Inflation hits Cairo’s reforms

11 July 2008
Egypt’s plans to deliver economic growth and open up state-dominated industries have been hit by soaring inflation, which is the now the highest in the region.

Senior officials in Cairo can do little to mask their anxiety over inflation, which has almost doubled this year. The latest figures from the government show that the consumer price index rose to 20.2 per cent in June, up from 10.5 per cent in January. Other independent organisations put the figure at more than 20 per cent.

“Certainly it is a concern for everyone,” says Ali el-Tahry, managing director of Cairo-based investment bank Beltone Financial.

Prices have grown faster in Egypt than almost anywhere else in the world this year, according to the International Monetary Fund (IMF). And inflation in Egypt is now higher than in any other country in the region - the average for emerging markets is 7-8 per cent. “Does it worry us? Yes, of course,” says Egypt’s Deputy Finance Minister Hany Kadry Dimian.

However, Dimian points out that average infla-tion from July 2007 to May 2008 was 10.9 per cent, compared with 11.2 per cent for the same period the previous year. “On an average basis, it is still below last year’s rate,” he says. “I do not see it as a major impediment to growth so far.”

Unfortunately for Cairo, worse could be to come. The Central Bank of Egypt acknowledges that there is upward pressure on inflation, and some economists predict it will rise to 22 per cent by the end of the year.

Reform impact

Rising inflation could have a serious impact on Cairo’s economic reform programme, as well as the country’s social and political cohesion, with the poor suffering disproportionately from higher food and fuel prices.

“The economy has been performing quite well in terms of growth,” says Richard Fox, head of Middle East sovereigns at credit ratings agency Fitch Ratings. “But the benefits have not been widely spread. Inflation has worsened, so clearly it does have social and political implications.”

High inflation will also put pressure on local firms to raise wages, increasing the cost of doing business. “The higher it goes, the more likely it is to get engrained with wage setting,” says Fox.

High inflation is already having an impact on government finances. Credit ratings agency Moody’s Investors Service revised its foreign currency government bond rating for Egypt from a stable to a negative outlook in late June, principally because of the inflation figures. At the same time, it downgraded the government’s local currency bond rating from Baa3 to Ba1.

“On balance, Moody’s considers that the risks to the government’s creditworthiness have tilted to the downside given the high and accelerating rate of inflation,” says Tristan Cooper, lead analyst for Egypt at Moody’s.

The reasons for rising prices are clear and many are beyond Cairo’s control. The cost of food and beverages has jumped by 27 per cent in the past year alone. This is partly because of the higher demand for biofuels, which has resulted in farmers worldwide taking land previously used for food production and using it to grow fuel, and partly because of the activity of speculators. Even though Egypt is a net exporter of hydrocarbons, rising oil and gas prices are also being passed on to consumers, with transport costs up 20 per cent over the past year.

“The inflation we have is not really a domestic issue, it is imported,” says Maged Shawky, chairman of the Cairo & Alexandria Stock Exchanges (Case). “Inflation is a global challenge. A lot of the drivers are global, not specific to Egypt. Everyone else is dealing with the same conditions.”

Political unrest

While all countries have been affected, Egypt’s relatively low income per capita and high rates of poverty mean its citizens are more exposed to rising food prices than most, increasing the potential for political unrest. Food, beverages and fuel make up more than half of household expenditure, according to the IMF. In 2007, food riots in Cairo underlined the dangers of this situation for the government.

According to Fitch, the country is more vulnerable to macroeconomic volatility from inflation shocks than any other in the region. Out of 73 emerging market economies around the world, only 10 are more vulnerable than Egypt, it says. This is because of the country’s already high inflation rate, loose monetary conditions and large government debt.

Egypt’s government subsidies soften the effects of inflation for many of its citizens, but the pressure they place on government finances inevitably rises along with prices. Cairo is one of six countries around the world where food subsidies are expected to account for more than 1 per cent of gross domestic product (GDP) this year, and one of five where fuel subsidies will cost more than 5 per cent of GDP.

