The Big Picture: Everything you need to know about Egypt’s IMF loan answered in nine questions
How did Egypt get into this economic mess?
Years of inefficient expenditure have led the government into accumulating an “uncomfortably high” public debt. Key factors that have played into this is Egypt’s long history of high expenditure on poorly-targeted energy subsidies, as well as a large wage bill for government employees that was not necessarily met with a rise in efficiency. According to official data, the government’s fiscal deficit had increased from 7–8 percent of GDP pre-revolution to 10–13 percent post-revolution.
The government, as a result, had no option but to borrow from the banking system.
But the more the government borrows from the banking system, the less money there is available to the private sector to borrow. The less money there is available to the private sector, the higher the cost of borrowing in the form of high interest rates. Private businesses, as a result, got crowded out. In Fiscal Year (FY) 2009/2010 (fiscal years end in June), the debt owed by the government (public debt) had reached 70% of GDP. In FY 2015/16, that number had risen to almost 95% of GDP.
The government decided that it needed to implement some serious reforms to decrease its debt. However, reforms such as planned increases in fuel prices, and the introduction of the capital gains tax and the value added tax were delayed.
Simultaneously, a foreign exchange crisis was brewing up as the Central Bank of Egypt’s (CBE) foreign reserves were gradually depleting. While the Egyptian government isn’t blameless, several external factors have to be taken into account as many of our major sources of foreign currency have been hit hard.
Global oil prices have fell sharply during the last couple of years, affecting the economies of GCC states, who we had strongly depended on for financial aid. The slump in oil prices has also had its effect on work remittances from Egyptians living abroad resulting in less foreign currency entering our financial system. After the 2011 revolution, our economy had found it increasingly difficult to attract foreign direct investment because of the instability of the region and resistance to real reforms. Moreover, the global economic slowdown took a major hit in the revenues attained from the Suez Canal.
Adding salt to the wound is the ever-deteriorating state of the tourism sector, which was once our main source of foreign currency. From sporadic terrorist attacks to planes being taken down to news of assassinations of foreigners, the sector has seen huge numbers of tourists flocking away from Egypt. Flight bans from Russia, the UK and Germany have ensued as well as numerous travel warnings from European countries. Between October 2015 and June 2016, tourism arrivals had declined by around 63.9%.
The shortage in foreign currency had placed immense pressure on the pound and the exchange rate. Importing businesses have found it increasingly difficult to source USD as the CBE had put limits on foreign exchange services. This led to numerous shortages in goods such as medication, baby formula, and sugar, among others. People had no choice but to resort to sourcing USD from the black market.
Moreover, the government’s utilization of a fixed exchange rate system led to an extremely overvalued pound. While delays from CBE officials in taking action and floating the pound exacerbated the problem even further. By the end of September of 2016, the official exchange rate was estimated to be overvalued by about 25 percent in real effective terms.
So, why resort to an IMF loan and do we have any other options?
It became clear to the government that we don’t just need money to fix our economy but we need serious reforms. While all the aforementioned financial woes are a cause for concern, perhaps the real gist of the problem is the loss of investor confidence in our economy.
That’s where the International Monetary Fund comes into the picture. While the IMF will provide Egypt with the necessary funding it needs to plug our financial gaps, taking part of an IMF-approved reform program is like receiving a certificate from a trusted watchdog telling the world “You can come here. We’re good!” That may just be what we need the most at this point, as the IMF program would pose as a catalyst to attract foreign investment into Egypt.
While there may be other sources of funding, the IMF program would give us both the money and the credibility we desperately need at this point.
What does the IMF program entail?
The program is built on four pillars: financing, policy reforms, inclusive growth and a social safety net for the most vulnerable in our society.
1. Fresh External Financing
The program came into effect in late November 2016, following months of back-to-back meetings with IMF officials. Full details on the terms and conditions of the loan were released in mid-January 2017.
