OBG Event

08 Oct 2012

To say that the past year has been eventful (to put it diplomatically) would be an understatement. You often hear movies described as “thrilling” and “gripping”, or “edge of your seat”, but fiscal policy and currency depreciation don’t usually evoke the same reaction.  But “edge of your seat” seems a very apt way to sum up Egypt’s economic performance.  The ups and downs since the revolution have been palpable – the downs obviously more so.  Over the past 18 months, Egypt has undergone a significant political transformation and the impact on the economy has in some ways been equally profound, if not as groundbreaking. In the heady pre-global crisis days of 2007 and 2008, Egypt was racking up growth in excess of 7%. Industries like communications and manufacturing were growing by double digit figures; tourism jumped up by as much as 21%.

But the combination of falling global demand, together with the instability wrought by the revolution, meant that GDP growth last year fell to 1.8%. Some estimates for this year bring that up slightly to 2.2% — far better than neighboring Greece which is now in year six of recession. 

Yet poverty in Egypt remains stubbornly high. Official unemployment has risen to more than 12%, not counting the vast ranks of the underemployed and labour strikes curtailed industrial output. Tourism has slumped, contracting by nearly 6% last fiscal year. Annual FDI inflows in 2011 fell by more than $10bn when compared to 2007/08. Reserve cover has dropped by more than five months over the same period.

As a result, the general mood – rightfully so, given the tumult – has been gloomy. However, in recent months, there has been a steady drip of good news, which, while nowhere near a recovery, has provided a glimmer of optimism.

Headline inflation has fallen from 18% in 2008 to around 6.5%. And in spite of fears over a currency freefall, the pound’s depreciation has been well-handled. In the months leading up to the printing of our report, it only lost 1% of its value. Similarly, while still high, yields on treasury bills have also eased gradually since the election, slowing shedding a couple hundred basis points. Over the same period, the stock market has rebounded 37%. With the IMF negotiations back on track and major construction projects re-starting, the mood is starting to change.  All of this heralds a new, albeit hesitant, confidence in both the management of the economy and the direction of the country as a whole. It is still far from the pre-crisis boom, and the short-term outlook looks foggy at best, but it does seem to imply that Egypt has engineered the beginnings of a turnaround.

To sustain this, Egypt will have to leverage its competitive advantages, and do so in a way that satisfies demands for social justice. This is tricky enough in the long-term but even more so when there is a greater sense of urgency. However, the same attributes that made Egypt so popular with emerging market investors five years ago are still there, providing the country with some very attractive fundamentals.

Of the five factors we see as offering the potential to drive growth, perhaps the most influential is also the most obvious: the sheer size of the domestic market. With upwards of 85m people, 60% of whom are under 30, the opportunities for expansion both in terms of potential consumption and employment are sizable. There is a need for everything from housing to soap to electricity, and equally there is a labour force there to build it, manufacture it or generate it.

Equally central to Egypt’s recovery is its positioning. It has become something of a cliché to talk about the country’s fortuitous location but that does not make it any less true. This is strengthened by extensive, if unreliable, infrastructure.  The quality varies wildly but rural road accessibility is high, and the maritime network – including the Suez – is extremely competitive. Refining capacity is the highest in Africa and pipeline connections ensure ease of access to neighbouring markets.

This is backed-up by a robust trade profile. The Eurozone accounts for 42% of Egypt’s exports, and while demand is muted thanks to the debt crisis, the long-term advantages of eventual tariff-free access to a 500m person market are enormous. However, perhaps more important are the COMESA and GAFTA agreements, which open doors to increasingly voracious East Africa and Middle East economies. These treaties benefit from a conducive trading environment, with container costs and processing roughly half of the regional average. 

A fourth key advantage is the sizable supply of natural resources. Oil and gas reserves have both been steadily increasing in recent years. The reserves-to-production ratio is declining, thanks to immense domestic consumption, but offshore deposits still offer promising yields. Given the fiscal pressures the government is facing and the need to boost medium-term electricity output, the ability to access feedstock is important.

Finally, an oft-overlooked benefit of Egypt’s economy is its diversification. Unlike the commodity-dependent economies of the Gulf or the still agrarian economies to the south, the proportional split of Egypt’s GDP amongst industry and services helps buffer the country from sector-specific risks. 

