Egypt's Economic Crisis: How to Help Cairo Help Itself - The Washington Institute for Near East Policy

The Washington Institute for Near Policy, by Michael Singh---rather long, but worth the read

Because Egypt's economic crisis has political roots, international donors cannot save the country by themselves. But they can use the IMF negotiations to help Cairo recognize that a turnaround will require not just economic reform, but more inclusive government and political reconciliation.

Just as Washington is contending with a spreading civil war in Syria and trying to head off a conflict with Iran, U.S. policymakers find themselves worrying about yet another looming contingency: economic collapse in Egypt. As Secretary of State John Kerry stated during his recent visit to Cairo, "It is important, even urgent, that the Egyptian economy gets stronger." The United States and its allies have several options for addressing this concern, but each requires a fuller understanding of the country's economic problems and how the Egyptian government has responded thus far.

IMMINENT COLLAPSE?

Since the January 2011 revolution, Egypt has been gripped by deepening stagflation: economic growth in the last three months of 2012 was a mere 2.2 percent according to official data, while inflation rose in February 2013 to an annualized rate of 8.7 percent, its highest level since 2010. This combination has placed mounting pressure on ordinary Egyptians, who face rising prices for basic goods (e.g., food, medicine) and increasing unemployment, which rose to 13 percent in the last quarter of 2012, up from 9.8 percent during the same period of 2010 -- which translates to an additional 850,000 jobless people.

These problems are largely driven by two factors. First and foremost is political instability, which has spurred capital flight and harmed domestic businesses. Second is the lack of flexibility in Cairo's fiscal and monetary policies, particularly its mounting budget deficits (a result of large food and fuel subsidies) and its efforts to defend the Egyptian pound against devaluation.

Political instability following the revolution, which has yet to abate, drove a massive outflow of foreign direct investment and portfolio investment; according to Egypt's Central Bank, these losses totaled $418.1 million and $3.3 billion, respectively, in the second half of 2011. This in turn encouraged Egyptians to convert their deposits into dollars and move money abroad, exacerbating the pressure on the pound.

The capital outflows have been accompanied by a sharp decline in tourism, another important source of foreign exchange. Egypt's Tourism Ministry has reported a "loss" of $2.5 billion in tourism revenue since January 2011 compared to typical pre-revolution levels, and the World Economic Forum recently -- and devastatingly -- ranked the country as one of the world's most dangerous destinations for tourists. These developments decreased demand for the pound, the value of which has declined from about 5.8 to the dollar in 2010 to a record low of 6.78 today (and reportedly 7.3 on the black market).

Eager to avoid an increase in the prices of key imports priced in dollars, the Central Bank moved to defend the pound's value, resulting in a staggering decline in Egypt's foreign exchange reserves from almost $37 billion before the revolution to about $13.5 billion today. Furthermore, about half of these reserves are in the form of gold, which is essentially illiquid because it is deposited in Egypt. This means that available reserves are sufficient to cover just over a month's worth of imports, which is critical given Egypt's need to purchase fuel and wheat on global markets and service its external debts.

Meanwhile, the government's post-revolution budget deficit and debt have increased at an accelerating rate as the pound's diminishing value and high global commodity prices drove up Cairo's subsidy bill (which accounts for at least 27 percent of all government spending). This was accompanied by increased spending on social benefits, a key demand of the revolution. Overall, subsidy and social benefit spending rose 49 percent from July 2012 to January 2013 compared to the same period the previous year; the budget deficit rose by 36 percent to $17.7 billion that period and is projected to increase to $27-34 billion by July. With Egypt's international credit rating repeatedly downgraded, the government has been forced to finance these enormous deficits by relying almost exclusively on domestic debt, which last year rose $34 billion to reach $184 billion, or almost 70 percent of gross domestic product. This has increased domestic borrowing costs, potentially crowding out private-sector borrowing that is vital to renewed economic growth.

Taken together, these developments paint a dire picture for Egyptians, especially if the government runs short of the foreign exchange required for food and fuel imports, resulting in shortages. According to Egypt's Ministry of Industry and Foreign Trade, food products represent about 17 percent of the country's imports, and oil products about 18 percent. From 2011 to 2012, these imports increased at least 10 and 28 percent, respectively. Egypt's wheat supply is reportedly already under pressure, reduced from six months' stock to three. The alternative -- ending the Central Bank's defense of the pound -- could mean a sharp drop in the currency's value, significant inflation, and even more pressure on the budget and the banks. Either way, Egypt faces the possibility of significant economic hardship and further social unrest.

For its part, the Egyptian government appears to be banking on a third scenario -- muddling through. President Muhammad Morsi's current policy amounts to reducing food and fuel imports, though not to crisis levels, while counting on stopgap assistance from friendly countries to prevent the Central Bank's foreign exchange reserves from reaching critical levels. Yet this policy cannot be sustained indefinitely; public anxiety about the pound is accelerating dollarization of deposits, and upcoming debt payments could combine with other factors to trigger a deeper crisis (similar to the $650 million Paris Club payment Cairo made in January, which caused a sharp drop in reserves).