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Tuesday, 27 December 2016

The new New Deal

2016 was the year when the Egyptian economy probably bottomed out. Promises of an avalanche of investment following 2015’s Egypt Economic Development Conference (EEDC) were dashed as the pace of reform turned sluggish and shocks emanating from global markets and terrorism exacerbated the nation’s challenges. Instead of debating policy and trying to kickstart economic activity, investors were obsessed with the exchange rate. It was not a question of whether Egypt would experience a devaluation, but when — and by how much. And, as we expected at the end of 2015, the delay in taking action made pressure pile up from very early on in the year.

We got our answer on 3 November, when central bank governor Tarek Amer shocked the market by announcing letting go of his institution’s grip on the exchange rate and setting the currency on a free float. The central bank said it was moving “with immediate effect, to a liberalised exchange rate regime to quell any distortions in the domestic foreign currency market … [to] allow market demand and supply dynamics to work effectively in order to create an environment of reliable and sustainable provision of foreign currency.” We saw the step to be a change in course away from an unsustainable limbo that would have spelled economic collapse.

With the float of the EGP implemented, the hard work of building a real economy is only starting, and that’s why we believe 2017 will not be a year where results are attained, but rather a foundational one in which the premise of a new New Deal is laid down and implemented gradually. We believe there is a realization by the powers that be that the economic aspect of the social contract between government and the citizens of Egypt is unsustainable and has to change in 2017. Gone are the days when everyone could expect the government to sustain an artificial exchange rate for political purposes, maintain its role as the single employer in the country, and uphold a system under which commodities are made available on the market at subsidized prices. In its place, as part of the new New Deal, the government will allow more room for the private sector to operate and will lay down the foundations for a system of cash transfers that could be means-tested in the future, something similar to a more generalized Takaful and Karama projects, the World Bank-sponsored welfare programs.

While we do not expect subsidies to go away, the distribution mechanism will differ. Subsidized prices distort the market, but an alternative was not readily available through the banking system given challenges in reaching rural citizens and the very low banking penetration rate. Instead, the central bank will use the penetration success of mobile network operators. Where the banks have failed to expand their clientele, mobile operators have managed to reach practically the entire country with a cumulative penetration rate of over 100%. Earlier this month, the central bank released new regulations governing mobile payment services designed to expand use of the service in Egypt and enhance financial inclusion. Under the regulations, banks will be able to employ agents to deliver services including the establishment and verification of customer identity — and micro-enterprises, organizations and merchants will be able to pay or collect funds through their mobile accounts.

This will likely become the foundation of the new New Deal as the buzzwords for Egypt in 2017 will be “financial inclusion.” The plan would give the government the chance to channel subsidies in cash, rather than in-kind, directly to consumers, replacing the less efficient, distortive systems currently in place. It follows the unremarkable failure of smart card-based subsidy systems that failed to catch on for reasons ranging from poor rollouts (as with the system designed for fuel) or due to poor management and hacking (as with the one designed for bread). Using mobile phones will provide an improvement to the one glimmer of success in this system — the supply ration card piloted in Port Said — by making it operate more smoothly, better targeted, and improve its reach.

At first, we speculate the system would not be means-tested, but would involve extensive data gathering to improve it operationally and make it better-targeted.

Nonetheless, the system would also serve a separate, two-pronged purpose. It would improve access to capital and — critically — consolidate the gray economy into the formal one. This fits in adequately with the (so far unsmooth) rollout of value-added tax that, through collecting taxes throughout the value chain, should bring in more people and firms into the formal economy and expand the tax base. In principle, enhanced financial inclusion should give the historically disenfranchised segment of society access to funds — be it cash subsidies from the government or economic capital — improve the government’s finances by cracking down on leakage in the economy, strengthening its oversight over economic activity, and having the added bonus of drying up sources of funding for illicit activities and terrorism.

