J.9_Annex_1-Egypt_Growth_Diagnostic_Exec._Summary.pdf

EGYPT GROWTH

DIAGNOSTIC STUDY:

Executive Summary

USAID/Egypt Team

A. Albertine M. ElSamadony J. Fabiosa R. Abdel-Hakim A. Kamel1 I. Lotfi N. Lotfi M. Abu El Wafa

USAID/Washington, DC Team S. Anderson T. Holt J. Mason

Formerly with USAID.

EXECUTIVE SUMMARY

For over 30 years, the U.S. Agency for International Development (USAID) has committed itself to improving the lives and livelihoods of all Egyptians. Across the entirety of the USAID assistance program in Egypt—whether in health, education, agriculture, trade facilitation, enterprise development, tourism, or infrastructure—the Agency’s work has been informed by an awareness that increasing private sector investment will be the primary catalyst for the type of transformative economic growth that leads to long-term improvements in the wealth and well-being of Egyptians.

To guide future work in support of the Egyptian people, the USAID Mission to Egypt initiated this Growth Diagnostic (GD) analysis in December 2013. The methodology chosen for this analysis is applied by international financial institutions and the USG (both the Millennium Challenge Corporation and USAID) at the country level to identify, characterize, and rank order the binding constraints inhibiting private investment and growth. The methodology permits countries and donor agencies to direct efforts toward easing the most binding constraints to achieve maximum impact on private investment and growth. For Egypt - prior to the present report - the last application of the methodology was undertaken by the IMF in 2007.

At the time this study was initiated, Egypt was led by an interim government in the wake of its second political transition in two years. These transitions brought about significant political instability that exacerbated the longstanding constraints inhibiting growth by increasing the risk associated with investment. The economic hardships faced by the Egyptian people are believed to have contributed to their demands for political change.

Today, Egypt is at a point of inflection. Elections have been held to endorse a new constitution and elect a president, and parliamentary elections are slated to be conducted in the coming months. The new president, Abdel Fattah el Sisi, has signaled his interest in tackling longstanding policy reforms and has taken some initial steps. Nonetheless, the new government has not yet articulated a long-term economic strategy and deep economic policy concerns persist. Furthermore, there is lingering concern over the willingness and ability of the newly-elected government to overcome the entrenched bureaucracy, distortions in the economy, and preferential relationships that characterized prior administrations. Of primary concern for promoting private investment is the role of the government (referred to as the “public sector”) in fostering economic growth; the concern being that, instead of serving as a catalyst for growth by focusing on strategic areas, the public sector crowds out private investment through public investment programs, state ownership of productive assets, impairments to competition, and associated protectionist policies.

The new government has made several statements laying out ambitious goals for turning the economy around and bringing economic growth back to Egypt. It remains to be seen whether the public sector will be able to foster an environment where growth occurs at a sustained rate to make up for years of stagnation, strong enough to meet the needs of the rapidly growing population, and also inclusive enough to offset the increasing levels of inequality and poverty.

Methodology:

In January 2014, USAID staff launched a series of consultations and roundtable discussions in Egypt with public officials, business community members, civil society, and academics to gather evidence and solicit opinions to help inform about maladies in the Egyptian economy, if any, and identify factors that constrain private investment and growth. The study began with an analysis of the economic performance of Egypt over the last three decades, examining the growth patterns experienced by the country and aiming to discover symptoms of maladies in the economy. In summary, the analysis revealed the following insights:

1. The performance of the Egyptian economy in the last three decades was only modest.2 Real per capita GDP growth did not exceed 3% for six out of every ten years. For two out of those six years, the economy grew by less than 1%, which represents years with significant contagion effect from worldwide economic slowdowns.3 In the remaining four of the six years, the economy grew by only 1% to 3%, which represents periods of recovery from these same external shocks.

2. Egypt’s upper average growth rate of 5.3%, in 2006-2008, can be attributed primarily to growth in specific sectors that benefited favorably from positive international shocks, such as high energy prices.

