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

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