Egyptian and IMF officials are starting negotiations this week in Cairo to finalize a 3-year program worth $12 billion. These negotiations will last about two weeks, after which the IMF will return to Washington with a “Letter-of-Intent” specifying the policies that the government of Egypt will undertake over the course of the program. If the negotiations are successful and the program is approved by the management and Executive Board of the IMF, Egypt would receive the first tranche of the $12 billion loan by October. The news that a deal is in the making has already led to a jump in the Egyptian stock market and a modest strengthening of the Egyptian pound in the black market.
While this development is garnering considerable attention, it is worth recalling that Egypt has been down this road twice in the last five years. In June 2011, the government of the Supreme Council of the Armed Forces (SCAF) reached an agreement with the IMF on a program amounting to $3.6 billion, but backtracked, saying that it did not want to add to the country’s external debt and that this was something best left for an elected government to handle.
In late 2012, the government of Mohamed Morsi reached an agreement with the IMF for a $4.8 billion program. However, just a week before the IMF Executive Board was to meet to discuss the Egyptian request on December 19, 2012, the government requested a postponement of the meeting because it was unable to meet a key prior condition of increasing the sales tax on a variety of consumer items because of the potential political fallout. The agreement was abandoned.
What Has Changed?
So why has Egypt changed its mind about an IMF program now? After all, the IMF has been ready and willing to support Egypt financially for the last five years. Some have argued that Gulf Arab countries are unable or unwilling to continue their support for Egypt in the wake of the recent sharp decline in international oil prices, forcing the Egyptian government to turn elsewhere. Undoubtedly there is merit in that argument. But equally important, the timing for an agreement is right for three other important reasons.
First, while the Egyptian economy has been floundering since 2011, it is not in a crisis. Growth is currently only about 3-4 percent, inflation has reached 14 percent, unemployment is running at 13 percent, with youth unemployment nearly three times that rate, and foreign exchange reserves stand at $17 billion, or about half the level they were at the end of 2010. These indicators clearly point to an economy that is in poor shape, but not one that is in full-blown crisis. Therefore, unlike other countries that request IMF assistance, Egypt does not have its back against the wall with no other option but to agree with the IMF on what needs to be done. If it feels the conditions the IMF places on obtaining the loan are too onerous, it can still walk away.
Second, the IMF itself is changing its approach and not pushing austerity at all costs in its programs. There is a clear recognition inside the institution that conditions in a program have to allow a country sufficient flexibility to implement policies that are not harmful to growth and employment.
Third, the government has already initiated many of the policies the IMF would regard as central to achieving the program targets and objectives. This was not true of the previous agreements.
The two main policy areas that the IMF program will focus on, and where Egypt has already made some progress, are the public finances and the exchange rate regime.
- Public Finances: On the public finances, there is an urgent need to reduce the fiscal deficit which is running close to 10 percent of GDP. This deficit is driving inflation and creating serious external imbalances. The key question is how to reduce the budget deficit without adversely affecting economic growth. To generate additional revenues, the government has prepared a value-added tax (VAT), which is currently facing some resistance in parliament, and its passage into law will surely be part of the program.
Reducing subsidies will also figure prominently in the program. As part of the 2014-2015 budget, the government took a major step in this regard by raising fuel prices across the board and introduced a five-year plan to increase electricity prices and eventually eliminate the subsidy. However, even after the July 2014 reforms, subsidies remain large, amounting to 8.5 percent of GDP, and the process to reduce them further has stalled. The program will include commitments by the government to further reduce and eliminate subsidies. There already indications from the Egyptian government at the highest level that they intend to proceed in this direction. Doing so will create the fiscal space for the government to increase public expenditures, including on infrastructure and megaprojects that are essential for generating growth and employment.
- Exchange Rate: The Egyptian pound has been under continuous pressure in the last five years. However, the government and the Central Bank of Egypt (CBE) have been very reluctant to devalue the rate, using a mix of foreign exchange intervention and interest rate hikes to maintain tight control on the value of the pound. In March this year, the CBE devalued the pound by 13 percent to EGP 8.85 per US dollar and said it would move to a more flexible exchange rate regime. While recognizing that this change is needed to increase exports, reduce imports, and attract foreign investments, the CBE has sent mixed signals about its intentions to weaken the pound further. As a result of the uncertainty about what the CBE is or is not going to do, the rate in the black market reached EGP 13 to the dollar. The IMF will insist that Egypt take further action on the exchange rate, possibly including a step devaluation and a change in the exchange rate regime in favor of more flexibility.
What Can Be Expected from the IMF Program?
The IMF program is expected to bring in a substantial amount of foreign exchange at relatively low interest rates. Aside from the $12 billion from the IMF, the government expects a further $9 billion from other international financial institutions such as the World Bank and the African Development Bank. Add to this private investment inflows, government borrowing from international capital markets, rolling over of maturing short-term government debt, and additional support from Gulf Arab countries, Egypt gets close to filling a projected external financing gap of $16-20 billion annually in the coming years.
Second, there will be a reduction in inflation as a result of the improvement in the public finance and reduction of the fiscal deficit. Initially, there may be a jump in inflation following the reduction in subsidies and the devaluation of the pound, but over time inflation should slow down.
Third, just having an IMF program would send a very strong signal to domestic and foreign investors that Egypt is committed to putting its economic house in order and that it is on a path of economic recovery. This is what is known as the IMF’s “good housekeeping seal” of approval.
IMF and Egyptian officials will claim that the program will generate higher and more inclusive growth that will create an adequate number of jobs to reduce unemployment. The program will not do that directly and certainly not in the short term. The key to putting the Egyptian economy on a sustained high growth path will be private investment, which unfortunately has been falling steadily since the uprising. As a point of comparison, in 2007-2008, when growth was averaging over 7 percent a year, total investment was 28 percent of GDP. Today it is only 16 percent. Moving the investment rate up significantly requires major structural reforms designed to make Egypt more business and investor friendly. Such reforms will be included in the IMF program, as they typically are in all programs, but they do take time to implement and even longer to yield positive results.
All in all, having the IMF endorse the Egyptian government’s economic program will on balance be a positive development. It will help arrest the economic decline that Egypt has experienced in recent years, but it is not a magic bullet. A 3-year program cannot miraculously cure all the ills confronting the Egyptian economy. Furthermore, it is extremely important to note that the success of the program is predicated on a major improvement in security. Without this, foreign investment and tourism, both of which are mainstays of Egypt’s economic growth, will not increase and may even fall further. Even if all goes well, the Egyptian population will have to be patient as the benefits of in terms of jobs and incomes may take many years to realize. Nevertheless, Egypt should take this opportunity to agree on an IMF program and not let it slip by for a third time.
Mohsin Khan is a Nonresident Senior Fellow at the Rafik Hariri Center for the Middle East focusing on the economic dimensions of transition in the Middle East and North Africa. Elissa Miller is a Program Assistant at the Rafik Hariri Center for the Middle East.