Building for the future: Challenges and reforms both shake and strengthen the sector

Industrial activity remains an economic mainstay in Egypt, with well-established sectors such as textiles, food processing, consumer staples and automotive assembly. Egypt’s large population makes it an attractive market for manufactured goods given robust consumer demand, which is set to increase with the pace of expansion in the overall economy and per-capita income levels. In 2012, however, some of the opportunities in this long-term outlook may be less obvious, as recent political uncertainty is likely to delay expansion plans and create an operating environment marked by rising costs.

BACKGROUND: With Egypt’s natural gas reserves converted into production fields, the country’s overall industrial strategy has been to supply energy-intensive factories with natural gas at rates far below the global market price. Although this method has been successful in other gas-rich Middle Eastern economies, gas prices are increasing as domestic demand for energy rises, and future policy will likely need shift away from using gas as a lever to propel industrial growth.

Manufacturing accounts for about 16% of GDP, according to statistics from the Ministry of Economic Development. Industrialisation has long been a priority in Egypt, and the country has come a long way throughout the 20th century. In the 1950s and 1960s, under President Gamal Abdel Nasser, Egypt followed a state-centric approach to development. Central planning, state-owned enterprises and nationalisation schemes were among the regime’s key policy tools. Despite the gains, Nasser’s vision proved economically unsustainable, and during this period Egyptians came to associate broad-based economic development with state leadership and largesse.

Egypt reversed course in 1973, when President Anwar Sadat eschewed ties with the USSR and aligned the country with the US. Sadat spearheaded a new industrial and economic policy that he termed infitah (or “opening” in Arabic), which was based on the courting of both domestic and foreign private investment. This approach proved politically unpopular, and dissatisfaction came to a head with the 1977 Bread Riots, two days of protests against a plan to end subsidies on basic foodstuffs. Although infitah was supported by both the World Bank and International Monetary Fund (IMF), the riots eventually compelled Sadat’s government to commit to preserving the subsidies, which have since become a fixture of Egyptian economic policy. In the past six years, Egypt has budgeted between 8% and 12% of GDP on the government compensation schemes. Today, the renegotiation of their terms is one of the most contentious issues up for debate.

CURRENT CRUNCH: Despite varying policy approaches, Egyptian industry managed to grow and establish a global presence in a number of sectors. However, recent political shifts, which began with the outbreak of unrest in January 2011 that led to a revolution and the ouster of President Hosni Mubarak, have taken a toll on production activities.

An economic survey by CEEMEA Business Group, an association for African, Middle Eastern, and Central and Eastern European businesses, estimates 35% of Egypt’s industrial firms suffered a drop in revenues of up to 10% in 2011. Still, some encouraging trends have come to light, such as the experience of several consumer staples segments, which saw demand hold up and even rise during the turbulence of 2011. At the same time, however, manufacturers of durable goods were suffering as buyers decided to hold off until a more stable political regime emerges.

In the aftermath of Mubarak’s departure and the uncertainty this left behind, the auto industry was one of the sectors hardest hit (seen analysis). Although car ownership domestically is low, at roughly 30 cars per 1000 people, sales by producers plunged by some 30% in 2011 to 176,157 vehicles, according to the Automotive Marketing Information Council. The luxury segment declined even more than the market for cheaper automotives. Meanwhile, the country’s only publicly traded auto company, assembler Ghabbour Auto (GB), posted a 19% drop in year-on-year sales in 2011.

STRUCTURE: Industrial policy of the Mubarak era generally targeted growth through liberalisation: ending central planning in favour of enabling the private sector, limiting cumbersome bureaucratic processes, opening to foreign investment, offering incentives for job-intensive manufacturing, and establishing clear and consistent monetary and fiscal policies. These reforms were accompanied by initiatives to improve education and adopt the latest technologies in an effort to move beyond manual labour and into more a lucrative knowledge-based economy. As recent discoveries have established that Egypt has some of the world’s largest reserves of natural gas, industrial policy has sought to create jobs and economic growth by providing the resource at a low cost to energy-intensive industries.

Key industrial activities to have emerged include petrochemicals production, pharmaceuticals and fast-moving consumer goods (see analyses). Textiles and automotive assembly are also mainstays. Egypt is often a headquarters for regional manufacturing, attractive for its large low-cost workforce and strategic position. In addition to being close to European markets, centrality in the Arabic-speaking region stretching from Morocco to the GCC, means that goods packaged in the country can find markets with similar customers both to the east and to the west.

OVERSIGHT: The government has several bodies charged with implementing its industrial policies. The General Authority for Investment (GAFI) serves as a “one-stop shop” for potential investors, as well as an investment promotion body. The Industrial Modernisation Centre is a development agency that encourages public-private partnerships to deepen Egypt’s links with the global economy. The Ministry of Trade and Investment’s Industrial Development Authority is responsible for implementing the ministry’s policies.

