Egypt’s Economic Crisis – STRATFOR

The Egyptian economy faces persistent economic challenges that have only worsened with the unrest that has followed the Arab Spring. The fledgling Muslim Brotherhood government in Cairo must balance the needs of a powerful military establishment with the needs of a fractious populace. Strikes, protests and sporadic violence have become a daily occurrence in the Middle Eastern country of more than 80 million people, and various government announcements have been quickly reversed. In this unstable environment, investor confidence has plummeted, damaging the country’s financial position and bringing Egypt to the edge of complete instability.

Egypt’s negative financial account has exacerbated the outflow of foreign exchange previously driven by the country’s large trade deficit, and foreign reserves are dwindling. Without foreign reserves, Cairo would be unable to pay for foreign currency-denominated imports and would be unable to maintain the value of the Egyptian pound. The government has two realistic options: Find outside financing to make up the difference, or ask the population to accept higher costs for a range of goods and services. In the current environment, the first option will be difficult. But the second option carries profound political consequences and could worsen already significant unrest.

The nature of Egypt’s economic challenges is neither new nor surprising. Egypt’s large population and limited arable land outside the Nile Delta historically have made capital accumulation and development a challenge. These challenges have grown as Egypt’s population increases and oil production falls. Cairo knows it needs to enact a range of cost-cutting reforms while negotiating with the International Monetary Fund for a $4.8 billion credit line that would help stabilize its currency and restore the confidence of global investors. This policy will meet with some success. But it is highly likely that Egypt will have to rely heavily on the time-tested use of its strategic position in the Middle East to secure foreign aid and investment.

Questions about the future of energy subsidies dominate the Egyptian economic conversation. Egypt used to export a significant amount of oil, but oil production has slumped while subsidized consumption has continued to rise. Although Egypt remains a net exporter of crude oil by a small margin, the country is a net importer of refined petroleum products. Despite these developments, long-standing subsidization policies are politically very difficult to get rid of without a significant backlash from the public.

Egypt, however, can no longer afford them. Energy subsidies make up 72 percent of total subsidies and one-fifth of the government’s total budget. Though they are expensive, completely ending the subsidies would increase prices of energy-related goods and services by around 30 percent, which would trigger inflation in other sectors. The complete removal of subsidies is probably out of the question.

Changes can be made to mitigate the impact of reduced subsidies. Blanket price subsidies benefit higher income private consumers the most, since they have the money to own cars, run air conditioners, etc. These consumers were targeted in late 2012 when the government removed subsidies for high-octane gasoline. The changes, however, were made obsolete almost immediately as high octane consumers switched to lower octane gasoline.

Egyptian Agriculture, Area Harvested 1960-2012

Offsetting these inflows are significant, growing outflows including a petroleum import bill that rose 360 percent between 2003-2004 and 2011-2012, contributing nearly $12 billion to Egypt’s total import bill of $59 billion that year. In addition to a rising import bill, the instability associated with the 2011 unrest that unseated former Egyptian President Hosni Mubarak and continues to this day has triggered a flight of investment. Egyptians have pulled their money and investments out of the country, causing the country’s financial accounts to dip to negative $4.2 billion in 2010-2011 and to negative $1.3 billion in 2011-2012. Egypt’s positive financial flows in previous years had offset its negative current account balance, injecting enough foreign capital into the domestic system to maintain stability.

Without that balance, Central Bank reserves have fallen from $36.2 billion in December 2010 to $13.6 billion in January 2013. Although the rate of loss slowed in 2012, it dropped suddenly in January 2013 by $1.4 billion. At that rate, the government will run out of foreign reserves in less than 10 months. The drop, however, was somewhat abnormal, and can be explained by costs associated with open market transactions and a larger-than-average foreign debt payment.

Only Bad Options

Egypt’s position is highly reminiscent of challenges faced and overcome by previous governments. It is, however, worsening in ways that significantly constrain Egyptian President Mohammed Morsi’s policy options. A growing population is not being matched by growing economic opportunities. While for most of its history Egypt has relied on a strong state to control a very poor population, persistent unrest in the country has made this challenge even more difficult. High oil prices and a growing petroleum import bill require either new sources of funding or a system that does less to incentivize high levels of consumption.

Egypt is facing a difficult situation in which it must either redistribute national resources, impose a lower standard of living or attract foreign capital.

Although politically challenging and thus unlikely in the immediate term, redistributing national resources toward government aims could become necessary if the economic situation continues to deteriorate. To raise money, the government could seize easy-to-liquidate assets. This could include the forced conversion of foreign currency bank deposits, which in Egypt currently total more than $26 billion. Other potentially vulnerable assets could include private pension funds. State-owned companies could be privatized, but that could be difficult in the current political climate.

Threatening the savings and fixed assets of the Egyptian elite, however, could entail challenging the military for assets under the control of high-ranking current and former military officials. The ruling Muslim Brotherhood is in a delicate balancing act with the military for control, and cannot afford to upset that working relationship when the population is already so prone to unrest. As a result, it would be extremely difficult for the Muslim Brotherhood government to proceed with these changes. They would not, however, be out of the question in a true emergency or in the event that a military-dominated government emerges.

