Democracy Lab

Egypt's Economy: The Downside to Growth

Mubarak may be gone, but his economic policies still haunt Egyptians.

Note: This article is an abridged version of an in-depth country study produced as part of the Prosperity Index project of the Legatum Institute. Complete versions of all 12 are available on the Institute website.

The Egyptian republic's economic course has been problematic, to say the least. Gamal Abdul Nasser's experiment with nationalization, central planning and Soviet-assisted industrialization left the economy hobbled by regulation and inefficiency. Anwar Sadat's successor regime relaxed the government's grip, but accumulated a mountain of foreign debt that caused stagnation through much of the 1980s.

But fortune favored the economy thereafter. Much of Egypt's external debt was forgiven or restructured in the wake of the Gulf War. And in the decade that followed, per capita GDP calculated in terms of purchasing power rose by one-third simply on the strength of containing both inflation and budget deficits.

Mubarak subsequently introduced major market-based reforms -- steps toward privatization and deregulation -- that permitted growth to accelerate to the 7 percent range. His technocrats also negotiated the global recession without a tumble, responding with a domestic stimulus (mostly infrastructure investment) that largely offset declines in private investment and exports. In the two years prior to the Arab Spring, the economy seemed to be back on the rapid development track.

However, in the years of high growth, though unemployment in the formal market rarely fell below 9 percent, youth unemployment hovered around 25 percent, and increasing numbers of college graduates never managed to get a first job. Moreover, the stimulus barely touched smaller enterprises, reinforcing the popular impression that the game was rigged in favor of insiders.

The revolution and lingering uncertainty during the transition exacted a huge toll on economic performance. The economy has since been creeping back, but at a pace hopelessly short of the 7 percent pace needed to absorb new entrants to the labor force.  And the prospects for acceleration are mixed.

The first economic challenge to the newly elected government is to reduce uncertainty about the viability of Egypt's finances. Before the revolution, the Ministry of Finance had targeted a gradual reduction in the overall fiscal deficit from 8.1 percent of GDP in 2009-10 to 3.5 percent of GDP by 2015 -- and thereby to decrease the public debt from 77 percent of GDP to 60 percent.

Government debt per se creates no immediate threat since relatively little of it is owed in currencies other than Egyptian pounds. But deficit reduction will almost certainly be a condition for much-needed support from the IMF. In any event, permitting the recent surge in deficit spending to continue for much longer would undermine the prospects for a return to rapid growth.

That's because government borrowing is absorbing much of Egypt's relatively meager domestic savings, crowding out private investment. Credit has been increasingly skewed towards support of the government and away from financing private activity.

The other side of the budget ledger matters, too, of course. As the economy recovers, there will be scope for raising revenue by widening the tax base, as well as by fighting corruption and tax evasion. One high-priority target is the revision of export contracts, particularly for natural gas, which would bring in billions in added revenues.

Then there's the issue of price and exchange rate stability. Egypt, like other relatively small open economies, must reconcile conflicting goals here. It needs an exchange rate that makes the country an attractive venue for foreign direct investment and a competitive source of goods and services for global trade. But Egypt is also a big importer of food and fuel, so both domestic inflation and government spending can be quite sensitive to depreciation in the exchange rate.

That explains why the Central Bank of Egypt (CBE) has been spending down its foreign currency reserves in the teeth of declining foreign investment, foreign tourism income, and Suez Canal receipts. But it also explains why the CBE has been of two minds on monetary policy.

Responding to the economic downturn, it cut minimum bank reserves to ease constraints on domestic liquidity in the face of surging government borrowing. However, the CBE has been reluctant to lower interest rates for fear of depressing the Egyptian pound's exchange rate, encouraging capital flight or creating expectations of higher inflation.

The new government will have little choice but to continue this juggling act. With foreign exchange reserves badly depleted, Egypt must secure credit from the IMF and other international lenders that follow in the IMF's wake. A tentative deal providing $4.8 billion contingent on budget reforms was announced on November 20, and another $10 billion in aid from other donors is likely to follow. This will give the CBE the resources to stabilize the exchange rate, and thereby to contain import-price inflation, until Egypt regains the confidence of investors.