Egypt is also a signatory to a number of free trade or other preferential trade agreements, such as the Agadir Agreement facilitating trade between Egypt, Tunisia, Morocco and Jordan; the Pan-Arab Free Trade Area (PAFTA); the Common Market for East and South Africa Agreement (COMESA); and a EU partnership agreement (see Economy chapter). One of Egypt’s most significant bilateral relationships is with the US, outlined in the Trade and Investment Framework Agreement. The Qualifying Industrial Zones (QIZ) initiative is an important feature of this relationship. The QIZ establishes specific export-oriented economic zones in Egypt that enjoy duty-free access to the US market so long as a set percentage of the products’ inputs (11.7% at time of printing) are sourced from Israel. There are now 19 different QIZs in operation in the country, with 705 qualified companies and $1bn in annual revenue generated. The QIZs have played a crucial role in preventing the implosion of the Egyptian textiles industry at a time when many textiles industries worldwide are suffering as a result of low-priced Chinese exports.

However, the free zone model predates the QIZ initiative, as Egypt first turned to tariff-free industry incentive schemes in the 1970s. There are now nine publicly owned free zones located near various air and sea ports, according to GAFI. Companies operating in these zones must export at least 50% of production, and incentives structures include a lifetime exemption from all taxes, Customs and export-import regulations; exclusion from some labour provisions; and the option to sell into the local market if Customs duties are paid.

TRADE: A robust return for industrial exports is still a ways off, given the soft demand in the eurozone, Egypt’s largest export market, deflating trade throughout 2012. Still, the market has held up reasonably well, with exports totalling LE78.8bn ($13.2bn) in the first half of 2012, according to official figures. That this figure is down by just under 1% from the first half of 2011, when the country was in the midst of a political upheaval, obscures the fact that some key sectors did see gains, and it stems fears of further drops as conditions improve.

Exports of pharmaceuticals, which tend to be inflexible, reached LE1.5bn ($251.1m) in the first half of 2012, up 14.2% from LE1.3bn ($217.58m) during the same period in 2011. Chemical and fertiliser exports rose to LE16.27bn ($2.7bn), up 1.7% on LE16bn ($1bn) in 2011. Khaled Abou El Makarem, deputy council member of the Chemical and Fertilisers Export Council, told local press that the sector’s realignment towards growing African markets helped sustain sales. Furniture exports, meanwhile, rose 20% year-on-year to LE1.25bn ($209.2m) in the first half of 2012. These volumes are on course to meet the government’s goal of LE160bn ($26.8bn) in total exports for 2012.

TEXTILES: The textiles industry is a crucial component of the economy and industrial production, making up 3% of GDP and contributing up 27% of total industrial output, according to 2008 GAFI figures, the latest available (see analysis). The sector has long thrived on a number of endogenous advantages, including local cotton crops, low labour costs, power supplies and proximity to European markets. These factors have also allowed Egypt to remain among the few countries to preserve a viable textiles sector in the wake of the 2004 expiration of the Multi-Fibre Arrangement, which imposed quotas on textiles exports from developing countries. The removal of the cap has allowed Chinese exports to dominate global trade, thanks to its low labour costs.

Egypt’s long-staple cotton crop is arguably the crux of the industry’s longevity and quality. The basic cost of Egyptian fabric is $0.13 per metre, according to the International Textile Manufacturers Association (ITMA). The cost is equal to that in India and China, and cheaper only in Turkey. Additionally, the cost of unskilled labour, at $0.50 an hour, is on par with China and cheaper than India, two main sector competitors. Skilled textile labour in Egypt stands at $0.80 per hour – a third of China’s $2.40 and $0.30 cheaper than India. In the developed Italian market, the rates for skilled and unskilled craft are $21.80 and $23.90, respectively.

As a result of these advantages, a number of key competitor countries have set up production facilities in Egypt. A Chinese-Egyptian industrial zone was established for this purpose in 2006, and more than 70 Turkish firms have invested in the country as well.

As of February 2010, there were 3243 textile companies in Egypt, 214 of which were operating in a QIZ and utilising imports from Israel, like fabrics, chemicals, thread or zippers. The main exports from QIZs are denim and t-shirts, markets worth approximately $100m and $20m, respectively, according to GAFI industry data.

INDUSTRIAL ACTION: One notable threat to textiles and other production is that the workforce can be politicised. Since Mubarak’s departure, strikes in the sector have been all the more common, in line with the increased populism that has come with Egypt’s ongoing political evolution. Workers at Misr Spinning and Weaving in Mahalla, the largest public-sector factory in the country, announced open-ended strikes in May 2012 that came to a tentative conclusion in late July, when workers’ demands were partially met.

The company’s workers staged a series of strikes in 2008, considered at the time to be an open challenge to Mubarak, and the sector’s labour leaders were prominent in the anti-government movements of 2011 and 2012. “Countrywide labour challenges have been hurting business as strikes are nearly becoming a daily routine,” said Serge Vermaere, the managing director of DSD Ferrometalco, a Cairo-based and German-owned steel products manufacturer. “Risk of abrupt stoppage in the production cycle are making customers look elsewhere before placing an order in Egypt.”

RISING COSTS: Labour costs will increasingly become a risk on businesses’ margins in most sectors. Operating risk in 2012 was based on generally rising costs, including electricity prices, which are expected to climb as the country debates how to end or scale back its generous energy subsidies. Footing the bill is a major challenge to financial solvency, as between 8% and 12% of GDP has gone to energy subsidies in recent years.

