The Arab world’s second-largest economy, with a GDP of $229bn in 2011 according to the World Bank, has faced exceptional economic circumstances since the start of its political transformation 18 months ago. The turbulent process set in motion then has continued in 2012, and its effects are to be seen across the nation’s balance sheet – from a reduction in foreign direct investment (FDI) to a significant decline in crucial sectors, such as tourism. However, the attributes which enabled Egypt to record GDP growth rates of around 7% in the years leading up to the global financial crisis remain in place. How best to use its comparative advantages to satisfy the population’s desire for social justice, while continuing Egypt’s recent history of economic reform and expansion, will be the foremost question on the government’s agenda for some time to come.

REFORM: The political upheavals of early 2011 came at a time when the economy was demonstrating its resilience to the global economic crisis and showing signs of a sustained recovery. A number of factors combined to shield the country from the deleterious effects of the credit crunch which rocked the world’s largest markets from 2008: its conservatively regulated financial system is characterised by relatively modest capital flows and portfolio investments, with a banking segment not significantly exposed to the toxic assets that lay at the centre of crisis. A diversified economy and high levels of domestic demand helped to shore up GDP growth in the challenging post-crisis environment, as did government efforts to ramp up this local demand as a countervailing force to lower levels of interest from abroad.

The Ministry of Finance (MoF) moved quickly to introduce a stimulus package for the 2008/09 and 2009/10 financial years (June to June) totalling LE25bn ($4.2bn), 90% of which was directed towards infrastructure projects, and at the close of 2010 it announced details of a new stimulus plan that promised to inject LE10bn-20bn ($1.7bn-3.3bn) into the economy by allowing state employees to borrow against their salaries to make retail and other purchases. The question of unemployment, meanwhile, was addressed by a multi-pronged strategy which combined an effort to attract LE66bn ($11bn) worth of investments for labour-intensive and agricultural projects, a more effective use of national savings, and new legislation aimed at developing domestic trade and attracting surplus liquidity from wealthy neighbours in the Middle East and North Africa (MENA) region. The government’s manoeuvring at such a crucial stage of recovery continued a series of necessary economic interventions and reforms.

RECALIBRATION: Those initiatives represented a recalibration of the state’s interaction with the economy, and sought to address such fundamental systemic weaknesses as inflexible government policies, persistent fiscal deficits and anaemic levels of private sector activity. The government enhanced the business environment by overhauling an onerous and inefficient tax system (see analysis) and in 2008 had introduced a separate economic court system, which, through the use of specialised judges, is designed to resolve complicated business conflicts in a more timely fashion than the mainstream judicial process.

This recent history of wholesale economic reform was central to the ability to recover from the effects of the global economic crisis of 2008-09 far more quickly than many had expected. Despite a slowdown from the roughly 7% annual growth rate posted for the seven years prior to 2008, Egypt showed a relatively robust 4.7% GDP expansion for the 2008/09 financial year. By late 2010, quarter-on-quarter GDP growth had reached the 6% mark, and for 2011 the MoF was predicting a return to the 7% levels of expansion to which the nation was more accustomed.

POLITICS INTERVENES: The political events of 2011 paused Egypt’s trajectory of long-term economic reform. The transitional governments and military council which have attempted to guide the country through a difficult process of transformation have been compelled to address the short-term challenges that have resulted from the social unrest rather than Egypt’s longer-term problems.

The disruption to commercial activity during and following the popular uprising in January 2011 was extensive: the prolonged closure of the stock market undermined investor confidence; tourism receipts fell by more than 33% for the year, according to the Ministry of Tourism; FDI, which had already dropped by 50% from 2009 to $3.7bn in 2010, slumped even further to $900m in 2011, according to the World Bank; and Central Bank of Egypt (CBE) figures show that international reserves fell sharply as the government dipped into them to meet its fiscal requirements and prevent the depreciation of the pound, to the extent that by the start of 2012 its reserves were sufficient for only three months’ import cover.

As a result, rather than the 7% forecast by the Ministry of Planning, GDP growth for the 2010/11 financial year came in at 1.8%, according to the CBE. The World Bank revised its forecast of Egypt’s 2012 GDP growth to 2.5%, while its forecast of 3.5% for 2013 came with the caveat that both internal and external risks, such as the sovereign debt crisis in Europe and domestic political uncertainty, threatened to reduce this. The uncertainty of the country’s political future has complicated the ability of the MoF and other state bodies to re-engage with the development of Egypt’s economy, and the low growth figures that have been delivered as a result threaten to bring about yet more social unrest. Breaking this cycle of legitimate demands for social justice, civil disturbance and increased economic deterioration will be one of the most significant challenges facing the government in the short term.

