President Abdel-Fattah El Sisi meeting with Christine Lagarde, head of the International Monetary Fund (photo via Sisi's official Facebook page).

The IMF’s Overly Optimistic Review of Egypt

08/22/2018 . By Osama Diab

Over the past several months, there have been several benchmarks in the International Monetary Fund’s loan to Egypt. The IMF’s executive board approved the third $2 billion tranche of the loan at the end of June, bringing the total drawn funds since the signing of the loan agreement in November 2016 to $8 billion. In July, the IMF released its third review of the economic reform program, which, very much like the previous two reviews, was full of praise of the Egyptian authorities for the strong implementation of the economic reform program. “The economic situation has continued to improve during 2018. Strong program implementation and generally positive performance has been instrumental in achieving macroeconomic stabilization,” reads an IMF press release on the completion of the third review. “The near-term growth outlook is favorable, supported by a recovery in tourism and rising natural gas production, while the current account deficit is expected to remain below 3 percent of GDP and the public debt ratio to decline markedly by 2023.”

Despite the praise, the economic situation in Egypt has been marred by uncertainty and volatility since the program’s implementation. High levels of inflation and unprecedented increases in prices of public utilities have left most Egyptians negatively affected by the program. The latest report addresses some of these issues, but does not adequately acknowledge or remedy others - particularly the impact of subsidy cuts on lower-income residents.

Structural Risk
The IMF has identified in its report one major looming risk: capital outflow as a result of tightening global financial conditions. Because Egypt devalued its currency in November 2016 and increased its interest rates to contain the inflationary impact of the pound devaluation, massive inflows of so-called hot money had entered the country. The year following the devaluation has seen $17 billion of investments in Egypt treasury bills, which are short-term debt instruments. Many analysts have warned of this influx of capital with no strings attached because if the circumstances with which they were brought in change even slightly, a massive withdraw could happen, increasing the volatility of the situation and exposing the economy to immense risks. At the time, when analysts were expressing their concerns, the IMF saw this influx as a positive sign. Yet the third review shows that the IMF is now acknowledging the risks: “There has been a shift to capital outflows in recent months as tightening global financial conditions have contributed to a pullback by investors from emerging markets more broadly. Should these patterns intensify, financial conditions could tighten appreciably,” the report reads.

The IMF praised in its report the building up of international reserves and argued that “the healthy level of foreign reserves and flexible exchange rate leaves Egypt well positioned to manage any acceleration in outflows.” This also brings back suspicion of many analysts about measuring foreign reserves in an absolute number rather than one relative to other indicators, such as short-term external debt obligations. It is true that international reserves in absolute terms have skyrocketed from about $15 billion in June 2016 to about $40 billion in 2018. However, one indicator of the sustainability of the debt, regardless of its absolute size, is the short-term external debt relative to foreign reserves. This ratio was 10 percent in fiscal year 2011–12, which simply means that the short-term debt obligations constituted 10 percent of the size of international reserves. This ratio stood at 30 percent in the second quarter of FY 2017–18.

Debt and Taxes
The report was also overly optimistic regarding Egypt’s mounting debt. The 2018–19 debt is projected to decline to 86 percent of gross domestic product. The report has as its base point the 103 percent of GDP ratio of 2016–17, which completely ignores the increase in 2017–18, when the size of debt went up to 105 percent of GDP in March 2018 and is projected to have increased since to about 108% of GDP. To go down from 108 percent to 86 percent of GDP in a few months when the trend is still upward would seem a bit unrealistic and it is not clear why the IMF report completely dropped the 2017–18 years from its analysis.