The entire “Extended Fund Facility” is worth around USD 12 bn, which will be evenly distributed over a three-year period. The IMF has also confirmed that Egypt had already secured the full financing for the first year. The loan is expected to be re-paid over a 10-year period.
2. Policy Reforms:
a. Exchange Rate System:
In order to crackdown on the black market and rebuild international reserves, the days of an artificially overvalued currency had to end. On November 3, several days before the activation of the loan, CBE Governor Tarek Amer had ordered the floatation of the pound, checking off one of the key conditions needed to unlock financing from the IMF. The move shocked the market, with the CBE devaluing the exchange rate by 32.5 percent.
While the inflationary effects of the devaluation had resulted in a public outcry, adopting a flexible exchange rate system, where market forces determine the exchange rate, has numerous benefits.
The liberalization of the pound would attract foreign investment and build international reserves. Most importantly, it would improve Egypt’s competitiveness and support Egypt’s exports and tourism sector, as they are now relatively cheaper to outsiders. If the security situation is under control, it is expected that Russia and the U.K would lift the ban on travel to Egypt and the U.S. would mark Egypt as safe. In late January 2017, Germany had lifted its restrictions to flights to Sharm El Sheikh.
b. Fiscal Policy:
When it comes to fiscal policy, the government’s main target will be to control its public debt. By the end of the three-year program, public debt is expected to decrease by almost 10 percent of GDP.
The fiscal consolidation program includes clamping down on government expenditure. The energy sector will be completely reformed, with fuel subsidies to be gradually removed over the next five years. A day following the liberalization of the pound, fuel prices had already seen a hike. The government will also modernize the sector by restoring the financial stability of the state-owned Egyptian General Petroleum Corporation. Moreover, the public wage bill is projected to decline by nearly 1percent of GDP.
On the side of revenues, the introduction of new taxes such as the value-added tax (VAT), which finally replaced the general sales tax late last year, as well as the expected return of the capital gains tax will play big parts.
c. Monetary Policy:
As for monetary policy, the CBE’s main aim will be to contain inflation. Prior to the devaluation, inflation had reached 14 percent. However, the devaluation, VAT, and the energy subsidy reforms are expected to lead to the increase of average inflation to 18 percent in FY 2016/17 before coming down by mid-2017. The goal is to bring down inflation to mid-single digits in the medium-term. The CBE will also control the amount of credit it gives to the government and banks, in addition to managing liquidity and reserves.
3. Social Safety Net
There is no doubt that the previous reforms are currently at the utmost need, however, these austerity measures and the inflationary effects of reforms will likely have detrimental effects on the poor if not protected. The IMF program dictates that the government provide a social safety net to the most vulnerable tranche of society, which includes low-income groups and the elderly, by devoting around 1 percent of GDP out of the expected fiscal savings to additional food subsidies and cash transfers. This would be in addition to the already-active Takaful and Karama funding programs. The strength of the social safety net, however, depends heavily on the effective removal of poorly-targeted energy subsidies and revenues expected from the implementation of the VAT.
4. Inclusive Growth
In order to avoid falling into the same pitfalls again in the long-term, the program ensures that economic growth has to be inclusive and sustainable. Several structural reforms will be implemented to increase economic growth and reduce unemployment. The government will develop a collateral registry by end-March 2017 to help grant credit to small- and medium-sized enterprises (SMEs) in an effort to facilitate financing. A specialized youth-training program will also be introduced, as well as an action plan to promote exports.
Who do we owe the money to?
Around USD 35 bn is needed to ensure the success of the program, with half of that needed specifically just to replenish our reserves. While the IMF provides most of the funding for the program (USD 12 bn), it has been confirmed that China, the UAE, Germany, the U.K., France and Japan will provide extra funding.
Egypt will also be sourcing extra funds through the issuance of Eurobonds in the global bond market. As of late January, Egypt had raised USD 4 bn through the issuance, which, according to Finance Minister Amr El Garhy, covered the government’s FY2016–17 financial gap as well as part of that of FY2017–18.