STRENGTH IN DIVERSITY: While the challenges to the country’s economic growth remain significant, planners within the MoF and Ministry of Economic Development can take solace from the fact that the diversification of Egypt’s economy grants them some room for manoeuvre. After millennia as an almost exclusively agricultural economy, Egypt’s first steps towards a modern manufacturing industry came in the first half of the 19th century, during the rule of Muhammad Ali. Another drive towards industrialisation came with President Gamal Abdel Nasser in the 1950s, and his ambition to see everything from “the needle to the rocket” made within the newly independent country. The result is was a relatively well-balanced economy, diversified across agriculture (14.5% of GDP in 2010, according to the MoF), industry (37.6%) and a more recently prominent services sector (47.6%). Agriculture, which includes irrigation and fisheries, grew at an average rate of 3.45% during the 1990s, accelerating to 4% in 2008/09 before dropping to just below 3% in the wake of the global economic crisis, as demand from industries dependent on agricultural policy declined. Government strategies have sought to introduce more efficiency to the sector, such as through the introduction of modern machinery and methods. The goal of reducing Egypt’s wheat imports from around 50% of the national requirement to 45% have been tempered by the need to protect its large and generally unskilled workforce. Today, agricultural activity accounts for 28.2% of the labour market, according to Egypt’s Central Agency for Public Mobilisation and Statistics.

Within the industrial sector, manufacturing activity is the largest contributor to GDP (16.5% in the 2010/11, according to the MoF), and Egypt has well-established manufacturing segments in clothing, textiles, furniture, paper, cement and pharmaceuticals. Textiles activity, in particular, has been a driver of growth in recent years, partly as a result of the Qualifying Industrial Zones agreement of 2004, by which Egyptian textile goods are granted tariff-free access to the US market (see Industry chapter). According to the agreement, a minimum of 11.7% of the production input must be sourced from Israel.

POTENTIAL FOR GROWTH: Fertiliser manufacturing is another area in which Egypt has shown steady growth, and expansion in this segment has seen the country turn from a net importer of fertiliser to a net exporter. Prior to the recent change in government, the expansion of the manufacturing sector was a key element of the broader economic strategy, with six segments identified as areas of potential growth: engineering machinery and equipment, consumer electronics, automotive components, life sciences, biotechnology and handicrafts. Championing manufacturing is likely to continue under the new administration, which is seeking to provide employment opportunities for the young population.

Still, within the industrial sector, extraction activity accounted for 14.9% of GDP in 2010/11. Primarily made up of oil (6.2% of GDP) and gas (8.3%) processes, but also encompassing a nascent mining industry, this segment has been reinvigorated by a number of new finds in recent years. In 2009/10 Egypt’s proven oil reserves reached a new high of 18.3bn barrels, while the nation has the third-largest natural gas reserves in Africa after Nigeria and Algeria (see Energy chapter). In 2009/10, the cumulative foreign investment in the oil and gas industry reached $16.3bn and, as the geographic dispersal of the segment protected it from many of the disruptions caused by the social unrest of 2011, the government’s plan to increase production by 5% per annum until 2020 remains unaltered.

BUILDING BOOM: Egypt’s rapidly expanding economy in the years prior to the global credit crisis also brought about significant growth in the construction sector, which contributed LE24.8bn ($4.2bn) to GDP in 2005/06 and LE60bn ($10bn) in 2010/11. Growth in this segment was aided by government stimulus packages, as well as the demand for housing, commercial, hospitality and industrial projects generated by the swelling ranks of the nation’s middle class.

The same factors combined over a similar period to fuel the expansion of the telecommunications sector, where three licensed mobile operators – Vodafone, Etisalat and Mobinil – compete to offer voice and data services to an increasingly tech-savvy population. Growth in this area, aided by a subscription fee cut by the government in 2007, has been rapid. According to the Ministry of Communications and Internet Technology, Egypt had 31.21m internet users at end-June 2012, up 20.64% from a year before. The mobile penetration rate, meanwhile, stood at 112.75% in June 2012, up from 102.76% at the end of 2011.

Acting as both enabler to and beneficiary of this growth is a financial services sector that accounts for 7.2% of GDP and is composed of 39 locally licensed lenders led by the reform-minded CBE; the oldest stock exchange in the region, which in 2012 took possession of a new headquarters in Cairo’s Smart Village; a vibrant insurance segment with 17 direct insurance firms and more than 600 private insurance funds overseen by the Egyptian Insurance Supervisory Authority; and the hundreds of intermediaries that facilitate the growth of the market.

