How much should we worry about Egypt?

After the tumultuous events that led to the ouster of Hosni Mubarak from the presidency of Egypt in February 2011, the country remains amidst a protracted transition with significant economic ramifications. There are a number of uncertainties on the political front, the most important of which is the new constitutional setup that will formally define the division of power between the Parliament, the government, and the president. At the moment, tensions stem above all from the ongoing presidential campaign and the standoff between the elected Parliament and the military-led government.
But as much as the political disputes dominate the headlines, equally thorny challenges exist in the economic sphere. Economic growth is expected by the IMF to stall from 1.8 percent to an almost anemic 1.5 percent this year while the budget deficit is expected to reach some 10 percent of GDP. The political situation has resulted in an enormous strain on the country’s foreign reserves as tourism has taken a major hit and trade flows have been adversely affected. Since the ouster of Mubarak, the country’s reserves have plummeted by more than 50 percent to a total of$ 15.1 billion as of March. This is barely enough to cover three months of imports, a figure regarded by many as the absolute necessary minimum. By contrast, the Central Bank has spent an estimated $ 21 billion to defend the exchange rate since the onset of the crisis. This has not been sufficient to prevent persistent downward pressure on the Egyptian pound which is currently subject to a managed exchange rate regime. Although actual depreciation has been limited to 4 percent since the beginning of the year, market expectations are pointing to a far sharper plunge of close to 20 percent.
One of the main near-term challenges for Egypt comes from likely delays to a proposed $ 3.2 billion loan facility from the International Monetary Fund which was expected to be signed by May 15. The package is widely viewed as an essential step in stabilizing Egypt’s economy, partly because a number of other bilateral support measures likely hinge on its successful conclusion. The current government has put the country’s needs for external funding at $ 11 billion over the coming two years. The government’s ability to raise a significant proportion of this on market terms is in doubt as the yields on Egypt’s US dollar bonds are nearing 7 percent and the overnight deposit rates stand at 9.25 percent. Moreover, Moody’s and Standard & Poor’s have over the past year and a half lowered Egypt’s credit rating four times to B2 and B, respectively. Beyond this, the ability of the country’s banks to absorb more debt is also being questioned. In spite of the tightening constraints, concrete assistance has been very limited, although Saudi Arabia has reportedly begun to transfer the funds for a $ 1 billion deposit. Egypt has also secured a $ 1.2 billion three-year facility from the International Islamic Trade Finance Corporation.
In its latest statements, the IMF claimed that it had not yet secured sufficient domestic backing for the planned loan. The Fund has repeatedly underscored the need for a broad-based consensus to back the program, so as to have a high degree of assurance about its effective and timely implementation in the current contested political environment. Securing such a consensus has proven difficult with, for instance, the candidate of the Freedom and Justice Party last week suggesting that he might only back the IMF loan if there is a clear commitment to disburse it to an elected government instead of the current military-led administration.
Egypt now clearly finds itself facing something of a classic chicken or the egg situation. The political uncertainties can at some level only be overcome through the emergence of a high degree of political consensus. Yet such a consensus may only materialize if the basic rules of the game are better defined among the key power centers. Whether the IMF or other lenders have the willingness to commit to this uncertain situation in the absence of such rules, is unclear. If they do not, the precarious situation on the currency front may well spin out of control in the form of an uncontrolled devaluation. Such an outcome would prove politically controversial, partly because it would probably involve the exchange rate correcting far beyond the current market expectations and economic fundamentals, with some estimates suggesting as much as 50 percent. This outcome could hence involve considerable disruptions, not least renewed inflationary pressures at a time when the political pressure is intensifying for boosting public spending so as to shore up living standards. Both the financial sector and real economic activity would likely be hard hit. By contrast, a smaller devaluation would likely be fairly manageable, partly because of the relative insulation of the financial sector and the widespread use of subsidies on essential consumer staples. Some suggest that such an exchange rate correction could well constitute part of the IMF deal, even if at least some of the leading presidential contenders have questioned the need for this.
For the region as a whole, stabilizing the situation in Egypt would clearly be highly desirable. It would create the basis for the stabilization of trade and investment, not to mention the revival of Egypt’s tourism industry. It would also make possible a shift in the political debate from an open-ended contest to a more focused debate of the country’s economic challenges and the policy responses to them. The key question today is whether any of this can happen without a leap of faith on the part of the IMF or other donors.

Dr Jarmo T. Kotilaine is the chief economist at
The National Commercial Bank.