4 Questions about Egypt's Economic Crisis
Egypt has been grappling with an economic crisis since last year, with the Egyptian pound plunging, foreign reserves drying up, and inflation surging. This eventually led to the International Monetary Fund (IMF) stepping in and providing Egypt with a US$3 billion loan facility last December.
Can Egypt weather the storm and what should we look out for? We reached out to Yury Zusman, a London-based emerging market strategist and the author of a research series EM Dynamics, to shed light on the four key areas that will show us where the macro picture is heading.
Currency
Hedder: Why did the Egyptian pound fall to record low?
Zusman: What happened last year was that Egypt experienced very rapid capital outflows, driven by geopolitics and rising rates. Egypt, which was maintaining a fixed exchange rate regime, started to quickly run down its reserves. This was exacerbated by the fact that the exchange rate became overvalued during the pandemic leading to a widening current account deficit and a greater need for foreign capital to finance it.
With falling reserves, Egypt became at risk of not having enough foreign currency to pay its liabilities. Ultimately, the country was forced to let the currency adjust to a significantly weaker level.
As part of the agreement with the IMF, Egyptian authorities now agreed to allow for a flexible exchange rate. This way the exchange rate could adjust and the forex market could clear without the need to spend the foreign reserves of the Central Bank of Egypt (CBE).
Inflation
Hedder: How does inflation affect the government’s ability to contain the financial crisis?
Zusman: Egypt has been struggling to bring down its inflation, with prices going up over 30% during 2022. Part of this is due to a global commodity price shock combined with currency devaluation and FX passthrough. However, the CBE also engages in quasi-fiscal activities, including subsidized lending to a big portion of the economy, which can be extremely inflationary.
Apart from raising the cost of living, especially for the most vulnerable parts of society, high inflation also reduces the competitiveness of domestically produced goods and services and can lead to the need for further currency devaluation.
As part of the agreement with the IMF, the CBE committed to winding down most of these lending schemes and transitioning all remaining such activity to the fiscal authorities.
Government Reform / State Exit
Hedder: The Egyptian government – in particular its military – is heavily involved in different sectors of the economy. Does the IMF agreement require any reforms relating to that?
Zusman: Yes, an important IMF requirement is for the Egyptian state to reduce its footprint in the economy by isolating the most strategic sectors and selling down its assets in the rest of the economy.
According to the IMF, public sector companies, excluding the military-owned ones, amounted to around 16% of the economy in 2018. This figure is likely higher now.
There is less information about the exact size of the military involvement in the economy, but another 10-15% of the economy seems like a fair estimate. Anecdotally, military-owned enterprises are involved in almost everything under the sun: bottled water manufacturing, retail fuel stations, cement production and holiday resort properties. While there are many other economies where the state accounts for a large share, I think the military's dominance in the private sector is quite unique to Egypt.
Debt Level
Hedder: What about their government debt level?
Zusman: If successfully implemented, these reforms are designed to get Egyptian government debt back onto a sustainable path.
When you look at the key drivers of the debt trajectory, growth, primary fiscal balance, interest expenses and currency are the key drivers of sustainability and default probabilities, both in terms of macroeconomic theory and empirical evidence. To Egypt's benefit, the government already has a primary surplus, which it achieved during the previous EFF program. It needs to maintain that and hopefully increase the surplus slightly.
The country also historically has had very good growth, but needs to implement the aforementioned reforms to maintain it at a high level and avoid a growth shock in the near-term.
The Egyptian government uses about 50% of its revenue to pay interest expenses, which is very high. Paying such a high proportion of revenue just to service the debt can lead to political challenges and result in the country's unwillingness to pay its debts.
Structural reforms will help bring its interest costs down, while raising additional tax revenue will generate more revenue overall.
More from Hedder:
EM Dynamics, a monthly research series on emerging market economies
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