While Mubarak's deregulation strategy paid off in terms of growth, it allowed corruption to fester: Egypt, ranked a wretched 112th among 183 countries on Transparency International's Corruption Perception Index in 2011. The most corrosive consequence of corruption -- and more generally, the failure to provide equal protection of economic rights -- is that it reduces social and economic mobility. Small- and medium-sized enterprises, the likely engines of mobility, face daunting barriers when they compete with the incumbent elite.

The list of impediments to free enterprise in Egypt is long. According to the World Bank, a business owner needs 218 days to obtain a construction permit. It takes seven procedures and 72 days to register property. Getting an electricity hookup averages seven procedures and 54 days, and costs four-and-a-half times the annual income of an average Egyptian. Moreover, despite substantial growth that made Egypt's industrial base globally competitive in key areas and raised the economy to what the World Bank calls "lower-middle income" status over the past two decades, the discrimination against small business only heightened.

Market reforms are thus a key to fixing what ails Egypt, increasing the potential rate of growth while opening the door to new entrepreneurs and creating jobs to absorb the burgeoning workforce. But such reform is an immensely difficult process in the face of elites that have little to gain and much to lose from change.

The mainstay of Egypt's efforts to deal with poverty is the array of food and fuel subsidies noted earlier. One problem with this approach is that it distorts consumer prices, creating incentives to waste food and fuel. But the most troubling aspect of the subsidies as now constituted is that most of the benefit goes to households and businesses that aren't really needy. Two-thirds of the cost of the subsidy system is linked to fuel. Yet, according to household surveys, less than 5 percent of the fuel subsidies aid the bottom-fifth of the income distribution.

Much the same can be said for food subsidies. Two-thirds of all households now have ration cards, and the bulk of the benefit is going to the middle class. Dumping the subsidies overnight (and replacing them with cash grants to the poor) would not be politically practical. I favor gradual replacement, focusing on the fuel subsidies, which cost more and matter less to the poor. And this is apparently the direction approved by the IMF. But it will be critical to link the phase-out to cash grants and/or in-kind support to the vulnerable.

While transfers must be part of any plan to cope with poverty, they shouldn't be viewed as a substitute for jobs. Restoration of Egypt's once-booming tourism industry, which is more labor-intensive than most modern industries, should thus be a top priority. But the key to job creation in the long-run is a flowering of small- and medium-sized enterprises that can make productive use of unskilled labor, as well as aiding mobility for middle-class entrepreneurs.

To that end, these firms need better access to credit. While subsidizing credit can be a slippery slope -- the costs are hard to contain, and the target group has a way of expanding -- some preferred access makes sense to offset the capital market's bias toward large-scale enterprise. This might take the form of direct business loans or credit guarantees through private banks. Moreover, the government cannot afford to give short shrift to rural areas, where the poverty is greatest and the exit to cities is creating social dislocation.

Consider, too, in this regard, the importance of bringing the large numbers of small businesses that find it too expensive to operate legally into the open. The astonishing size of this underground economy -- by one estimate, it accounts for 40 percent of all employment -- reflects the general difficulty of doing business in a climate of corruption and bureaucratic indifference. But until underground enterprises become part of the formal economy, they will not directly benefit from measures designed to make it easier to challenge entrenched producers.

While unemployment is a chronic problem for Egypt, its nature has changed considerably in the last few decades. It's no surprise that unemployment is exceptionally high  among the young (around 25 percent) -- high fertility rates in the 1990s guaranteed unmanageable labor force growth now. What is surprising is that young college graduates are faring no better than their less-educated peers.

One reason: As the government shed enterprises in the last decade, it ceased to be a reliable employer of last resort for college graduates. Another: Business owners traditionally give first priority in employment to relatives. But arguably the most important reason is that universities don't provide the skills that the rapidly evolving Egyptian private sector needs.

The main issue isn't underinvestment in tertiary education -- one-third of high school graduates go to university -- but the system's failure to make good use of the resources. The new government thus faces the difficult task of remaking a higher-education establishment built for a different era.

Egypt's recent economic history is punctuated by ironies. In particular, development proved to be profoundly destabilizing, dislocating millions of citizens in the rush to cities, raising the visibility of a detested new class of crony capitalists and creating expectations of mobility that were impossible to realize.

