subsidies and public wages. Note that the government financed expenditures by borrowing from domestic banks.
  • The external current account deficit rose to nearly $5 billion – over 2% of GDP – while the trade account worsened and tourism collapsed. 
  • Capital fled the country and foreign direct investment dried up.

The result was a drastic fall in international reserves from $36 billion in December 2010 to $15 billion in September 2012, returning to the same level as 2004 (see Figure 1). Unhappily, the overall picture in 2012 looks no better under President Mohammed Morsy, elected as president in June 2012 in the country’s first democratic election. Indeed, the three major international credit rating agencies – Moody’s, Fitch, and Standard & Poor’s – have all downgraded Egypt’s sovereign credit rating2.

Figure 1. Egypt: International reserves

Creating employment

How can the new government address these issues in the short run so as to keep the people from returning to Tahrir Square? Creating jobs has to be the first priority. But these cannot be generated out of thin air.

Improving the education system to eliminate the skills mismatch between the types of college graduates produced by universities and the demands of the private sector is a long-run proposition. Promoting private business through infrastructure development and eliminating certain labour regulations so that businesses will hire more workers is similarly something that cannot be done overnight.

The only way to reduce unemployment in the short run would be through expanding government employment. This would reverse recent trends over the last few years towards shrinking the size of government. It is also very likely that such public employment schemes will result in a permanent increase in the government workforce. The good news is that increases in government employment has already begun: some 400,000 jobs have been created by the government in 2011-12 alone.

The other major move is to cut subsidies, which accounted for 10% of GDP and 27% of government expenditures in 2011. Fuel subsidies alone make up 48% of the total subsidies bill. Food subsidies must also be decreased because they distort the agricultural system and increase the budget deficit. Egypt continues to import wheat and is susceptible to volatile commodity prices. This volatility is reflected in food inflation that averaged nearly 19% in 2010-11. In the budget for 2012-13, the government has proposed reducing fuel subsidies by 25% – primarily subsidies provided to commercial enterprises – but it has, in fact, increased food subsidies by 8% over the previous year.

Conclusions

To address its problems, Egypt needs a coherent economic strategy and substantial external financing. An IMF program seems to be on the cards and it will provide Egyptians and the international community with evidence that the Egyptian government is putting its economic house in order, despite engaging in some populist measures to appease the public3. Discussions about financing reportedly suggest around $4.8 billion or higher to ease adjustment. At the same, such financing would provide a macroeconomic framework to help reduce inflation and reduce balance of payment pressures4. In the new program with Egypt, the IMF should give the highest priority to two issues:

  • First, the government has to rationalize the very costly subsidies scheme. Replacing the current subsidies scheme with a more targeted system directed at the truly needy, possibly through direct cash transfers or coupons, is essential to ensure long-term fiscal sustainability.
  • Second, the Central Bank of Egypt (CBE) has to let the exchange rate move in response to market pressures5. Keeping the Egyptian pound relatively stable since the beginning of 2011 has cost over a $20 billion loss of foreign exchange reserves.

Egypt has been a leader in the Middle East and its economic policies are often followed by other countries in the region. Naturally, there is high interest in the economic model that post-Mubarak Egypt will adopt. Will Egypt be a populist government-dominated economy that is unfriendly to business? Or will it be a market-oriented economy integrated with the world? With the help of the international community, Egypt will hopefully continue along its market-oriented route.

 

References

Enders, Klaus (2007), “Egypt—Searching for Binding Constraints on Growth”, IMF Working Paper WP/07/57, March.

Williamson, John (1989), “What Washington Means by Policy Reform”, in J. Williamson (ed.), Latin American Readjustment: How Much Has Happened, Washington, D.C, Peterson Institute for International Economics.

Frot, Emmanuel, Anders Olofsgård, and Maria Perrotta (2012), “Development effectiveness after the Arab Spring: Challenges ahead”, VoxEU.org, 26 October.

Gylfason, Thorvaldur, and Per Magnus Wijkman (2012), “Can the EU mobilise resources for peace in its neighbourhood?”, VoxEU.org, 4 November.


1 See Klaus Enders, “Egypt: Reforms Trigger Economic Growth,” International Monetary Fund Survey, February 13, 2008.

2 For more details on recent economic developments in Egypt, see Mohsin Khan and Svetlana Milbert, “Economic Policies in Egypt: Populism or Reforms?” Washington, DC: Atlantic Council, 2012.

3 Other incentives that can be provided by the international community for Egypt to stay on the reforms path include debt relief (see John Williamson and Mohsin Khan, “Debt Relief for Egypt?” Washington, D.C.: Peterson Institute for International Economics, 2011), and trade agreements (see Meredith Broadband, “The Role of FTA Negotiations in the Future of US-Egypt Relations,” Washington, D.C: Center for Strategic and International Studies, 2011).

4 For a discussion of the IMF Managing Director’s visit to Cairo, see Mohsin Khan, “Lagarde to Visit Egypt: Is an IMF Program in the Offing?” Washington, D.C.: Atlantic Council, August 15, 2012.

5 While the CBE maintains that it has followed a policy of “managed floating” since 2004, this is difficult to reconcile with the facts. Between 2004 and end-2010, the exchange rate appreciated by only 5.5 percent while international reserves rose by $21 billion. And since January 2011 to date, international reserves fell by over $20 billion and yet the Egyptian pound only depreciated by 3.5 percent with respect to the US dollar. It therefore remains to be seen how ready the CBE will be in allowing demand and supply factors to determine the rate. The track record is not too promising.

Topics: Development, Global crisis, Politics and economics
Tags: Africa, development, Egypt, growth, Middle East

Senior fellow in the Hariri Center for the Middle East, Atlantic Council

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