Finally, Egypt’s position as a major destination for tourism was established in the 19th century, and in 2010/11 the sector contributed LE41.8bn ($7bn) to GDP, or 3.2% of the total. An estimated 14% of the population work within the industry, which is built around the nation’s ancient heritage and the more recent development of its Red Sea and Mediterranean coastlines. While tourism in Egypt recovered quickly after the global economic crisis, rebounding from a 2.3% dip in 2009 to rise by 21.4% in the first half of 2010, the effects of the political unrest of 2011-12 have been more persistent. Tourism revenues were down 30-35% in 2011, according to Hisham Zaazou, senior assistant to the tourism minister, although visitors numbers seem to have bounced back in first-half 2012, rising 27% year-on-year to 5.24m.

PUBLIC FINANCES: During the half-decade prior to the 2011, Egypt’s attempts to reduce its fiscal deficit met with considerable success: by 2008/09 the 10.2% deficit of 2001/02 had been brought down to 6.9% – an improvement largely attributable to the government’s 2004 decision to refocus its tax policy.

Since that time a process of reform has transformed a sclerotic and inefficient system into a simplified structure within which tax revenues have increased year-on-year (see analysis).

Egypt’s reformed tax system has served it well in the wake of the uprising. Overall tax revenue, which includes some of the income from the Suez Canal, rose in 2010/11 over the level registered the previous year. Revenues from taxes on income, profits and capital gains, goods and services, and property all showed increases over the previous year, while revenues from taxes on international trade showed a modest retrenchment of some 6%, primarily as a result of the interruption of business in early 2011.

FISCAL SITUATION: However, Egypt’s non-tax revenues, such as the sums derived from tourism activity, have been more adversely affected by the recent political events, falling by 25% over 2010/11. This decline, combined with a rise of fiscal expenditures as the government moved to satisfy the salary demands of public sector workers and calls for increased spending from the wider population, resulted in a fiscal-deficit-to-GDP ratio of 9.8% for 2010/11 – reaching almost LE134.5bn ($22.5bn), compared to LE98bn ($16.4bn) the previous year.

The reduction of the fiscal deficit represents a considerable challenge for the government. Earlier attempts to improve the fiscal situation through the introduction of a property tax and the replacement of an inefficient sales tax with a value-added tax (VAT) were put on hold due to the unfavourable economic conditions which followed the economic crisis. Reducing public outlays, in balance sheet terms the simplest method by which to address the deficit challenge, is complicated by political factors. The largest component of government expenditure is that of subsidies, grants and social benefits, which represented 33% of the total in the period July 2011 to May 2012, according to the MoF.

Energy subsidies account for 61% of the total subsidy bill in 2010/11, and Egyptians have become accustomed to the cheap petrol and butane which are the result. Some 70% of the population possess a ration card, which grants them access to subsidised bread and other staples, much of which is imported. Shortages of fuel or bread have, in the past, led to civil unrest, and more recent supply bottlenecks have threatened to bring yet more disruptions.

SUBSIDY SPENDING: Any attempt to significantly alter the nation’s subsidisation programme, thus carries political risk, while the subsequent rise in fuel and food prices would also have inflationary implications. Egypt’s headline consumer price index showed an inflation rate of 7.25% in June 2012 – an improvement on the 9.5% of December 2011 but nonetheless the extension of a trend which has seen a sharp rise in food prices over the past year against a background of rising global prices.

Egypt has dealt with inflationary pressures in recent years by overhauling the framework by which it sets monetary policy (see Banking chapter), and with some 42% of the population living below the poverty line, according to a 2010 report by the Institute of National Planning, maintaining downward pressure on inflation is a government priority. Nevertheless, in 2012 the MoF made public its desire to adopt a strategy that distributes subsidies more effectively – echoing proposals that have been put forward by some economists (see analysis).

“Most of the government’s subsidy spending is wasted and not consistent with the objectives of the revolution regarding social justice; around 80% is not needed, going to energy-dependant industries and luxury consumption,” Magda Kandil, the former executive director and director of research of the Egyptian Centre for Economic Studies, told OBG.