While global food and fuel prices are largely outside the government’s control, it may be unwittingly contributing to its problems. According to a recent report from the IMF, restrictions on rice exports by major producers including Egypt, India, China, Vietnam and Cambodia, which between them supplied 40 per cent of global rice exports in 2007, “have likely accounted for a substantial part of the price surge this year”.

Along with wages, food and fuel subsidies are placing a heavy burden on the government’s budget. From July 2007 to April 2008, the subsidy bill surged by 69 per cent and its wage outlay by 19 per cent. In the budget for the current financial year, 62 per cent of government spending is on wages, subsidies, grants and social benefits.

A recent decision to increase public sector wages will put further pressure on inflation rates and the government deficit, although Cairo says it will raise enough additional revenue to offset the impact of higher wages, by increasing some taxes and fees and reducing energy subsidies. However, it is difficult to significantly cut subsidies at a time of high inflation.

Despite the difficulties, El-Tahry insists that the country is “very well placed” to deal with high oil and food prices. Strong economic growth should bring in higher tax revenues, helping the government to pay its subsidies bill.

There are certainly some positive aspects to the Egyptian economy. The country is enjoying high growth rates and the Case stock market has outperformed other exchanges in the region in recent years.

Dimian says growth should remain at close to 7 per cent in the coming years, while the debt-to-GDP ratio has been decreasing.

After several years of high unemployment, the jobless figure is also improving, helped by greater economic activity. The number of companies being set up has risen from about 1,400 in 2002/03 to more than 6,300 in 2006/07. This is still accelerating and the figure for the first five months of this year was more than 3,300, according to the Finance Ministry, creating 84,500 jobs.

On average, 71 companies were set up every week from 2002 to 2007. The figure for the first five months of this year was 165 a week. An economy dominated by the state is slowly being opened up to private enterprise.

Much of the investment is coming from beyond Egypt’s borders. In recent years, foreign direct investment has grown to more than $11bn a year, from just $509m a year at the start of the decade. “There is a huge amount of investment going into Egypt,” says El-Tahry. “It does not necessarily spend as much on creating awareness as other countries.”

While most investment used to be in the oil sector, these days the growth is being driven by manufacturing industries, construction and the financial sector.

However, the figure for this year is likely to be several billion dollars lower than hoped, after the sale of Banque du Caire was unexpectedly put on hold in late June after bids came in below government expectations. This is a setback for the government, which has been trying to strengthen the weak banking sector.

Such difficulties raise doubts over the much-lauded programme of economic reforms being pursued by Cairo. “We would have been much happier if it had sold Banque du Caire for whatever price it could get,” says one observer.

Nonetheless, the wider reform programme does not look to be at risk. The Finance Ministry says the government’s institutional and structural reforms are the reason for the economy’s impressive growth.

Reducing prices

However, such growth could come under pressure if inflation remains high. Unfortunately, beyond the tax rises already planned, the tools at the government’s disposal to bring down prices are limited. Egypt already has a relatively large fiscal deficit and a high public debt burden.

The Central Bank of Egypt has raised interest rates in an effort to contain inflation. On 26 June, its monetary policy committee raised the overnight deposit rate by 50 basis points to 10.5 per cent and the discount rate by 100 basis points to 10 per cent. However, it acknowledged in a statement after the meeting that “the balance of risks to the inflation outlook continues to be on the upside”.

Overall, its approach has been cautious. “It highlights the fairly rudimentary inflation-targeting tools of the central bank,” says Fox. “Inflation has been raised far above its comfort zone. It is difficult for a central bank to know what the right level of interest rates is in these circumstances. It obviously wants to keep growth going so it does not want interest rates to rise too much. It is a delicate path to tread.”

For investors to be reassured about the Egyptian economy, and for sustainable growth to continue, inflation needs to be brought down to more manageable levels. Dimian remains optimistic that this can be done, once the supply-side shocks of higher fuel and food prices diminish.

“After the impact of the supply shocks fades away, inflation should start to decline,” he says. “Fading away usually takes 12 months.”

Others are less sure that it can happen so quickly. “The problem for Egypt is that it is not clear when prices might go down,” says Fox. “I suspect there is worse to come.”

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