These competitive advantages have long helped drive growth in Egypt, and in spite of the turbulence of the past 18 months, their appeal has not dimmed. If anything, they have grown in importance in the face of large downside risks, as some of the country’s longstanding weaknesses have become increasingly apparent.

Egypt faces a number of challenges that have been exacerbated by the revolution, chief among them a lack of inclusive growth. The subsidy debate highlights this most acutely, particularly during high inflation years, but the problems extend far beyond that. Some estimates of the poverty rate place it as high as 42%, and the spate of industrial strikes have highlighted concerns over wages. There is also a risk of a hollowed labour structure, as demand for low-skilled and high-skilled workers outstrips those of middle-skilled workers.

The poor state of the fiscus is also worrying, for all the obvious reasons. Falling reserves, low revenues and stop-and-start debt negotiations have helped drive the deficit up to 11%. Nor is there any immediate or easy remedy to alleviate this – particularly if you consider the mix of needed (and sometimes contradictory) policies the government must tackle, ranging from inflation-targeting, subsidy-restructuring and stimulus-spending.

While recent months point to broader stability in the domestic economy, FDI-related risk perceptions remain a concern. The government has taken a prudent approach to managing depreciation, but that hasn’t stopped tongues wagging. Legal wrangling over land deals still plagues the real estate sector and flare-ups of industrial action and unrest contribute to worries of instability. 

Finally, Egypt faces a profound challenge in addressing long-term political questions, not only with the constitution and parliamentary elections, but also in terms of institutional trust and governance. There is a need not only to reinvigorate the country’s bureaucracy but also to improve policy implementation and project delivery. 

However, even when faced with these constraints, and even amidst a global slowdown, the potential for a solid, if not exactly strong, recovery is still there.  

It is within this context that we see three key sectors as defining Egypt’s potential trajectory, particularly in the medium-term. These sectors will not be able to fix all that ails the country, but they do have the ability to not only stimulate activity in other areas, but also boost employment, increase revenues and stabilize the broader economy.

Industry – and manufacturing in particular – is central to any economic narrative for Egypt. Although it has declined relative to other sectors in recent decades, manufacturing accounts for roughly one-sixth of GDP, and stretches across a host of segments, from petrochemicals to textiles. Sales were hit last year in areas such as durables and automobiles, but demand was surprisingly firm in some sub-sectors such as consumer goods.

Crucially, Egypt benefits from both strong export ties and a vast consumer population, which provides firms with both accessible domestic and foreign markets. A host of supporting infrastructure, ranging from QIZs to the IMC, helps buttress growth through fiscal incentives and capacity-building. Subsidy pricing and wage rises will require some juggling, but Egypt remains impressively competitive against other emerging markets as a manufacturing destination.

Energy – both in terms of upstream production and downstream generation – will also be a major GDP contributor in the short, medium and long-term. 

Fiscal issues have plagued the oil sector, but gas has done remarkably well. Exploration has shifted to more technically-challenging offshore fields but as evidenced by the discoveries last month in the Nile Delta, there is still plenty to be found. One of the top three gas producers on the continent, Egypt benefits from extensive mid-stream and downstream infrastructure, including refineries and processing plants.

However, it is consumption that is driving this sector. Now a net oil importer, Egypt’s burgeoning demand for both feedstock and electricity is opening up a raft of opportunities in the years to come. Although gas pricing issues remain unresolved, the government is aiming to virtually double generating capacity by 2027, in response to demand that is growing at an average of 7% annually.

Given the high exposure of the sector to sovereign debt, and the drop in profitability last year, singling out the finance industry as a key sector might seem somewhat counterintuitive. However, the size and comparative health of Egypt’s financials provide the fuel to stoke growth in the years to come.

Thanks to a combination of both earlier reforms and last-minute emergency measures by the CBE, non-performing loans continued to decline last year, while non-government deposits increased modestly and overall liquidity remained high. The limited penetration of mortgages and specialized SME loans, along with improving credit transparency and a renewed interest in sukuk, emphasises the country’s significant potential.

This plays out in the capital markets as well. Nearly four-fifths of the listed companies achieved profits in 2011 and on a value basis, the Egyptian market is one of the more attractive in the region. Trading received a boost earlier this year thanks to the telecoms sector and the NILEX, while still small, has followed a counter-cyclical trajectory, expanding by five listings in 2011. However, for these three sectors to maintain their appeal for foreign investors over the long-term, while still helping engineer a turnaround in the short-term, Egypt will need to carefully consider its strategy.