Ending government subsidies would be politically unpopular, but given Egypt’s fiscal position and dwindling foreign-currency reserves, the country cannot continue to import oil and resell it at a loss domestically. Any talk of foreign aid from the IMF or similar organisations will require that subsidies be re-evaluated, and it is likely to be at the top of the lenders’ lists of desired reforms. However, the process of reform is already under way, with the government selecting specific energy-intensive activities, like steel, cement and ceramics, to receive higher rates. Given the political environment of 2011 and 2012, the targets of subsidy reform have been industrial energy consumers over voters. For certain energy-intensive industries, this will mean paying more for electricity or natural gas, or both.

Though energy and labour costs will likely have the greatest impact on profit, other factors exist. Insurance costs for assets and workers may rise, and a roughly 4% depreciation of the Egyptian pound in 2011 has made imported inputs more expensive.

SUBSIDY DEBATE: Hassan Younes, former minister of electricity and energy, told parliament in February 2012 that subsidies to companies in petrochemicals, aluminium, ceramics and steel production were ended as of January of that year, citing the “enormous profits” of firms in those sectors as a justification for increasing their operating costs by removing state support.

The start of the year also saw a hike of prices paid for natural gas by certain activities classified as “heavy industry”, such as cement and steel. These buyers will now pay the state – the only seller in this regulated market – $4 per million British thermal unit (mmBtu), up from $3 mmBtu (see analysis).

The drawback is that investors looking to Egypt may see fewer incentives in the coming years than in the past, if a large-scale departure from government subsidies and policies takes place. Younes’ exchange with parliament in early 2012 illuminates the advantages and disadvantages in the subsidies debate. In response to the minister’s explanation that industrial firms are profitable enough without government help in meeting energy costs, member of parliament Yasser Al Qadi responded with concerns that Egypt could remain economically dependent on foreign countries if it did not empower its own industrial base, according to a report in local media. He advocated a slow and phased removal of subsidies rather than a sudden one.

CHALLENGES: The approach to industrial policy in the late Mubarak era focused on boosting industry to get Egyptians working and expanding from basic activities to advanced, skills-based jobs. This mandated allocating natural gas at below-market rates to give local firms a comparative advantage. However, implementation of these objectives has been incomplete, with a variety of problems, including the inability to simplify bureaucracy, persistent inflation and a lack of skilled labour.

According to a survey by the German Development Institute, these factors were persistent and growing problems – and they have only been exacerbated in the years since 2003. “Government inefficiency has always been a drawback to the Egyptian market and privatisation is good solution to this,” said Emile Bado, the managing director of Swedish industrial manufacturer Atlas Copco. “This would help open up the economy and give more incentives to foreign companies.”

Sameh Attia, the managing director of IDG, developer of Engineering Square, said that while the government may not currently be able to provide many financial incentives, reducing red tape would improve the investment process. “It’s not realistic to think Egypt can offer exemplary incentives to entice investors,” he told OBG. “However, basic infrastructure and streamlining bureaucracy would be of enormous benefit.”

LABOUR EFFORT: Worker training appears to be an issue as well. According to the World Economic Forum’s “Global Competitiveness Report”, Egypt finished lower in 2009 than it did in 2006 in categories such as capacity for innovation, quality of scientific research institutions, and the quantity and quality of local suppliers to industry. Addressing this will be critical going forward. “Human capital is the main factor for success,” Nader Riad, the president and CEO of Bavaria, a fire fighting solutions firm, told OBG.

At the time, small improvements were noted regarding the availability of technology and research and development collaboration between universities and industry. By the 2011-12 issue of the report, Egypt had dropped another 13 spots, from 81 to 94. This fall underscored many of the economic challenges that brought about the revolution’s outbreak, which have also been manifested in the recent strikes.

OUTLOOK: Policy uncertainty for most of 2011 and the start of 2012 also slowed down capital flows and constrained expansion. A privatisation programme under way was cancelled in May 2011, and court challenges have reversed several recent others, including land sales that were allegedly completed illegally, and the purchase of department store chain Omar Effendi by a Saudi Arabian holding company.

As of May 2012, a number of fundamental questions concerning Egypt’s future remained unanswered, primarily in the domain of politics and its impact on industrial activity. What remains clear, however, is that the long-term outlook will be determined by demographic factors. With a population of some 85m, purchasing power will undoubtedly remain key in determining the country’s industrial outlook. Sales in defensive areas such as consumer staples, food and pharmaceuticals fared better than pricier items in 2011 and early 2012, indicating that demand is resilient and certain to grow.

In the second quarter of 2012 the most critical variable seemed to be exactly how long uncertainty would last. “The very act of having a president in place helps give investors the confidence to move forward,” said Khaled Akl, marketing director for consumer staples manufacturer Unilever. “It gives a sense of direction.’’ From there, as questions are addressed and laws and implementation strategies enacted, the focus can shift from the uncertainty to the long-term scenario.

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The Report: Egypt 2012

Industry chapter from The Report: Egypt 2012

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