On the other hand, the government is already transferring some of the costs of maintaining the current system to Egyptian citizens and companies. Although the removal of subsidies for high-octane gasoline was ineffective, it did demonstrate Cairo’s willingness to place a greater economic burden on the upper classes, shielding the majority of Egyptians from the shifts in an effort to maintain popularity and political credibility. The government indicated in a Feb. 19 announcement that it may impose a 50 percent increase in the domestic price of fuel oil for all industries except electricity generation and food production. In a second announcement, it indicated it would attempt to repay a quarter of its outstanding $9 billion debt owed to foreign fuel suppliers in Egyptian pounds instead of dollars. This will likely complicate future fuel import contracts, but it will preserve national foreign exchange reserves. These announcements signal that foreign and domestic companies will be asked to share the burden of reforms as the government attempts to pass the obligation for financing foreign imports out of the public sector.

Nevertheless, many economic changes necessary to relieve the government’s financial commitments and shift more costs to consumers will necessarily have a more widespread effect. For example, an 8 percent devaluation accomplished during January and February has already made imports more expensive. Additionally, the government is restricting access to U.S. dollars in an effort to prioritize basic state functions while preserving foreign reserves. This will make it more difficult for Egyptians to import non-essential goods, may cause shortages and will spur a black market in both foreign currency and goods, but it will help to protect government resources.

Such economic policy shifts have the potential to generate spiraling unrest. The government is therefore very conscious of the fine line between economic reform and political suicide. Any changes that could affect the Muslim Brotherhood government’s credibility will therefore be taken in very small, moderate steps with frequent reversals in the face of political backlash. Most likely, this means major changes will not be possible.

Still, even small changes can add up to enough public savings and financial stability to convince foreign investors to return, at least in a limited fashion. For that, Egypt needs an agreement with the International Monetary Fund to provide a direct credit line and to approve Egypt’s economic policies. International Monetary Fund approval would make it possible for Egypt to attract direct and portfolio investors, providing much-needed capital inflows.

But before Egypt can sign a deal with the International Monetary Fund, the Muslim Brotherhood-led government must sort out what adjustments it can afford politically. Given the danger of additional political destabilization, the International Monetary Fund is unlikely to require major structural changes, especially since major structural changes are almost a political impossibility. The International Monetary Fund will still need to see some plan of action for bringing at least a modicum of stability to the domestic economy. So far, an ongoing process of negotiation among Egypt’s social sectors has yet to yield a plan. And with parliamentary elections scheduled for April, an agreement is unlikely until later in the year.

Strategic Rent

A larger strategic question is in play for Egypt. As a pivotal country in the region, Egypt has historically been able to leverage significant financial benefit from its strategic position. The last time Egypt was in this economic position was in 1990, when Iraq had recovered enough from the Iran-Iraq war to invade Kuwait, pulling the United States into the first Gulf War. A strategic U.S. ally since the 1978 Camp David accords, Egypt was able to leverage renewed U.S. commitment to the Middle East as the Cold War was coming to an end to secure $20 billion worth of debt relief from the United States and billions of dollars in loans.

Although Egypt has received aid from neighboring countries, particularly Qatar, Cairo needs a more sustainable answer to its economic challenges. International Monetary Fund negotiations could fail if Egypt’s political obstacles to economic change prove insurmountable for the new civilian government. In that case, Egypt will likely require significant assistance from foreign governments. As the global economic heavyweight with significant military ties to Egypt, the United States is the most obvious potential ally. Washington enjoys heavy influence in the International Monetary Fund, and could increase its direct economic aid to Egypt. A U.S.-led diplomatic effort to aid Egypt also could prompt other creditor nations to forgive Egyptian debt.

Egypt’s peace treaty with Israel remains critical to the Middle Eastern balance of power. In the wake of the political shift in Egypt, the U.S. government is looking for assurances that the new Islamist government in Egypt will not undermine the agreement, which depends on Egyptian military enforcement. The Muslim Brotherhood has a close relationship with Hamas. Since coming to power, it has used diplomatic channels with Hamas in lieu of military pressure. This is an as-yet untested strategy. Since it depends upon mutual trust between the Egyptian government and Israel, not to mention the cooperation of Hamas, the United States is uncertain whether the Muslim Brotherhood is up to the task.

As the United States pulls back from military engagements in the Middle East and South Asia, there is increasing urgency to support key allies around the world in maintaining regional balances of power. For Egypt, this presents an opportunity. No matter what government is in power, Cairo’s economic and political imperatives are clear: The United States is the country most able to leverage diplomatic and financial influence to help Egypt stabilize its economic situation. As a result, Egypt is under pressure to find an accommodation with U.S. interests in the region, and the United States has an opportunity to solidify its influence in a pivotal Middle Eastern power.

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