A turbulent political transition: from hope … In February 2011, a youth-led movement toppled President Hosni Mubarak. A 30 year-dictatorship ended in 18 days. About 800 people died. As elsewhere is the Arab world, the popular uprising intended to subvert an élite-centric political and economic system. The military, led by commander-in-chief and defense minister Mohamed Tantawi, avoided large-scale bloodshed but did not impede Mubarak’s ousting. Headed by Tantawi, the Supreme Council of the Armed Forces (SCAF) managed the transition: it suspended the Constitution, dissolved Parliament, and announced “free and open parliamentary and presidential elections”. Between November 2011 and January 2012 parliamentary elections took place in three stages, in order to ensure the presence of a judge in each of the about 51,000 polling committees. The Islamists gained 70 percent of the seats. A previously marginalized Muslim Brotherhood (MB) won via its political arm, the Freedom and Justice Party (FJP). In March 2013, the parliament elected a 100-member Constituent Assembly (CA) to draft a new Constitution. In May 2012, a MB leading member, Mohammed Morsi, won the presidential elections at the second round, with a 51.9 percent turnout and 51.7 percent of the vote, to become the first Islamist head of state of the Arab world.
… to institutional quagmire. In April 2012, the Supreme Administrative Court (SAC) suspended the CA. In June 2012, the Supreme Constitutional Court (SCC) ruled the parliamentary elections invalid. The majority of the seats declared illegal were held by the MB. Next, the SCAF dissolved the lower house of parliament, the House of Representatives. As a result, the CA – supposedly suspended – bestowed legislative powers to the upper house, the Shura Council. Shortly after, Mursi rejected the SCAF decision and ordered the House of Representatives to reconvene. In July 2012, the SCC – backed at a later stage by the SAC – voided the President’s pronouncement. In August 2012, Morsi ordered Tantawi to retire. Granted budgetary autonomy, the military withdrew from politics. In November 2012, Morsi gave himself almost-unlimited powers by decree, de facto freeing his decisions from judicial oversight and making both the CA and the Shura Council immune from dissolution by Court order. Serious public demonstrations ensued. In December 2012, Morsi annulled his decree. The new Constitution – controversial about the role of Islam and personal freedoms – was passed in a referendum with a 32.9 percent turnout and 63.8 percent of the vote. In June 2013, the SCC declared both the CA and the Shura Council invalid, calling into question the legitimacy of both the Constitution and the upper house’s legislative activity to date.
An ongoing, chaotic power-struggle. In post-Mubarak’s Egypt, two forces battle for power through different means. The Islamists enjoy widespread support in rural areas, won the elections, and exercise a recently acquired authority. The secular opposition, mostly urban, fragmented, and less popular, remain influential in key State’s institutions such as the Courts and the Army, and tries to exert control through these. While this power-struggle unfolds, Egyptians grow frustrated by the lack of political cooperation, rising polarization, policy-paralysis, and – above all – the hardening economic conditions. Increasingly, Morsi and the MB are accused of “hijacking” the revolution and muscling aside critics, precisely the methods of Mubarak’s regime. State institutions, perceived as traditionally in favor of the élite, are losing popular support. Despite the non-Islamists’ little ability to mobilize the street, protests occasionally turn violent, although possibly overplayed by foreign media. The military remains on the sidelines, and is unlikely to reengage – unless instability were to markedly rise.
Upcoming elections: MB losing grounds, opposition lacks coordination. Parliamentary elections, originally scheduled for April 2013 were postponed to October. To ensure judicial supervision, the electoral process requires three months to unfold; the results are expected in December 2013. All Islamist parties confirmed their participation. The MB’s FJP is likely to win, despite growing popular disappointment. The Salafists – an orthodox Sunni movement, mostly represented by the Nour Party – captured a quarter of the votes in the last elections and are gaining popularity. The non-Islamist parties struggle to put forward a unified platform. Most of the opposition managed to unite in a National Salvation Front (NSF), and called for the formation of a new government. Yet, there are different views on how to handle the elections. While founding member Mohamed El-Baradei proposed a boycott, former presidential-candidate Amr Moussa called for the enforcement of transparency measures, such as monitoring by the European Union and the Carter Center. A civic movement – the “Rebel” campaign – intends to collect 15 million signatures and hold a mass protest on June 30, to withdraw confidence from Morsi and obtain early presidential elections.
