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Egypt: Heading Toward Macroeconomic Destabilization



Revolutions are euphoric events. Politics engage all as never before or after, and few bother to think about such mundane issues as economics, but then economic hazards will arise. Unfortunately, serious macroeconomic destabilization is likely in Egypt.

The Egyptian revolution appears to be a middle-class, liberal revolution like the European revolutions of 1848 or the East European revolutions of 1989. In both cases, two decades of strong economic growth followed, but only after a brief but severe macroeconomic crisis. Today, economic policy in Egypt must have two aims. Its immediate concern is to contain and mitigate the inevitable macroeconomic crisis. In the next stage, it should improve the economic system so that Egypt can achieve the high economic growth it needs for the next two decades.

The Egyptian economic system remains quite socialist. State enterprises and state-owned banks dominate much of the modern economy. The exchange rate is tightly regulated and monetary policy passive. The stock exchange is minuscule and hardly plays any role. Many prices are controlled and consumer subsidies are prevalent. In recent years, Egypt has undertaken some liberalization and privatization, which have boosted economic growth to around 5 percent a year, but much remains to be done.

The macroeconomic situation in 2010 was rather tenuous. It is the domestic government finances that arouse concerns. The budget deficit was 8.4 percent of GDP, and it has lingered around 7 percent of GDP for a long time. Inflation remains stubbornly high around 11 percent, and it is likely to rise with higher global food prices. Gross public debt amounted to 74 percent of GDP at the end of 2010, but most of it was held by state-owned banks in Egypt.

The foreign account on the contrary offers surprisingly reassuring numbers: Foreign debt was only 16 percent of GDP, the current account deficit just 2 percent of GDP, and international reserves amounted to $32 billion, while Egypt's GDP was $216 billion.

The revolution is likely to aggravate the fiscal balance as well as the foreign account. Much of Egypt's manufacturing stood still for two weeks of revolution, which has been followed by frequent strikes for higher pay that are not likely to abate easily. As a result, GDP growth is likely to decelerate significantly. The government has already reduced its forecast for 2011 from 6 percent to 3.1 percent, but the situation could easily get much worse.

The highly regulated Egyptian economy is likely to become ever more imbalanced. Before the old government resigned, it raised the wages of six million public employees by 15 percent as well as their pensions. It will be impossible in this revolutionary climate to raise controlled food prices, but global food prices are rising, and Egypt is a major food importer. The result will be quickly expanding subsidies. For 2011, the government has forecast a substantial increase of tax revenues (3.6 percent of GDP),but this is unlikely because tax collection becomes more difficult when taxpayers dare to stand up against the state. Under these conditions, it would be surprising if the large budget deficit did not expand considerably, though it is too early for plausible predictions.

One of Egypt's greatest sources of foreign earnings is tourism, generating about $10 billion a year or 5 percent of GDP in foreign revenues in comparison with merchandise exports of $25 billion. Tourists do not like instability, which will inevitably follow a regime change. After the collapse of a police state, crime usually surges, as no alternative legal system is in place, and many old security policemen become professional criminals. Under these circumstances, tourist revenues are bound to plunge. With rising domestic demand and contracting production, merchandise exports are likely to fall. Foreign investors are highly sensitive to instability, and Egypt's annual net foreign direct investment of a few percent of GDP is likely to fade away. In addition, the old elite are likely to spirit both their own and state funds out of the country as long as they can. Therefore, Egypt's current account deficit will probably increase substantially. In all probability, the natural easing of controls after the revolution will also involve the exchange rate, which is then likely to decline.

Under these conditions the already high inflation may significantly exacerbate a widening budget deficit, high wage and pension increases, rising global food prices, and a declining exchange rate. And Egypt's passive central bank is unlikely to be able to impede inflation, since it has neither the mandate nor the instruments to do so.

In fact, macroeconomic crisis is a standard initial outcome of revolutions and democratic breakthroughs, because people demand more from the state but are not prepared to pay as much as previously. The question is what can be done today to mitigate this all-too-likely crisis and to facilitate its solution.

The immediate aftermath of revolutions offers a bonanza for the old elite to seize state funds. Therefore, the first thing is to throw out the old elite from their top positions in the state and state corporations, especially the banks, because their sole preoccupation in the next few months will be to appropriate funds and transfer them out of the country. The new government will need to impose proper controls over and audit the public finances. For this purpose, it will need international assistance. The International Monetary Fund (IMF) can assist in this matter.

Another early effort must be to sound the alarm about this burgeoning financial crisis so that people understand and stop making impossible demands on the faltering state.

Presumably, Egypt will soon require a stabilization program with the IMF. To prepare the ground, the new Egyptian government—when there is one—should invite the IMF to establish a precautionary program that easily can be transformed into a standard standby program when the need arises.

Egypt has always been a rent-seeking economy where powerful officials have benefited from kickbacks and arbitrage between state-controlled and market driven prices These rents can easily explode if the exchange rate tanks and subsidies soar. Therefore, a policy of comprehensive deregulation needs to be thought through and formulated early on, though it might take several months before the public realizes the need for such a strategy. It is such structural reforms that will decide whether Egypt will rise as an economic phoenix with high growth rates based on rising efficiency and increasing employment as happened in Eastern Europe after 1989, or whether it will fall back into rent-seeking authoritarianism as most post-Soviet republics have done.

Later on, many other tasks will arise, such as establishing a modern tax system and developing a normal central bank, but they will take more time and need not be undertaken at the very outset.

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