REFINING THE TAX FRAMEWORK: In February 2012 the finance minister, Momtaz El Saeed, revealed that the country needed to find $11bn over the next two years to fund a programme of economic reform that would see the further development of the taxation framework and a restructuring of the subsidy system. The proposal to replace the sales tax with VAT is once again back on the agenda, as is the stalled property tax. Subsidies, meanwhile, will be restructured to “ensure access only to those who deserve [them]”, according to a MoF statement, with industrial users likely to be the first to face market prices.

The MoF has promoted its scheme, launched in March 2012, for Egyptians living abroad – according to the World Bank there are more than 4m of these – to purchase land in Egypt, by which it hopes to be able to raise $15bn over the next four years.

In the meantime, negotiations with the International Monetary Fund (IMF) over a $4.8bn loan which was initially refused by the transition government in 2011 continue. The extension of such a loan facility is currently seen by many observers as crucial to Egypt’s ability to secure large-scale funding from other international sources (see analysis).

DEBT STATUS: Egypt’s fiscal challenges have resulted in a re-shaping of the nation’s debt profile over the past year. With the level of political uncertainty making an approach to the global bond markets impractical, and in the absence of a consistent lending programme from international sources, the government has turned to the domestic market in its efforts to meet its fiscal obligations. As a result, the gross domestic debt of the government rose to LE1.02trn ($169.9bn) at the end of March 2012 (or 65.6% of GDP), compared to LE847.9bn ($141.9bn) a year earlier. Average interest rates on the Treasury bonds and Treasury bills from the central government, local government and public authorities had increased to 12.89% by the end of March 2012, with some bond sales in early 2012 producing yields of nearly 16%. This began to ease as the year progressed: average yields on one-year T-bills fell to 15.01% at an auction in mid-September, while the yield on the country’s dollar bonds due in April 2020 rose slightly to 5.21%. A reliance on the domestic sector for funding has become costly, despite a move to lower banks’ domestic currency reserve requirements in an attempt to boost liquidity and thus reduce yields, and threatens to crowd out the private sector from the credit market (see Banking chapter).

Egypt’s external debt, however, is relatively small – a fact which differentiates it from the struggling economies of Europe. The ratio of external debt to GDP stood at 13% in March 2012, while government external debt, which accounts for around 76% of the total, decreased by 4.8% between March 2011 and March 2012, from $26.8bn to $25.5bn. This favourable debt position will be to the country’s advantage when the return to political stability allows it to approach the currently inaccessible international markets.

TRADE: As the decline in revenues from taxes on international trade during 2010/11 demonstrates, Egypt’s trading activity has been adversely affected by the recent political unrest, although downward pressure on exports actually began with the global economic crisis. The contraction of total export proceeds in 2009/10 by 12% to $17bn resulted in a trade deficit of $25.1bn for that year – a figure that has stayed almost constant since.

Egypt’s biggest trading partner is the EU, which accounted for 42.3% of its exports in 2010/11, according to the MoF, and its trading relationship with the bloc was cemented in 2004 by the EU-Egypt Association Agreement. This deal established a 12-year trade liberalisation programme by which Egypt’s goods already enter Europe tariff-free, while around half of Europe’s manufactured exports are currently granted tariff-free access to Egypt.

Although the agreement has proved fruitful for both parties, Europe’s slow recovery from its economic downturn has led to concerns that Egypt’s export policy is weighted too heavily towards its northern trade partners. However, Egypt has several other well established trading relationships, upon which it might expand when its economy further stabilises. Egypt exported $4.9bn worth of goods to Arab states in 2010/11, representing 18% of total exports, compared to the 12% which this region claimed in 2006/07. With forecasts for GCC growth in 2013 settling around the 4.5% mark, Egypt’s regional neighbours offer a promising avenue of export expansion.

Vibrant Asian markets, too, represent a potential area of interest for Egypt’s exporters. Egypt shipped $4bn worth of goods to the Asian region in 2010/11, equal to 14.9% of total exports – a 1.4% increase on Asia’s share in 2006/07. Africa accounted for just 2% of Egypt’s exports, or some $543m, in 2010/11, yet with GDP growth predictions by the IMF for South Africa, Nigeria, Angola and Ghana ranging from 2.6% to 8%, Egypt’s African neighbours are of renewed interest to a government intent on reducing a persistent trade imbalance.

