Egypt’s landmark devaluation of the pound in November 2016 was a historic move hailed as a necessary step on a path of economic recovery, as the country embarked on an ambitious economic reform program with the International Monetary Fund. But as the inflation it unleashed reached a three-decade high—a staggering 32.8 percent—prices skyrocketed, leaving many families unable to afford food and other basic necessities. The inflation rate was almost double the IMF’s projection of 16.6 percent for the end of the 2016–17 fiscal year. This miscalculation was attributed to a “deeper than expected” devaluation of the pound. While the inflation rate has been decreasing, another potential risky prediction is becoming clear: one related to Egypt’s mounting external debt.
Egypt’s external debt is reportedly approaching the $90 billion mark. In terms of gross domestic product, external debt as a percentage of GDP has increased to nearly 40 percent, from 14.2 percent in late 2015. While domestic debt had reached 96.7 percent of GDP in June 2016, it has since stabilized because of the government’s strategy to replace part of it with external debt. This shift is due to the rapid increase in interest rates for borrowing of the Egyptian pound. An increase of about six percent was implemented after the pound’s devaluation to control inflation. But while this strategy might have proven effective in controlling inflation and the budget deficit, it exposes the economy to risk of external debt default if it keeps growing at this current rate for a few more years.
This is especially true in light of very weak government financing—the ability of the government to raise funds and collect taxes. Even if no default happens, a very large debt, combined with weak government financing, means that interest payments could eventually eat up more government revenue, leaving less for spending on other public services and investments that are crucial for the well-being of Egyptians and overall success of the IMF program. Already, in the 2018–19 fiscal year, interest payments alone will eat up almost 55 percent of all government revenues. On August 18, the credit rating agency Moody’s described Egypt’s outlook as “stable,” but warned that “very weak government finances will continue to constrain the rating pending further clarity on the sustainability and impact of the reform program.” Egypt only collects about 12.4 percent of GDP in tax, and more than half of it comes from consumption taxes such as value-added tax and custom duties. This further highlights the government’s worrying inability to collect direct taxes on income, profit, and property.
Yet the government does not seem to be planning to slow down on this loan-taking spree anytime soon. Early in April, Egypt raised $2.46 billion in a new euro-dominated bond sale at interest rates that range between 4.75 and 5.625 percent for bonds whose maturities range between 8 and 12 years. Egypt plans to issue more eurobonds in 2018–19 worth 6–7 billion euros. This alone will increase external debt even more—by about two percent of GDP. Moreover, Egypt is also expected to receive a fourth $2 billion tranche of its $12 billion IMF loan after the third review of the program, set to take place in June. In sum, according to the Ministry of Finance’s 2018–19 budget statement, Egypt is planning to externally borrow over 400 billion Egyptian pounds (LE)—$22.7 billion—over the coming three years, in addition to LE1.5 trillion in domestic borrowing. The government is very likely to go overboard, as it typically sets wishful financial targets, especially when it comes to deficit, debt, and tax collection.
The Theory Behind the Borrowing
It is commonplace to borrow during tough economic times to boost economic activity through debt-driven stimulus spending. The idea is that once the economy is once again on a growth track, part of the revenues from that growth could be used to repay the debt. However, for this strategy to be effective, certain conditions need to be met. First, it needs to be ensured that economy still has potential for growth and only needs a boost, which I argue is the case for Egypt. Second, a good deal of the borrowed money needs to be spent on investment that will create wealth in the short and medium terms, rather than on current expenses. Third, the state should have strong finances—meaning a good and proven track record of collecting taxes—because even if the economy grows and this growth is not reflected in increased tax revenues, the government could still fail to meet its debt commitments.
Egypt is mostly using its borrowed money to build foreign reserves and to plug the budget and balance of payments deficits, which means that a good portion of the borrowed money follows the logic of budget spending on current expenses and investment. Exports have slightly benefited from the pound devaluation, but it certainly did not pick up to an extent that would make these levels of debt creation less worrisome. Tourism has recently picked up, but if there is anything one could learn from experience, it is the precariousness of the tourism industry and its extreme sensitivity to political and security issues. Finally, Suez Canal returns and remittances from Egyptian workers abroad have stabilized over the last few years and are expected to remain stable.
As for spending on investment, Egypt has one of the world’s weakest rates of gross capital formation (GCF), which measures investment expenditure in the economy. In 2014, the global GCF constituted about 24 percent of the world’s GDP. Egypt’s GCF stood at 15 percent of GDP in 2016. Also, investment spending in the national budget has traditionally ranged between 8 percent and 10 percent of total spending. The projection for 2017–18 is 8.4 percent. As a consumer economy with a large and persistent trade deficit, finding foreign currency resources to service Egypt’s rapidly mounting external debt is by no means guaranteed. These circumstances are similar to that of Egypt’s late 1980s economic crisis, which led to the country to nearly default on its external debt commitments. In 1991, Egypt was saved when half of its external debt was forgiven by its creditors as a result of its participation in the First Gulf War, in a lucky turn of events.
Driving Down Debt
Debt reduction is one of the pillars of the IMF program. In its second review of the reform program, the IMF said that Egypt’s debt was “sustainable, but is subject to significant risk.” The IMF projects Egypt’s debt to decline to 87 percent of GDP by the end of the program in 2018–19 and 68 percent of GDP by 2022–23. IMF’s sees the worst-case scenario when it comes to public debt as “weaker growth and less ambitious fiscal consolidation, in which case public debt will decline modestly to 99 percent of GDP by 2022–23 from the current level of 103 percent of GDP.” With inflation, the significant diversion from the projected path was dealt with using a set of monetary tools, namely increasing interest rates which eventually helped lowering inflation rates. But if such diversion from the projection happens with debt, it might be too late to address it. The only “tool” available might be a suffocating austerity reminiscent of what was seen in Greece, and a vicious circle of recession in which the budget deficit leads to budget cuts, which leads to a larger deficit, which in turn leads to more cuts.