Egypt
Tip of the Iceberg
January 09, 2007

By Serhan Cevik | London

The rise in consumer price inflation is just the tip of a greater threat, in our view. According to the latest official figures, the consumer price index increased at an annual rate of 12.2% in November, up sharply from 3.2% at the end of 2005. Although the sudden rise in inflation is partly a result of one-off factors (such as the reduction in fuel subsidies and a supply shock in meat prices) that should gradually ease in the coming months, we must not overlook the role of macroeconomic imbalances in shaping the behaviour of inflation. In our view, loose monetary and fiscal policies are the real reason behind overheating of the economy and the resulting shift in underlying inflation (see The Dangers of Overheating, December 14, 2004). Unfortunately, we believe that the Central Bank of Egypt’s response so far — a 75bp increase in overnight deposit and lending rates — is not enough to correct negative real interest rates, curb demand pressures in the economy and bring inflation within the ‘price stability’ range. However, even though further tightening of the monetary policy stance is necessary, in our view, it would not deal with the underlying source of inflation — fiscal imbalances.

The extent of fiscal correction is inadequate to address fundamental weaknesses. Above-trend growth, soaring privatization revenues and the settlement of tax arrears helped to lower the general government budget deficit from 9.1% of GDP in the 2005 fiscal year to 8.6% in 2006. This may sound encouraging, but we believe that the extent and composition of fiscal correction is insufficient to address structural problems in the public sector. Even with the gradual reduction in fuel subsidies, government expenditures kept growing from 30.5% of GDP in 2003 to 33.5% last year. As a result, despite strong economic growth, the primary budget balance, excluding interest payments, stood at 3.3% of GDP. This is why the government’s proposal to reduce the overall budget deficit by 1 percentage point a year is not enough to improve debt dynamics and support the central bank’s ambitious plan to adopt inflation targeting, in our view.

Net public debt increased from 47.4% of GDP in 2000 to 70.5% last year. One of the best measures of credit quality and sustainable growth is the debt/GDP ratio. Regrettably, Egypt has a disappointing score on this front, with the marked increase in net public debt from 47.4% in 2000 to 70.5% last year. However, our concern is not just about debt dynamics over the longer term, but also the inflationary impact of fiscal imbalances. The recent adjustment in administered prices is a case in point. Since government subsidies are still at a highly distortionary level, the economy is likely to remain exposed to adjustment costs for the foreseeable future. Furthermore, the extent of monetary financing of the budget deficit remains at an unsustainable level. The central bank’s monetary claims on the public sector expanded by 66.1% since 2001, albeit the rate of increase slowing to 4.4% in the last fiscal year. In other words, the central bank still carries almost half of the country’s outstanding debt stock — an unprecedented degree of fiscal dominance that threatens economic and financial stability (see The Burden of Fiscal Dominance, October 12, 2005).

Achieving sustainable growth requires fiscal and monetary tightening. Egypt has a noteworthy potential to maintain welfare-enhancing economic growth, but achieving that on a sustainable basis requires, above all, fiscal consolidation, independent monetary policymaking and a truly flexible exchange rate regime. Unfortunately, despite some encouraging steps in the right direction, today’s policy framework is still nowhere near what the Egyptian economy actually needs, in our view. Indeed, although the authorities have tried to improve the business climate by reducing bureaucratic costs and the tax burden, the current blend of fiscal imbalances and negative real interest rates keeps contributing to unbalanced growth and higher inflation. In our opinion, the government’s reform strategy is just too slow to bring the necessary adjustment in time. And without significant fiscal correction — that is, running a primary budget surplus — at a sufficient level to ease fiscal dominance, we believe that Egypt’s economy and financial system will remain vulnerable to underlying risks and exogenous shocks.