Politics matters: dialogue needed but unlikely. As the composition of the next parliament is likely to remain unchanged, the government and the opposition need to collaborate in crafting a unifying national vision. Egypt needs credible leadership, political dialogue, a broad-based government with a clear mandate, and citizens’ consensus and support in order to implement a credible austerity plan, avoid unrest, and secure foreign aid.
The business climate is worsening. Since 2011, the country went through three heads of State, two Constitutions – one suspended, the other declared invalid -, two Parliament dissolutions and five finance ministers. Denouncing complicity with Mubarak’s regime, the government has reversed decade-old privatization deals, and imposed large tax bills retroactively. Many businessmen fled. Doing business is increasingly difficult and companies are struggling. Foreign investment has dried up. Political instability has led to a widening budget deficit, a series of credit downgrades, rapid Egyptian Pound (EGP) depreciation, a depletion of foreign reserves, a surge in bond yields and is keeping economic performance subdued.
A fragile economy, to muddle-through below-potential. Over the past 15 years, real GDP growth hovered around a long-term potential of 4.5 percent and never dipped below 1 percent year-on-year. The country’s gross national income per-capita – at USD 2,600 in 2011, about 5 percent of the United States’ USD 48,620 – implies a faster potential. Between 2006 and 2008 growth rose to about 7 percent, lifted by a government-led privatization and modernization program. In 2011 and 2012, during the transition from Mubarak’s rule, the economy stagnated at just over 1 percent – as tourists and investors fled. In 2013, growth is expected below 2 percent, negatively affected by political and institutional uncertainty, rising fragility of the country’s external position and sporadic unrest. The latest data confirm the slowdown: in July-December 2012 investments declined to 13 percent of GDP, in October-December 2012 growth slowed to 2.2 percent year-on-year and in January-April 2013 manufacturing contracted sharply. In April, headline PMI declined to 44.2 and data showed a weakening output, slumping new orders, and falling employment. In May, the 48.5 print kept signaling an ongoing contraction, lower orders and steady inflationary pressures. The stock exchange – the EGX 30, a weighted index of the 30 most capitalized and liquid stocks – has been extremely volatile in recent years, and is down about 10 percent year-to-date.
The ability to meet fiscal targets is deteriorating, Central Bank to the rescue. While tax revenues are weakened by below-potential growth, mandatory spending remains high. In 2013, public sector salaries constitute 30 percent of total spending, interest payments 30, and subsidies 21 – in total more than 80 percent of all public expenditures. In other words, the government’s budget deficit is structural, and high at about 10 percent of GDP; in June – by the end of the fiscal year – it is likely to approach 12 percent of GDP. The public debt is also high, at about 80 percent of GDP, and the Central Bank of Egypt (CBE) is increasingly funding it. In April 2013, the CBE net claims on the government rose to EGP 299 billion, an increase of EGP 76 billion since January.
The 2013/14 budget is too optimistic … The Ministry of Finance (MoF) recently submitted the fiscal year (FY) 2013/14 state budget to the Shura Council. The underpinning GDP growth forecast is optimistic, at 3.8 percent. Tax revenues are expected to reach EGP 497 billion, up 26 percent if compared to previous budget, and expenditures are expected to reach EGP 693 billion, an 18.6 percent increase. Officially, the budget deficit is expected at 9.6 percent of GDP. An energy subsidy reform aims at saving EGP 36.3 billion, mostly by rationing via smart-cards.
… and taxes are rising. In 2013, the Shura Council approved a progressive personal tax structure: annual income between EGP 5,000–30,000 is to be taxed at 10 percent; EGP 30,000–45,000 at 15 percent; EGP 45,000–250,000 at 20 percent; above EGP 250,000 at 25 percent; and above EGP 5 million at 30 percent – up from 20. It also set a flat corporate tax rate at 25 percent – a simplification from an original double rate of 20 percent for profits below EGP 10 million and 25 percent for profits in excess. The President approved a bill imposing a 20 percent tax on advertisements, a 0.4 percent tax on bank credit facilities, and a 0.1 percent tax on stock market transactions. The Real Estate Tax Authority – to generate additional EGP 2–3 billion in revenues – is starting to enforce property taxes on multiple-property owners for houses worth more than EGP 2 million. Single home owners are exempt. An increase in the sales tax rate – from 10 to 12.5 percent – is under review.
