Are the reforms paying back?

Egypt launched a long-awaited economic reform programme last November as part of its deal with the International Monetary Fund (IMF) that has provided funds critical to preventing the pound’s meltdown as well as opening the door for foreign funds to flow back into the country.

The aggressive reform programme has covered the removal of subsidies, especially energy subsidies, considered one of the taboos for Egyptian economic policy-making since 1977 even though energy prices were raised in summer 2014. With the signing of the IMF deal last November, the pound was floated and energy prices increased leading to an unprecedented inflationary wave in which official inflation exceeded 30 per cent during the first few months of 2017.

After seven months of the deal, the government resorted to increasing energy prices again, but this time the increase was bigger than expected. Though it was an expected move, people were shocked by its size, and so they ought to have been. First, the rate of increase in gasoline 92 petrol prices has been more than 40 per cent, which puts huge pressure on households. Second, diesel prices have increased by more than 50 per cent, which is a major challenge since diesel serves as a basic energy source for the transportation of goods. Such a huge price increase will impact on the prices of nearly all other goods, even basic goods such as vegetables and fruit whose transportation costs are a significant part of their overall cost.

Third, one day ahead of the rise in prices, the minister of petroleum assured people that there would be no forthcoming rise only for people to be shocked the following day by the new prices. Fourth, it has been announced that electricity prices will also increase in a few weeks’ time, something which will increase the burden on households further and further erode their purchasing power.

The scale and timing of the rises were shocking, yet there are reasons that may explain why the government acted as it did. First, the unexpected spike in the dollar exchange rate from LE8.88 to LE18 doubled the energy subsidies bill. Second, oil prices increased from around $43 per barrel in 2015-2016 to around $48 in 2016-2017, which increased the subsidies bill further and made it critical for the government to push for large cuts. Third, the government needed to contain the country’s budget deficit, which had got out of control and was estimated optimistically at LE370 billion this fiscal year thanks to the five per cent hike in interest rates made by the Central Bank of Egypt (CBE) in the unrealistic hope of containing inflation.

The above reasons have put the government in a corner and made it important to push for aggressive cuts if it wants to keep its agreement with the IMF and ensure the next tranche of the loan. This is critical to keeping the door open for the external borrowing that has become the main source of foreign currency for the country. Despite the pain, this wave of price rises will not be the last, and a few more can be expected to follow every new tranche of the IMF loan.

From a strategic standpoint, it is important to look at the progress of the reform programme so far from two sides, fiscal and monetary. On the fiscal side, the government has raised energy prices twice, such that prices now are close to double those of last October with estimated savings of around LE55-60 billion, according to official estimates. In addition, the government has applied a new value-added tax (VAT) instead of the old sales tax to widen the tax base and increase tax revenues. This could add around LE25-30 billion to tax revenues, according to official estimates.

The government has also increased electricity prices, and another wave of rises to follow soon could save a total of LE35-40 billion, again according to official estimates. Other moves such as increasing the cost of public transportation will probably not lead to significant savings as increases in energy costs will eat into any savings. As a result, the fiscal reforms could lead to total savings of around LE115-130 billion.

From the monetary side, the CBE has made two critical moves. The first was floating the pound last November, which was expected, according to initial expectations, to raise the exchange rate from LE8.88 per dollar to LE12-14. Yet, the move in fact resulted in an overshoot of the exchange rate that reached LE18 per dollar due to a large uncleared backlog of demand for foreign currency at the banks, lack of foreign currency liquidity in the market after the float, and the delay in the move, all resulting in a big gap between the official and parallel markets.

Doubling the price of the dollar has more than doubled the energy subsidies bill, which would have witnessed an increase of around LE60-65 billion at prevailing oil prices before the last energy price hike. One might claim that the pound will rebound after the full implementation of the programme, which could be the case, though a slight recovery of 10-15 per cent for the pound is more likely than a strong recovery.

The second move made by the CBE was hiking interest rates to contain inflation, though this was very debatable given that the prevailing inflation is supply-driven caused by increasing input costs due to the pound’s devaluation, increasing energy prices, increasing customs rates, the application of VAT, and other things, rather than demand-driven, which is usually caused by a fast-growing economy and which can be contained by hiking interest rates to contain demand.

With LE3 trillion of local debt, every one per cent increase in interest rates will result in a LE25-30 billion increase in the cost of the debt. Thus, the ineffective five per cent increase in rates should result in increasing the cost of the debt by around LE125-150 billion on an annual basis, if it can be sustained. With around half of the outstanding debt being short term and needing to be refinanced soon, the actual increase in the cost of the debt is around LE65-70 billion this fiscal year, assuming the hike in interest rates will not be fully reflected in the cost of the debt immediately.

One might claim that the CBE can decrease interest rates any time it chooses, but this does not seem a reasonable scenario in the medium term as long as the IMF is engaged and would like to see the CBE taking a bold stand against inflation. In all cases, such moves had clear effects in the last fiscal year, and they will have an even bigger effect in the new fiscal year.

Accordingly, the burden on the budget due to monetary moves since the application of the IMF programme and assuming no increase in interest rates or increases in the dollar exchange rate is around LE125-135 billion on an annual basis, while the savings in the budget due to the fiscal austerity programme are around LE115-130 billion, including the upcoming increase in electricity prices and assuming no further increases in international oil prices. As a result, technically we have not really started saving yet, and more aggressive cuts need to be on the way to get the budget under control.

With this in mind, it is critical to question the implications of the monetary policy moves that have put a huge burden on the budget and the coordination between monetary and fiscal policy-making at such a critical time. If the results of the monetary policy moves have been realistically forecast, it would probably have been better not to embark on the reform programme on the basis of such a self-defeating model.

Omar El-Shenety

06 July 2017

This article was published in "Al Ahram Weekly"