x Abu Dhabi, UAEThursday 27 July 2017

Energy the elephant in the room for Egypt

While talks with the IMF for a loan continue, Egypt has to resolve a basic problem - it spends more than it makes. Much of the expense revolves around handouts.

Egypt's overall budget deficit has widened over time, along with increasing subsidies, especially on energy. Amr Abdallah Dalsh / Reuters
Egypt's overall budget deficit has widened over time, along with increasing subsidies, especially on energy. Amr Abdallah Dalsh / Reuters

Anyone following Egyptian economic news is probably aware that the government has signed a preliminary agreement with the IMF for a US$4.8 billion (Dh17.63bn) aid package.

The cabinet revealed it is keen to finalise this deal as it believes global investors would perceive it as a stamp of approval on Egypt's economic programme - despite the current travails on the political front. One has to suspect the major issue has to do with subsidies in general and energy subsidies specifically, which seem to be the elephant in the room.

No one wants to risk the social implications of aggressively cutting the bill.

The country has been back and forth for several months with the IMF on its loan request, raised from an earlier amount of $3.2bn.

First, the IMF wanted to see a more stable government and political system. Now that the president and his appointed cabinet have resumed talks, the IMF is asking for an economic programme that effectively tackles the country's troubled finances both in the short term and on a more strategic level.

One assumes that the IMF technical team indicated that Egyptian officials would have to take more austerity measures and exercise greater prudence with the dispensing of the net international reserves - and may not enjoy the same liberty they had to draw on it - and to support the currency. Simply put, Egypt spends far more than it makes.

Funds coming in from taxes, privatisation proceeds and so on are less than money spent on salaries of public-sector employees, subsidies and so on.

The expenditure of the government has been growing at a cumulative average growth rate of 16 per cent since 2006-2007 to this fiscal year, far higher than revenue, which recorded a rate of only 10.8 per cent.

The overall budget deficit has widened over time, along with increasing subsidies especially on energy.

To finance that gap, which has averaged 130bn Egyptian pounds (Dh77.36bn) over the past three years, the government borrows either domestically or from abroad.

Egypt has predominantly relied on domestic local currency debt from the banking system, but the ballooning deficit has meant that it was unsustainable to borrow domestically. Such borrowing not only crowds out the private sector, but the system itself has been running out of funds.

The central bank intervened twice in the past year to reduce the required reserve ratio, first from 14 per cent to 12 per cent, then down to 10 per cent. Domestic debt as a percentage of GDP stands at 80 per cent.

As for international foreign currency debt, the ratio is much lower at 15 per cent of GDP - and this is the reason the government has now resorted to borrowing from international institutions.

Alleviation of the fiscal burden of subsidies and the need for reforms has been at the core of most attempts to reform public finances. It has been advocated by politicians, but it is the one thing politicians have continuously avoided tackling once they assume power.

The subsidy system started back in the 1950s, when the state took on responsibility for citizens in a wide range of areas.

Six decades later, the subsidy bill is tall and large, and stood at 130bn Egyptian pounds in the 2011-2012 revised budget, representing 27 per cent of total expenditures.

There are many economic studies that have tackled the issue of subsidies and which have presented well-researched findings on wastage.

Many of these also find that the ultimate beneficiaries of subsidies are actually the country's richest. According to a study by the Egyptian Center for Economic Studies (ECES), energy subsidies affect resource allocation as the richest urban quintile benefits from 33 per cent of these subsidies. Meanwhile, the poorest quintile benefits from only 3.8 per cent.

Nonetheless, a serious plan to phase out subsidies should carefully consider the direct and indirect impacts. There should be a wide and far-reaching public education campaign to explain the problem at hand and rationalise the reasons behind cutting expenditures.

Magda Kandil, the executive director and director of research at ECES, says there are economic and environmental benefits to reducing subsidies, such as cutting wasteful consumption, improving the allocation of resources, reducing greenhouse gases and encouraging alternative clean energy.

Benefits of reducing subsidies also go beyond simply cutting the expenditure bill; it should result in higher labour participation in the economy as it encourages labour-absorbing industries, a much-needed measure given Egypt's growing unemployment rate.

Contrary to the IMF's history in dealing with nations seeking its aid, the fund has repeatedly said it would not set pre-conditions on Egypt.

However, that does not mean there are no strings attached. The programme should ensure that Egypt's resources and donor funds will not be wasted. And it might also want to set some guidelines on the usage of the country's funds and net international reserves.

Sherif Metwally is a senior investment analyst at National Bank of Abu Dhabi's asset management group