This problem is hardly unique to Egypt -- think China and India. But the Mubarak regime lacked the political legitimacy to survive it. The new government's task is to restore that sense of legitimacy without sacrificing the growth that has, in many ways, changed Egypt for the better. And one key to success will be to convince ordinary Egyptians that they have a real voice in the process. No easy task, indeed.

Photo by MARCO LONGARI/AFP/Getty Images

National Security

The Good, the Bad, and the Ugly

The revenge of the Soviet military.

If you think Russia's change of defense ministers last month had much to do with defense or military policy, think again. The previous and now humiliated defense minister, Anatoliy Serdyukov, was put and kept in place by President Vladimir Putin -- even when Putin was not technically president (during Dmitri Medvedev's placeholding presidency from 2008-2012). Putin put him there to break the organizational resistance of the Russian military and drag it kicking and screaming into the 21st century. His fall may affect whether the Russian military becomes a modern force, but the leadership shuffle was more about the precarious new insider situation in the Russian leadership.

Putin had previously used Serdyukov to bend the Russian tax service to his will. Although detractors referred scornfully to Serdyukov as a "furniture salesman" (he owned such a business in St. Petersburg before becoming a member of the Putin circle in part by marrying the daughter of Putin's close associate Viktor Zubkov), he was a loyal and adept manager. Having beaten the tax police into an efficient instrument of the Kremlin, Serdyukov was not a bad choice to shatter the dysfunctional organizational structure of the Soviet defense ministry -- and I mean Soviet, because that is what the Russian Ministry of Defense remained long after the U.S.S.R. was history.

The Soviet military had broken the back of the Nazi Wehrmacht and had held the United States to a frozen stalemate during the Cold War, but it long ago lost the ability to field an effective force. Organized around territorially-based divisions that were largely empty of soldiers day-to-day because the system relied on mobilizing reserves in times of need, the Russian army was a hollow force. Lots of generals and colonels populated military bases spread throughout Russia, but few of them had actual soldiers to command. Even worse, when constituted, this hollow force was barely mobile, had never learned to operate jointly among services, and was so dependent on direct orders from the top that local commanders at best relied upon inflexible battlefield set pieces, and at worst would have to call back to Moscow for instructions and authorization to cope with contemporary battlefield conditions.

To his credit, Putin recognized the problem and brought Serdyukov in to fix it. Resistance was fierce, but some Russian officers had been chastened by the military's near-disastrous performance against the much weaker Georgians in August 2008. So, with the help of the chief of the General Staff, Nikolai Makarov, Serdyukov eliminated the mass mobilization structure and the territorially-based divisions (a move that also required eliminating tens of thousands of senior officer positions responsible for commanding empty divisions in hundreds of ghost military installations across Russia, winning Serdyukov and Makarov the undying enmity of officers thus made redundant). Russia's new military structure is brigade-based and organized into four operational strategic commands designed to be able to respond more rapidly and flexibly.

This organizational reform was finished by about 2010, but to successfully implement a military doctrine that calls for a technologically advanced, joint, and professional force, the Ministry of Defense also needed to bring its personnel, education, logistics, and defense acquisition system into the 21st century. And it was here that Serdyukov really annoyed the Russian establishment by bringing in civilian officials (including women, if you can imagine) to change the way the military did business. By changing how business was done, Serdyukov changed how money was spent, and thus how corruption within the ministry and defense industries would be conducted. That is serious business in today's Russia.

Until stories began to appear about the shady dealings of Serdyukov and his civilian management team, all signs were that he had Putin's confidence and was implementing Putin's policies. Serdyukov had reportedly asked to be allowed to resign in spring 2012, but had been refused by Putin. And even as stories emerged in late October that the company Serdyukov had chosen to outsource logistics for the ministry was a front for the misappropriation of $100 million, Putin publicly affirmed Serdyukov's leadership as defense minister. Yet the embarrassing stories continued, and a raid on the apartment of one of Serdyukov's young female colleagues found...Serdyukov (along with jewelry and art reportedly worth millions). On November 6, Putin announced that he had dismissed Serdyukov because of the corruption investigation and appointed Sergei Shoigu, another reliable Putin enforcer who had headed the Ministry of Emergency Situations and recently become governor of the Moscow region.