The sovereign credit rating was downgraded to “junk”. Since the revolution, the three major international rating agencies – Fitch, Moody’s and Standard & Poor’s (S&P) – downgraded the country’s credit sixteen times, on worries about the government’s ability to meet its financial targets and maintain social peace. All current ratings – on foreign, domestic, long-term and short-term debt – indicate a high risk of default with little chance of recovery. In January 2013, Fitch cut its sovereign rating from B+ to B. In March 2013, Moody’s moved from B3 to Caa1. In May, S&P cut from B- to CCC+. Fearing non-payment on the back of a deteriorating credit standing, most international oil companies have decreased their supplies to the country. Additional downgrades will add pressure on yields, which in turn will increase the already large financing costs of the state budget. In June 2013, investors’ concerns pushed the average yield on 91-day Treasury-bills to 13.9 percent and the average yield on 266-day Treasury-bills to 14.7 percent.
The Shura Council approved the Sukuk law. In April 2013, Morsi signed into law a bill allowing the government to issue Islamic debt instruments, or Sukuk. Yet, implementing regulations – essential to launch the instrument – still need to be issued. Proponents claim it may raise billions of dollars. To finance the Ain Shams railway project the government is inviting regional Islamic banks to underwrite its first Sukuk issue.
The BOP is fragile, the trade deficit is rising. The current account deficit, at about 7 billion USD in 2013, is mostly financed by reserve depletion. Yet, in April 2013, Suez Canal revenues declined by 6 percent year-on-year. In 2013, the trade deficit rose to 10 percent of GDP, lifted by sticky fuel and energy imports. To narrow the external deficit the country needs to increase domestic savings either by reducing the public budget deficit or by letting the currency depreciate, reducing imports. Yet, the budget deficit is widening and the central bank has introduced foreign currency restrictions in support of the EGP. In the past, large falls in the real effective exchange rate improved the sustainability of the current account. Today, a significant accumulation of foreign-exchange (FX) demand is starting to constrain imports. At a cost: foreign goods are either more expensive or unavailable (in public pharmacies, imported medicines are difficult to find), trade volumes are down, and foreign investment are in decline. The external debt – below 20 percent of GDP – is not at worrisome levels, but average debt maturity is getting shorter, and interest rates are rising.
Tourism is suffering. Up to before the revolution, tourism accounted for 13 percent of GDP and employed thousands of workers. In 2010, a record 14 million tourists visited Egypt. In 2011, arrivals plummeted to 9.5 million, and are expected at about 11 million in 2013. Today, the Egyptian Museum – located in Cairo’s Tahrir square, the focal point of the 2001-revolution – is almost empty. So are the Pyramids, the Valley of the Kings, nearly all Nile-cruises and most Read Sea resorts. The Egyptian Tourism Federation estimates hotel occupancy rates at 15 percent in Cairo, and below 5 percent in Luxor, the site of the Valley of the Kings.
Ongoing depreciation amongst FX shortages. For FY2013/14, the government’s official exchange rate is 7.3 EGP/USD. Yet, as FX inflows dwindle, demand for USD accumulates, and FX liquidity dries up, exchange-rate volatility has increased. The EGP depreciated by 3.6 percent in 2011, by 2.5 in 2012, and by more than 10 percent since January, to range between 7.5-7.8 EGP/USD. The CBE has imposed increasingly stringent exchange controls and started a system of FX-auctions, where it targets 6.9 EGP/USD. The corporate and retail sectors find increasingly difficult and expensive to secure their FX needs. Vodafone Egypt made public their struggle in paying suppliers for the equipment needed to upgrade its network. Brokers warn foreign investors of lack of FX when repatriating funds, which might lead to the exclusion of the MSCI Egypt Index from the MSCI Emerging Markets Index. As a result, a parallel black market emerged, where the EGP trades at nearly 8 EGP/USD.
