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Sep 27, 2012 | 10:00 GMT

Egypt's Worsening Economic Outlook

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Summary

In the wake of the Egypt's 2011 revolution, the country is facing an increasingly unstable economic environment. Foreign lending has dried up, forcing Egypt to use its dwindling foreign reserves to stabilize its currency while relying almost entirely on the domestic financial sector to fund the government's budget deficit. Although some foreign aid has been promised, Egypt's attempt to secure lending from the International Monetary Fund is key. In exchange for support, the IMF would likely require complex domestic reforms involving subsidy cuts or currency devaluation.

Egypt is already facing serious political challenges, with sporadic outbursts of social unrest threatening the fledgling administration of Egyptian President Mohammed Morsi. Policy changes that increase living costs could trigger further turmoil. However, an IMF loan would help defuse investor concerns and restore Egypt's access to international capital markets. In the meantime, depending on the pace of IMF negotiations, Cairo may need to allow the Egyptian pound to devalue anyway in order to preserve the central bank's foreign reserves.

The Egyptian government expects to run a budget deficit of $30 billion in 2012. The bulk of government spending is tied up in subsidies, which take up about a third of the budget, and public employee wages. The government subsidizes a host of staples, such as cooking fuel and bread, but energy assistance — primarily for petroleum products and electricity — is the largest outlay. An estimated 8.7 percent of Egypt's gross domestic product and about 27.3 percent of the government budget is spent on these subsidies, according to the Egyptian Ministry of Finance. 

Egypt's Trade Balance

The government currently owes private fuel suppliers some $3 billion, according to a Reuters report citing unnamed sources. The delay in payments, which is due in part to suppliers' unwillingness to sell fuel on credit to Egypt, has caused fuel shortages and price spikes. In response, the government has offered fuel ration cards to drivers. Egypt's total import bill for petroleum products is also rising and outpacing crude oil export revenue. These sorts of rising costs inflate the country's overall trade deficit, which climbed to $3.7 billion per month in March 2012 — a 117 percent increase since January 2009. Revenue from service sectors such as tourism is also declining, worsening the overall balance of trade in goods and services.

Subsidies create dependencies on expensive foreign commodities by keeping prices low and stimulating demand. Cutting subsidies could therefore reduce the budget deficit while also shrinking the trade deficit. However, curtailing funding for fuel and bread would risk exacerbating the already volatile social environment in Egypt. This means Cairo can make only slow, moderate changes to its budget.

Egypt's Balance of Payments

Egypt's budget deficits and dwindling foreign reserves are being exacerbated by the country's negative balance of payments — the combination of its current account (trade in goods and services, plus transfers) with its capital and financial accounts. Historically, Egypt has been able to afford a trade deficit thanks to strong flows of international funding such as foreign aid and financial investment. But since the first quarter of 2011, Egypt's capital and financial accounts — as well as its current account — have been negative, causing some $4 billion to exit the country's economy per quarter. Several factors have contributed to this dynamic, including the rising import bill for petroleum products. But the primary cause is the loss of some $2.2 billion per quarter of financial investments that has occurred since investors lost confidence in Egypt's political stability in early 2011.

Devaluation Risks and Benefits

Egypt's central bank has typically defended the Egyptian pound against the effects of capital flight by tightly restricting its value compared to the U.S. dollar. Between the first quarter of 2010 and the second quarter of 2011, the pound lost 9 percent of its value against the U.S. dollar. Since then, it has devalued by only 1 percent despite Egypt's negative balance of payments. However, the bank currently holds $15 billion in foreign reserves — a number equivalent to roughly half of the budget deficit and enough to cover imports for about three months — down from nearly $21 billion in December 2010.

Ultimately, Egypt may be forced to consider devaluating its currency. Such a move would have a similar political impact to subsidy cuts — it too would make imports more expensive for Egyptians. The move would also put pressure on government finances already committed to subsidizing imported goods. Still, devaluation would help the central bank conserve foreign reserves by reducing what it spends on stabilizing the impact of the capital outflows — without immediately fixing Egypt's underlying structural challenges. This would not immediately fix Egypt's underlying structural challenges, but if done in a controlled manner, devaluation could help slow consumer demand and lower Egypt's reliance on foreign imports.

Moreover, while foreign aid will allow the bank to continue to stabilize the currency in the short term, substantial risks would remain. A sudden loss in investor confidence, a sharp decline in central bank reserves or a bout of social unrest — or some mix of the three — could force a sudden devaluation, regardless of the political consequences.

External Aid to the Rescue

In recognition of Egypt's challenges, offers of foreign aid have been pouring in — especially from other Middle Eastern countries. Qatar has promised to grant $2 billion to Egypt's central bank and invest $18 billion in the country over a five-year period (including $400 million to rejuvenate a stalled $3.7 billion oil refinery project outside Cairo). Saudi Arabia has pledged $4 billion in grants in addition to a $750 million line of credit to finance bilateral trade (primarily in petroleum products). Turkey has also promised $2 billion in aid. So far, of the promised funds, Egypt has received $1.5 billion from Saudi Arabia and $500 million from Qatar.

Beyond the Middle East, Morsi has been courting investment from China and urging the United States to renew $1.5 billion in annual military and social aid. Though relations with Washington have been complicated by the recent protests at the U.S. Embassy in Cairo, the United States is also considering forgiving $1 billion of Egypt's debt.

Most important are Egypt's negotiations with the IMF over a possible $4.8 billion loan. The organization is working with Cairo to establish an economic plan and, according to IMF officials, the two parties hope to reach an agreement by the end of the year. According to Egyptian officials, Morsi would then consult various sectors of Egyptian society about the plan in a sort of unofficial approval process. Any IMF plan would require Egypt to adopt more conservative fiscal policies, but the boost to international confidence in Egypt provided by the loan would be considerable. At that point, it might be possible for Egypt to use international lending to reconcile its short-term political pressures with its long-term budget needs.

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