So is this about corruption and cleaning up the Ministry of Defense so that money will no longer be stolen or diverted? Not really. It's more like Captain Renault being shocked (shocked!) to find that gambling has been going on, even as he is handed his winnings.

Or, to use an even better film analogy, think of the Russian political system as a giant Mexican standoff, where the antagonists are all holding pistols aimed at one another loaded with kompromat (a lovely Soviet short-form for "compromising material"). Everyone knows (and has evidence) that everyone else has been skimming money from government contracts and finances, and at any time anyone could be brought down by that information. The threat of revelation keeps everyone in line, and the risk of being the next target tends to prevent anyone from shooting first.

But if anyone steps out of line, they can be brought down -- as Mikhail Khodorkovsky was in 2003. Clearly, this is an unstable system: How does anyone know when it is safe to shoot? Part of the answer is that it is important to have a powerful protector, and the Russian press has been rife with speculation that Serdyukov lost his krysha ("roof" or protection) when his marriage to Zubkov's daughter fell apart (which has a convenient infidelity kompromat synergy).

So, the speculation in the Russian press goes, powerful players in the Russian leadership who did not like the financial implications of Serdyukov's changes to the defense business placed the stories and enabled the investigations that led to the shock (shock!) that corruption was bleeding funds from defense modernization efforts. Top contenders are Putin's chief of staff, Sergei Ivanov (Serdyukov's predecessor as defense minister, who was Most-Likely-to-Be-Tapped-as-Putin's-Successor in 2007, until Putin tapped Medvedev), and Deputy Prime Minister Dmitri Rogozin.* Both have responsibility for aspects of Russia's defense industry and military procurement and both had expressed doubts and even criticism of Serdyukov's efforts to buy defense technology (and even entire systems, including the French Mistral-class helicopter-carrier amphibious assault ship) from abroad, rather than sticking with under-performing Russian defense firms. When Putin returned as president, he announced an increase in Russian defense procurement -- to some $700 billion through 2020. Maybe that sounds like plenty to go around, but Serdyukov publicly stated that contracts would go to foreign firms if they could deliver technologically advanced systems that Russian defense enterprises could not.

With Serdyukov and his civilian management team out, and a more traditional defense minister (and new chief of the General Staff, General-Colonel Valeriy Gerasimov) in, things can get back to normal. While Shoigu and Gerasimov are not seen as particularly corrupt (to the contrary, they are generally viewed as highly professional and effective), their reversal of Serdyukov's management innovations benefits those who profited from the old way of doing things.

This explanation is fine as far as it goes, but in the Russian system, Serdyukov was too high-ranking to have been brought down by his equals (or subordinates). Serdyukov's protector was Putin himself -- the man who had put him at the Ministry of Defense and who affirmed on television that he would remain defense minister just days before Russian television exposed him at his reputed girlfriend's multi-million dollar apartment. In the Mexican standoff that is Russian elite politics, no one should have been willing to pull the trigger unless given the nod by the real protector -- and he had sent the message to stand down.

The unthinkable happened: one of Putin's men had to go because those below and around Putin sought to get rid of him, and they succeeded. When Serdyukov became a public liability, Putin dismissed him, and has since sought to cast the incident as the launch of an anticorruption campaign designed to ensure the success of Russian military modernization. But the sequence of events is not consistent with Putin as Master Puppeteer, and makes more sense as a case where Putin's hand was forced -- although he responded quickly and adroitly to assert control.

Far, far more serious than the shake-up's implications for Russia's military doctrine and modernization -- and they are serious, because it is unlikely that Shoigu will succeed by retaining Soviet-era management practices -- are its implications for the stability of the Putin regime and its reliance on clans, protection, corruption, and intimidation. The Serdyukov scandal is a hint that Putin is not in control, and that his political system has become vulnerable to fratricide. Russia's political class is now abuzz with talk of an anti-corruption campaign as a way for the leadership to reestablish legitimacy before a disaffected and newly-rebellious Russian public. What happens when the shooting starts? Maybe Putin is as good as Blondie, but that was just a three-person standoff. The Russian political terrain has changed, and it's a better bet that the other cowboys are walking around with loaded guns of their own.

* Correction: This article originally gave the wrong title for Sergei Ivanov.

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