Foreign-exchange reserves have shrunk. At around USD 36 billion before 2011, official foreign-currency reserves tumbled in March 2013 to about USD 14 billion – of which approximately USD10 billion were held in cash, just enough for 2 months of imports. On the back of the below-described inflows, reserves recovered to USD 16 billion in May 2013, and now cover less than 3 months of imports.
To avoid a balance-of-payments crisis, friendly governments are helping … Richer Arab countries are providing – via deposits and loans – hard currency to the CBE. Qatar deposited USD 3 billion to purchase 18-month Treasury-bonds at an interest rate of 3.0 percent. Lybia provided an interest-free credit for a year to purchase USD 2 billion in crude oil at international prices. Saudi Arabia and Turkey pledged approximately USD 1 billion each. Kuwait is expected to lend to the Ministry of Electricity EGP 1.1 billion, 35 percent of which to be allocated to the reform of the natural gas network. The Islamic Development Bank (IDB) plans to provide USD 920 million to finance infrastructure projects, of which USD 800 million for water pumping stations and the rest for an electricity generation plant in Damietta. The European Bank for Reconstruction and Development (EBRD) is likely to provide EUR 75 million for transportation projects. Short-term inflows could also be enhanced by a planned tender for Orascom Construction Industries (OCI) by its Dutch parent company. Such financial support buys time for the government but does little to address the basic structural problems of the economy.
… but not everybody is supportive: Russia rejected a recent request to lend USD 2 billion. The African Development Fund (ADF) – the concessional window of the African Development Bank (AFDB) – has frozen its lending until a convincing economic reform program is announced. Saudi Arabia requires political stability before disbursing a USD 200 million grant in support of small and medium enterprises.
Inflation is up, interest rate hikes to increase borrowing costs. Despite weak demand, inflation remains high and is likely to rise, expected at 9.5 percent in 2013, up from 8.6 percent in 2012. Depreciation has lifted inflation from less than 5 percent in December to 7.6 in March, up to 8.2 percent in May. Most firms are reporting rising input and output prices: the April PMI “input costs index” rose to 82 points, the “output price index” to 56 points; both showed signs of stabilization in May. The CBE Monetary Policy Committee (MPC), in charge of setting interest rates, raised them by 50bps in March. The overnight deposit rate, overnight lending rate, and discount rate were set at 9.75, 10.75, and 10.25 percent, respectively. Going forward, price pressures are likely to come from a widening budget deficit, its unconventional financing sources (i.e., increased reliance on CBE purchases of Treasury-bonds), currency depreciation and the ensuing rising input costs that firms are beginning to pass on to consumers. Were the CBE to further raise rates, the underlying causes of inflation would remain unaddressed and borrowing costs would increase. In 2014, consumer prices are expected to grow by 11.0 percent, and to further squeeze real incomes in a context of economic stagnation and high unemployment.
Unemployment is rising … In 2012, according to the official figures published by the Central Agency for Public Mobilization and Statistics (CAPMAS), the country population amounted to 84.3 million, and 23.6 million worked abroad. Between 2009 and 2012, the unemployment rate rose from 9.4 to 12.7 percent; 3.4 million citizens were unemployed. In 2012, working women were (only) 4.7 million, and female unemployment reached 24 percent. In 2013, the official jobless rate is likely to reach 13.5 percent. According to most analysts, however, actual unemployment might have already reached 20 percent. Youth unemployment, between 15 and 24 years of age, is higher, at over 25 percent – and reaches 42.7 for the 20-to-24 years old. Over the next decade, the working-age population is set to increase by around 1.5 percent per annum; every year, approximately half-million additional workers will enter the job market. However, given the current economic weakness, the creation of enough employment opportunities is unlikely – unless GDP growth were to accelerate to more than 3 percent.
… as well as poverty, especially in rural areas. As median incomes stagnate and food imports are made expensive by a depreciating currency, spending on food is becoming a bigger percentage of disposable income. On average, families spend 40 percent of their income in food, while the poor spend more than 50 percent. According to the 2011 Household Income, Expenditure and Consumption Survey (HIECS), between 2009 and 2011 the poverty rate increased from 21.6 to 25.2 percent. An additional 20 percent of the population lived just above the 2-USD-per day poverty line. During the same period, inequality remained constant at a 0.31 Gini coefficient, despite a decline in extreme poverty from 6.1 to 4.8 percent. Disparities between urban and rural areas – and between Lower and Upper Egypt – are significant. Rural areas host about half of the population, more than 78 percent of the poor and 80 percent of the extreme poor. In Upper Egypt, social indicators – such as health and literacy rates – fall behind national averages, and illiteracy among young women reaches 24 percent, twice the rates of young male.