FDI: As with the trade deficit, Egypt’s FDI challenge pre-dates the recent political changes. Global FDI inflows fell significantly in the wake of the economic crisis and Egypt did not fully escape this trend, seeing foreign net investment in the country fall from a high of nearly $13.2bn in 2007/08 to $8.1bn the following year, according to the MoF. The following year saw this trend continue, with total net FDI in 2009/10 of $6.8bn, a drop which was largely attributed to lower investment levels in the oil and gas sector – traditionally the largest beneficiary of FDI. A recovering global economy prompted the Ministry of Investment to declare 2010/11 as the year in which the decline in FDI would be reversed, predicting a figure of $10bn which it later adjusted to $8bn. However, the unrest beginning in January 2011 led to a significant drop-off in foreign investment interest, and the 2010/11 year ended with a net FDI total of $2.2bn. As a result, FDI as a percentage of GDP contracted from 8.1% in 2007/08 to 0.9% in 2010/11.

In terms of FDI origin, recent years have seen the UK overtake the US as the largest source of investment, contributing $4.3bn in 2010/11 compared to the latter’s $1.8bn. However, anaemic economic growth in Western economies has again compelled Egypt to look to other regions as it formulates its FDI strategy. The MENA region has been a significant source of FDI in the past (the UAE alone invested $3bn in 2006/07), and a recent pledge of $10bn worth of investment from Qatar and similar promises of support from Saudi Arabia suggest that this might become the case again. Following the return of political stability, hydrocarbons is likely to be largest recipient of FDI, although the Ministry of Investment has also earmarked infrastructure, renewable energy, and small and medium-sized enterprises (SMEs) in areas such as garment manufacturing and food processing as potential destinations for funding.

PPP PROGRAMME: Prior to the recent change of administration, Egypt had developed and successfully implemented a public-private partnership (PPP) programme as a means to encourage further domestic and foreign investment. A PPP unit set up in 2006 oversaw a number of projects in which domestic firms joined forces with consortia of some of the world’s largest companies to bid for initiatives, while the passing of a PPP law in 2010 aimed to encourage yet more external input by providing a more comprehensive framework for such ventures.

Unlike a privatisation programme which, as a result of poor implementation, has become a political impossibility due to opposition, the PPP programme offers a route to capital which does not contravene the demands for more social equity. “I don’t think PPP is dead as a concept. It is the only way to continue the development of infrastructure, especially as the country is suffering from a huge public deficit,” Sameh Badry, deputy chief financial officer at the Financial Division of National Société Générale Bank, told OBG.

SMES: Future economic growth, however, is dependent on more than foreign investment in large-scale infrastructural development. Whatever the outcome of Egypt’s political transition, it is likely that the new government will continue with an already advanced programme of developing the SME sector. Between 2003/04 and 2007/08 the private sector accounted for two-thirds of GDP growth, according to the MoF, and while much of this originated with corporate activity, a 2006 national census which revealed that 3m SMEs in Egypt accounted for around 80% of employment in the non-agricultural sector left no doubt as to the potential inherent in smaller local businesses. The importance of the SME sector is even more pronounced in a post-economic-crisis landscape that has seen domestic demand remain robust in comparison to slower foreign demand.

A policy of supporting SME growth dates back to at least 2002, when the MoF introduced special tax treatment for the sector, while more recently the government has shifted its focus towards ensuring SMEs have adequate access to finance as well as non-financial services, such as ICT. While these challenges remain, the electoral success of the Freedom and Justice Party, whose ranks contain large numbers of professionals and small business owners, suggests that SMEs will remain a government priority.

OUTLOOK: The events of 2011 have left Egypt’s new government with a number of challenges. As was shown in the MoF’s June 2012 “Financial Monthly”, a combination of “unfavourable global and domestic circumstances today [is] adversely impacting the performance of the economy, holding back growth and causing temporary disruption to the macroeconomic scene”. High levels of unemployment and inflation, a growing national debt and steep declines in crucial sectors are acute political and economic concerns, and the turbulent transition process has yet to be fully resolved. However, the fundamental attributes of the economy that made it such a target for foreign investment in the past remain in place: a large, cost-effective, skilled and unskilled workforce; a favourable geographical position; a range of natural resources including hydrocarbons reserves and tourist-friendly beaches and coastlines; a growing industrial base; and an increasing amount of expertise in fields such as ICT and other service industries.

Indeed, Egypt may have been travelling in the right direction before the uprising of 2011, but at the wrong pace. “Reform took too long – from 1991 to 2011. And it was carried out in a piecemeal way, so the benefits were not felt by the ordinary people. You cannot restructure a whole economy by addressing just 5% of the population,” Sherif Raafat, the chairman of Concord Corporate Finance and Securities, told OBG. Egypt’s move towards a market economy must accommodate the demands for social justice from a newly empowered people. If more political stability can be achieved, the country’s potential to both reform and provide for its citizens will be clear.