Expanded financial inclusion also gives the central bank more ammunition to intervene effectively in the economy. It is generally believed that Tarek Amer and his team’s decisions on interest rates have little impact on the response in consumer prices. The central bank’s actions do not filter through the rest of the economy because of the stubbornly low percentage of banked individuals and the anecdotally large size of the informal economy. Having better tools to manage the country’s monetary policy would be a step towards a more developed economy. This is how we see the government’s new policy fitting in the central bank’s along with programs recommended by the IMF, as part of its USD 12 bn financing package, and the smaller but more widespread ones by the World Bank Group.

All of this, while very promising on the drawing board, is certain to face a number of challenges on the ground. Setting aside threats from geostrategic complications or from international markets, there are four main challenges that threaten this new New Deal, in our view. The first comes from the within the government itself. Some branches of it have often impeded the speed of reform, by delaying issuing the executive regulations of the value-added tax, or arguably moved against the government’s reform agenda altogether in decisions like the one to raise customs on some goods or restore protectionist measures for certain uncompetitive sectors. Having a relatively inexperienced parliament in session could also add a layer of complications as, although we have not seen any evidence of meaningful dissent from government policy during the session, it grandstanding in the House will throw monkey wrenches into the flow of policy making.

The second threat could be in the rejection of the new New Deal on merit from the people or any subsequent government. The status quo has been in place for generations and, while observers might say it is unsustainable, a leap towards an unknown would also be seen as daunting by people on the street, especially as reforms tend to come with transitionary periods rife with uncertainty and some economic hardship.

Third, some reforms are likely to be stalled by roadblocks, even though the reform plans may not face ‘explicit’ rejection. A particular question is the competence of the state bureaucracy at the sub-ministerial level to deliver on planned reforms. Ensuring that this point is not reached would require a delicate balancing act between the decision makers in government, a public sector that remains bloated, coordination with international institutions, and oversight from parliament, as well as ongoing dialogue with — and continuous feedback from — the private sector.

The fourth risk factor, arguably the most potent threat, is the possibility of wide-scale social discontent. It is the threat flagged by a number of international observers including, for example, in Control Risks’ 2017 RiskMap and in S&P Global’s country risk assessment. The latter notes that sociopolitical tensions remain the major potential threat to economic recovery and that “the sociopolitical environment in Egypt remains fragile.” The report adds that the government is expected to face “considerable challenges from the population’s expectations, especially following the approval of the IMF’s program. Mounting public discontent, especially from vulnerable groups as a result of the rising cost of living, is a concern. At the same time, we understand from authorities that social protection and new compensatory measures are an important component of the fiscal consolidation program.” The main concerns there are from the toxic mix of elevated inflation rates and slow rates of job creation. Security risks are also expected to continue to weigh heavily in 2017.

We share the view that 2017, if successful, would lay the foundations for restoring Egypt’s economy to a growth path from 2018 onwards. Impact on the ground would be felt by the end of the year at the earliest, as job creation would be spurred and markets adjust along with the price level. This is why funding, from the IMF and other sources, is integral throughout the year. It would be the boon to sustaining social spending throughout the transition towards a more efficient and effective system. The best-case scenario has significant capital expenditure taking place in Egypt, with new investment (including both direct and as portfolio inflows) beginning to shape the country’s growth trajectory in 2018, a presidential election year, and driving us into 2019.

What is required from the government now is both policy stability — and a focus on providing the private sector with the support it needs to operate more efficiently, expand, and create new job opportunities. This requires legislative support and incentives to create jobs, which we anticipate from the proposed investment law, a stable tax code, and reduced intervention in the economy that crowds out private investment.

With all the uncertainties, there are still some specific green shoots we anticipate will create positive headlines in 2017. First gas from the Zohr supergiant gas field is expected by the end of the year. Egypt is still moving forward with plans to become a regional energy hub. Before that, around 10,000 MW of electricity from the power stations Siemens is building are also set to be commissioned during the year. Beyond energy, the positive impact of the EGP devaluation and float should support the country’s strongest exports — textiles, garments, and, security permitting, tourism — and help them expand in existing markets and open new ones.

We are keeping a particularly close watch on the tourism sector in 2017. After years of underperforming, the sector could return if Russia removes its restrictions on traveling to Egypt and European countries remove their travel warnings. Our concern is that if the sector does not see this expected revival by the winter season of 2017, it would not be able to recover fully for a number of years to come.

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