Subsidies are large, inequitable and inefficient. Fuel and food subsidies account for around USD 20 billion per year. Almost half of the bill, USD 7.5 billion, is for diesel, which fuels most commercial transport and nearly all farms’ irrigation pumps. Due to insufficient private trade, the government imports a growing proportion of total diesel needs, paying world prices and officially selling at 0.16 USD per liter. On the regular market diesel is hard to find: widespread hoarding led to growing shortages, long queues and tensions at fueling stations. On the black market it can be found at double the official (but still below world) price: a liter of diesel or gasoline can costs 0.5-0.6 USD – versus approximately 1 USD in the US and 2 USD in the EU. Similarly, cooking gas is sold at 7 percent of its actual cost. Bread is also heavily subsidized: a loaf costs less than one cent of USD. Most of the poor depend on it, yet there are allegation that loafs are used to feed animals. Paradoxically, Egypt is the world’s largest importer of wheat, as the local harvest accounts for barely half of consumption. In 2013, given the low-level reached by government stocks, the General Authority for Supply Commodities (GASC) has increased imports.
Cutting subsidies is long overdue, but a political suicide. For more than a decade, the élite refrained from implementing a targeted system of social benefits. Today, aware of an already falling popularity, the government is reluctant to impose painful austerity ahead the elections. Originally planned for April 2013, some measures to reduce fuel subsidies were postponed. To support public finances without reducing subsidies the government keeps borrowing at steep rates from local banks and is hoping on the appeal of Sukuk bonds. To support the EGP it has sold reserves for almost USD 20 billions, borrowed more billions from foreign governments, and delayed payments to oil companies. To pay down public debts, the state oil monopoly is exporting more crude. Privatizations have been ruled out. The decisions taken so far are rather marginal for the country’s financial sustainability: the cabinet has raised fuel prices for selected industries, declared luxury cars unworthy of subsidized fuel, stated the intention to double import-duties on luxury goods, and promised to target subsidies while protecting the poorest.
Difficult decisions are needed, but unlikely, as the government is unwilling. Once the new parliament is elected, President Morsi requires political consensus and a strong government to implement a credible plan. Durable economic and financial reforms are needed to heal the economy, improve the business environment, spur growth, boost the tax base, make the external position more sustainable, and secure foreign aid. Also, the education system needs to be better linked to the labor market, as enterprise surveys show that workers’ skills do no match the needs of private businesses. Public spending needs to be better targeted, in order to meet the needs of the most vulnerable while reducing the national budget deficit. However, increased economic hardship will inevitably lead higher unemployment and to fresh rounds of civil unrest – which in turn would increase the government’s reluctance to implement the required reforms.
The International Monetary Fund (IMF) loan: not before the elections. Ongoing political tensions and the government’s current economic management are hampering the approval of a USD 4.8 billion IMF standby agreement. Negotiations may be prolonged and are unlikely to conclude until after parliamentary elections in October 2013. The IMF deal would provide both a financial backstop and an anchor for reforms, improve the credibility of policymaking and reduce overall borrowing costs. It would also likely unlock additional USD 15 billion in multilateral aid – of which USD 2 billion loan from the World Bank – mostly on concessional terms. As a result, the deal would increase confidence, trigger foreign banks’ and investors’ appetite and lead to renewed private capital inflows. If negotiations were to fail, the US might cancel a USD 260 million aid package.
Fixing politics is needed for the economy to blossom. The gap between the population’s aspirations and what policy-makers actually deliver is widening and cannot be addressed through repression, as in the past. Policy polarization needs to be resolved, as current economic trends are making increasingly urgent a compromise. However, the political transition is still incomplete, and needs time. Yet, without a broader-spectrum government, including secular-minded politicians and technocrats, the reforms needed to secure the IMF loan and kick-start the economy are unlikely.