Will we be able to pay it back?
Some experts and officials have complained that undertaking such a sizable loan could only leave us with more debt on our hands. The IMF had also said that Egypt’s capacity to repay the loan is “adequate, but there are significant risks.”
However, defaulting on an IMF loan is unlikely. In the IMF’s nearly 50-year history of giving loans, there had only been 30 cases of arrears, which is money that is owed and should have been paid earlier.
Moreover, the IMF would have never lent Egypt the funding if it did not have quantitative proof that it would be able to pay it back. The IMF had performed quantitative analysis on Egypt’s capacity to repay the loan as well as its debt sustainability, which both had been publicly included in its report on Egypt. The IMF is a stakeholder in this program, so if Egypt loses, the IMF will also lose.
According to the IMF, what will 2017 feel like?
There is no doubt that 2017 will be a tough year for both private businesses and individuals of every tranche of society. Inflation will continue to rise from around 10 percent in FY2015/16 to around 19 percent in FY 2017/18, where it will start falling by mid-2017, reaching 19 percent.
The VAT, which was introduced late last year at a standard rate of 13 percent, will see that rate rise to 14 percent by mid-2017. Moreover, Petroleum Minister Tarek El Molla had confirmed that fuel prices would continue to rise in 2017. The wage bill is expected to decline to 6.7 percent in FY 2016/17, so any increases in public wages will be scraped off the table.
The CBE will also lift the USD 100,000 limit on transfers abroad by individuals, as well as the USD 50,000 cap on cash deposits for importing non-priority goods, by June 30.
How will Egypt fare by the end of the program?
Overall, economic growth is expected to reach its potential of 5 to 6 percent in the medium term, while inflation is expected to decrease to mid-single digits. Public debt is set to decrease by 20 percent of GDP within five years, while tax revenues will increase by 2.5 percent by end of the program.
The government will increase the level of fuel costs its recovers to 100 percent in FY 2018/19, gradually removing most if not all fuel subsidies. Electricity subsidies will also be removed completely within the next five years.
Even though the capital gains tax is expected to be reinstated in May 2017, the government had recently announced that it would be postponing the capital gains tax for another three years.
What can go wrong?
While the program also emphasizes strengthening public financial management and fiscal transparency by conducting regular reviews of the operational performance of government authorities, inefficiency on the part of management poses the most risk to the success of the program. Lack of experience and training on part of economic authorities may cause the delay of the application of some taxes, resulting in a shortage in necessary revenues and increased expenditure.
Fiscal policy may also dominate over monetary policy if the government does not properly manage its finances, leading it to borrow from the CBE again. If that happens, we would be stuck in a vicious cycle of high debt, high interest rates and high inflation rates. Growth would stagnate and poverty and unemployment would increase.
Resistance to reforms from the people and the private sector also poses considerable risk. As austerity measures intensify, political and social instability may rise. This strongly depends on political authorities communicating the vision of the program clearly with the people, explaining the short-term difficulties that the country and its people have to go through in order to achieve long-term economic soundness. Cohesion between the people and the government has to be achieved.
Unpredictable external factors may also play a part in the form of a generally slow world economy, and instability in the region.
Is the IMF loan enough to fix the economy?
If all goes well, our financial woes are likely to be solved by the end of the program. However, it is of the utmost importance that the government should focus on inclusive and sustainable growth. Once the country’s economy is up on its feet, it would be time to focus on the real problems of our economy. A clear action plan and vision has to be prepared for these structural reforms.
We have a history of tending to think by just giving the youth money (in the form of SME financing and others), the unemployment problem would be solved. However, we need serious reforms to the education sector, where necessary entrepreneurship and vocational training is provided, in order to enable the youth to climb the social ladder or we risk the erosion of the middle class.