In terms of deficit reduction measures on the revenues side, the IMF report projects an increase in revenues of 0.4 percent of GDP as a result of “the full year impact of higher value-added tax (VAT) and tobacco excises, higher stamp duties, and improved tax administration.” This stress on indirect taxation and higher stamp duties reflects well the trend in which the tax structure is becoming more and more regressive. According to figures from the Ministry of Finance, the first half of FY 2017–18 saw, for the first time, VAT revenues exceed half of all tax revenues (53.6 percent). This not only contradicts principles of tax and economic justice, but also the IMF’s own recommendation in the second review report of the economic program to increase the progressivity of personal income tax and improve corporate income tax performance by addressing base erosion and profit shifting, and reviewing tax incentive schemes for foreign direct investment and free economic zones.

The third review report also states that there have been stepped-up efforts to address tax noncompliance and increase the efficiency of revenue collection to boost revenues and “create fiscal space for investments” in health and education, infrastructure, and a sustainable social safety net. This approach to tax collection, however, does not address the deeper and more structural issues of tax avoidance and evasion that are pervasive among corporate players. An unpublished IMF report from December 2017 obtained by TIMEP demonstrates that the organization is aware of how acute the problem is. The report states that “a significant share of [FDI flowing into Egypt] originates from jurisdictions with a very low [corporate income tax] rate and/or very low cross-border withholding tax (WHT) rates on dividends, interest and royalties.” The December report says that this is “often suggestive of aggressive tax planning, as [multinational corporations] may indirectly channel their FDI through those jurisdictions to benefit from low taxation.”

As for deficit reduction measures on the expenditures side, a major cut is in the public wage bill, which is projected to further decline by 0.5 percent of GDP after having already dropped by 2 percent of GDP in the past two years. In an earlier article, I argued that the wage bill is only high relative to tax and government revenues because the latter is too low - not because wages are too high. Relative to GDP, Egypt’s wage bill at its peak was close to, if not actually less than, the international average. Better distribution of government wages is necessary, by balancing the distribution of actual service providers such as doctors and teachers, who are in short supply, against the overcrowded back office and administrative staff. Increased efficiency of the bureaucracy is also crucial, but the economic program’s unnecessary focus on the mere size of the wage bill is shortsighted and has serious long-term implications on the future of the middle class and women’s employment, since the public sector is a major employer of women.

Subsidy Cuts
Another major deficit-reducing measure on the expenditure side is the reduction of energy subsidies by a projected 1.3 percent of GDP. In its report, the IMF argues that energy subsidies benefit the well-off disproportionately, which is a valid argument as wealthier households and individuals - not to mention energy-intensive commercial establishments - consume much more energy. However, the way in which fuel prices increased disproportionately affected low-consumption (and therefore low-income) groups. For example, the price of diesel, which fuels microbuses that are mostly used by low-income commuters, increased by 50 percent in June 2018. The price of butane gas cylinders - which are also mostly used by residents of the less wealthy neighborhoods who do not have gas connections at home - has increased by 66 percent. On the other hand, petrol for private cars increased by 35 percent and 17 percent for 92 octane and 95 octane, respectively. As for water, the lowest consumption bracket also saw the largest increase, which is the third increase in two years, with a cumulative increase of more than 100 percent. Furthermore, the more recent hike in electricity prices was extremely regressive, where the increase for the lowest consumption bracket was about 70 percent, whereas for the highest it was a mere 7.4 percent.

Potential Positives
One positive aspect in the IMF report was its focus on making public procurement more transparent and competitive to optimize public spending and curb corruption. This is linked to the report’s call for reforming the current regime of industrial land allocation, in which land is sold at a pre-set price based on government review of applications. This makes the whole regime vulnerable to corruption and favoritism, and Egypt’s public coffers have historically suffered greatly from land privatization by direct order at below market prices to member close to the political regime.

Despite the fact that the economic reform program’s attack on public sector as the largest employer of women will disproportionately affect women, the government is working as part of the program on implementing gender budgeting starting 2018–19 and expanding its expenditure on public nurseries to enhance the ability of women to seek employment. Given the real difficulties that are facing women in the labor market, it is important that these programs do not end up being a superficial way of crossing “gender inclusion” of the IMF checklist after the female labor force participation rate had dropped since 2013.