What is next? Fundamentals and foreign-exchange inflows to support growth. Since the Mubarak’s departure the economy has muddled through, showing resilience. In 2011 and 2012, despite the post-revolution aftershocks, consumption levels have even increased. Indeed, fundamentals are uplifted by steady population, urbanization and consumption growth, and a strong informal sector estimated at about 35 percent of GDP. Remittances, oil exports, tourism, and Suez Canal receipts provide additional support and steady FX-income-streams. In other words, during difficult times the economy struggles – suffocated by inefficiencies and underinvestment, price controls, black markets and unemployment – but does not collapse. Between 2013 and 2017, in absence of reforms – essential to secure the IMF deal – growth is likely to stagnate below potential, between 3 and 4 percent. In the short-term, bilateral aid is likely to support the balance-of-payment, but a structural dependency on foreign capital will sooner or later end up in a crisis.
Base-case scenario – muddle-through – 60 percent probability. The most likely scenario assumes elections in October 2013, further policy fragmentation, a slow pace of reforms, and strenuous government’s efforts to uplift short-term international reserves through bilateral loans and deposits. Financing pressures are likely to remain elevated. Multilateral donor support could remain elusive and the IMF loan is likely to be delayed into 2014. Further polarization between the MB’s FJP and sections of the population will weaken the government’s ability to promote growth, deliver sustainable public finances, and respond to shocks. The currency is likely to steadily depreciate another 20 percent, to peak at about 8.0 EGP/USD, and average 7.5 EGP/USD in 2013. Such depreciation is unlikely to increase export competitiveness and reduce imports needs, improving the country’s external imbalances.
Bear-case scenario – crisis – 35 percent probability. In this scenario, elections are postponed to early 2014, and the IMF loan to the spring or summer of 2014. The economy could be hit by a self-reinforcing downward spiral, triggered by a lack of foreign-currency reserves and a balance of payment crisis. Rising sovereign spreads and accelerating capital outflows could bring about a sudden currency devaluation – to about 9.0 EGP/USD, and average 8.0 EGP/USD in 2013. Further money printing would push inflation above 10 percent. Slow growth, lack of reforms, weakening public finances and rising debt levels could result in a budgetary crisis. As a result, prices of basic food items would rise. The poor, the unemployed, and the young would suffer the most. The objectives of the revolution would be unmet, and street protests would ensue, bringing about further social and political instability.
Bull-case scenario – recovery – 5 percent probability. Past experiences show that if meaningful reforms are enacted, the economy picks up. Assuming elections in October 2013, an action-oriented government focused on managing fiscal and external financing needs, the announcement of a sustainable medium-term strategy, and an IMF deal by the end of the year, market and investor confidence could be quickly restored. Growth would recover and the international donor community would provide support. Under these conditions, the currency is likely to remain stable around 6.9 EGP/USD.
The world has seen this before: a recovery is possible. Before Egypt, other countries have gone through a drastic, systemic transformation in the midst of an unsupportive global context, social unrest, and financial instability. In the ‘90s, Eastern Europe, the Soviet Union, and Asia experienced an economic transition accompanied by political uncertainty and challenging market conditions. Often, the process started with a recession, falling real incomes, and high inflation; but once political compromise, structural reforms and fiscal discipline were enacted, most countries were able to successfully recover.
− In 1989, Romania ousted Ceauçescu and began its transition towards democracy and a market economy. For a decade living standards deteriorated, but then extensive reforms lifted the country’s economy.
− In 1991, the dissolution of the Soviet Union brought about the Russian Federation. Today, the Russian economy is amongst the eight largest in the world, and one of the largest global producers of oil and natural gas.
− After the 1997 Asian crisis, Indonesia toppled Suharto in 1998. Over the years, the government addressed its economic and political challenges, and reduced poverty. Today the country is the largest economy in Southeast Asia and a member of the G-20.
− After the 2001 financial crisis, Turkey was able to manage an orderly economic and political transition. Inflation and interest rates fell to single-digits, investor confidence and foreign investment soared, and unemployment stabilized. Today, Turkey is the world’s 17th largest country by nominal GDP.
− In 2004-2008, Brazil implemented reforms while investors were fleeing; it achieved sustained growth, reducing poverty and income inequality.
− Today, the Middle East and North Africa needs to follow these examples: hard choices are needed to boost inclusive growth and create employment. Egypt is no exception.