Given the complexity of the problems facing the country, there is no easy solutiuon. However, OBG believes that five specific strategic moves will help stoke growth and alleviate poverty while blunting the risk of losing any competitive edge. These five core elements include job creation and education, financial access, fiscal restructuring, policy clarity and legislative reform.

While each of these strategies merit a lengthy discussion on their own, we don’t have time for that but I’d like to take a brief look at each one in turn and elucidate what is being done to further them.

Given the extent to which unemployment and underemployment stoked the Arab Spring, ensuring that economic growth leads to job creation is crucial for Egypt’s recovery – particularly if the country is to address demands of social justice.

This requires cultivating labour-intensive industries such as manufacturing and fostering SME growth, which will also help reduce the wage disparity gap and expand opportunities for middle-skilled workers. As experience elsewhere has shown, given the right policies, manufacturing has the potential to provide high wages, spur innovation and reduce trade deficits.

However, this also requires additional investment in education. Egypt increased adult literacy by nearly 30% over the past two decades but there is still a significant skills shortage. Despite the provision of free education, secondary participation is low while tertiary institutions are overcrowded.

As a result, there are a number of proposals on the table to improve access, ranging from improved vocational centre oversight to increased teacher pay. This momentum needs to be maintained and even accelerated.

The second strategy is improving financial access. Egypt’s overall financial indicators are fairly robust, particularly when compared to most of its neighbours. Banks are in good health and  underleveraged, which has allowed them to take an active role in financing large-scale projects and government spending, but attractive yields on government securities and a legacy preference for blue-chip firms have limited penetration into the SME segment.

In fact, while they account for only 10% of credit, SMEs make up the vast majority of economic activity in Egypt – up to 80% according to some estimates –which means that there is dramatic room for growth. 

That is, if lenders can cope with clients whose bookkeeping can be opaque at the best of times. 

Institutions like the Nilex and I-Score have helped pave the way for improved credit access but both banks and the government need to build upon existing reforms if the economy’s huge SME sector is to expand.

One of the trickiest challenges the country is currently facing is that of restructuring swathes of the economy. Egypt has come a long way from the Nasserite policies of yore, but there are still areas where state involvement is heavy, resulting in market distortions and crowding out the private sector.

This is most obvious in terms of subsidies, which are clearly unsustainable in the current fashion. Eliminating them completely would seem unwise, given the need for them under certain circumstances, but they can be better targeted.  Similarly, raising gas and oil tariffs and further liberalizing the downstream energy sector could prevent further build-ups of arrears. The government has increasingly reduced its profile in the marketplace in recent years –privatizing banks, rolling out new PPPs, even looking closely at labour market rigidity – but there is plenty more that can be done.

Finally, the country is working on reforms to reduce inefficiencies, clarify policy planning and stimulate investment – an area where ever greater efforts will reap untold rewards. Overall the new Egypt is making a concerted effort to listen to the needs of the private sector. The government has made clear its intent to reduce the size of its bureaucracy and streamline operations. Following a year and a half of instability, ministers have been vocal about policy proposals and addressing investor concerns.

New reforms are being discussed for a number of key areas – such as utility tariffs and employee training – and capital is being funneled into needed areas, as evidenced by the new targets for energy and housing. 

Finally, particularly in light of the drop last year, increasing foreign investment remains a key component in future prosperity – not just for the capital it brings in but also the know-how.  Promotion and information are one part of this and we hope The Report: Egypt 2012, as a comprehensive, authentic and accurate review of the country’s economy – will play its own part in getting the message of Egypt’s long-term potential across to a global audience. 

Egypt has a challenging road ahead, and a number of key issues must still be resolved – but the story is not solely one of just gloom and despondency. I had wanted to end with a joke, or something to at least get you to crack a smile, but it seemed oddly inappropriate for a proud country that has gone through so much and suffered through much over this past year. 

More than 80 years ago, Winston Churchill gave the people of Britain a brutally honest assessment of the difficulties the country faced in 1940, saying “I have nothing to offer you but blood, toil, tears and sweat.” Here in Egypt you have already had the blood and the tears. Now it is time for the toil and sweat, to rebuild this country. And I look forward to us being here for yet another decade to monitor, to record and to relay news of that growth to the outside world.