3. Even if Egypt were to reproduce its GDP growth rate between 2006 and 2008, it would still be unlikely that growth would produce the desired development outcomes. Even during this period of modest growth the Egyptian economy was characterized by a persistently high unemployment rate (at 9%), increasing job informality (by 10 percentage points), and rising incidence of poverty (by 2 percentage points).

4. Egypt’s investment rate dropped below 20% in the early 1990s and has improved little in more than two decades. Improving the rate and quality of investment will be a key component of improving productivity and launching the economy into rapid and sustained growth.

With Egypt’s growth performance revealing some underlying economic maladies—including low investment, low productivity, high unemployment, increasing job informality, and rising incidence of poverty—the team then applied the growth diagnostic methodology of Ricardo Hausmann, Dani Rodrik, and Andrés Velasco (2005, hereafter referred to as HRV), to uncover the likely causal

In this study, growth rates are categorized as follows; high (strong) for growth rates in the top 25% of the distribution, upper average (modest) for growth rates in the top 50% but below 25%, lower average (poor) for growth rates in the top 75% but below 50%, and low (weak) for growth rates in the bottom 25%. During this period, Egypt’s growth rate of 5.3% was in the upper 32%, which is an upper average growth category.

Major worldwide economic crises includes the Latin American Debt Crisis in the late 1980s, the US Savings and

Loan Crisis in early 1990s, the Asian Financial Crisis in late 1990s, the Dot-Com Bubble in early 2000s, the Global

Financial Crisis in 2008/2009, and the Arab Spring in early 2010s. Bubbles are market outcomes where asset prices are influenced more by what Alan Greenspan called “irrational exuberance”, rather than by market fundamentals.

The Dot-Com Bubble was driven by the inflated promise of the internet sector, while the Global Financial Crisis occurred because of a bubble in housing prices in the US driven by easy credit that artificially boosted housing demand.

factors behind them. This methodology follows standard growth theory by focusing on investment as the main driver of productivity and growth, and considers broad categories of cost, return, and risk faced in actual investment decisions, as potential factors that tend to suppress private investment. Whether a specific factor within each broad category is binding or not was assessed using HRV’s four diagnostic tests, which employ market signals of supply and demand imbalances.

First, binding factors are usually associated with high prices; this is because investors aggressively compete for their limited supply, and bid up prices as a result. Second, if truly binding, changes in supply of these factors usually produce significant movements in investment. Third, firms tend to generally economize on these binding factors because of their high prices. And fourth, if successful, such firms will perform differentially better. In contrast, factors that are not binding are associated with low prices, insignificant economic impacts, and intensive utilization by firms. To implement this assessment on the set of potential constraints in Egypt, the USAID team collected, reviewed, and analyzed data, and based on a preponderance of evidence, narrowed down the number of binding constraints using a sequential process of elimination.

The Most Binding Constraints to Growth in Egypt:

The USAID Growth Diagnostic finds that, despite the fact that economic activities in Egypt are sufficiently rewarded (i.e., social returns4), the primary binding constraint to private investment in Egypt is low expected private returns due to low appropriability5. Specifically, investment demand is low because investors face considerable downside risk in realizing private returns due to (1) risks associated with macroeconomic instability resulting from fiscal and monetary imbalances; and, (2) risks associated with microeconomic distortions, specifically regulatory and policy uncertainty stemming from institutional and bureaucratic failures.

Private investors see the Egyptian investment climate as risky. The high risk associated with macroeconomic instability in Egypt is evident in the country’s heavily discounted equity prices, as shown by the low price-to-earnings ratio for Egypt’s broad stock market index. The country’s sovereign risk rating signals substantial risk. Specifically, Egypt’s persistent and worsening deficit (now representing 13.7% of GDP)—financed primarily through issuance of government bonds— has raised inflationary pressure and resulted in the government managing the currency to avoid depreciation. Even with these efforts, the Egyptian Pound (EGP) has depreciated substantially and a parallel market for foreign exchange exists, with a premium of 3-7% over the official rate during 2014. The potential loss of economic value from inflation and further currency depreciation increases the downside risk of private returns and creates a significant drag on investment growth in Egypt. Further, the government’s fiscal policy is widely suspected to be unsustainable and has resulted in a debt overhang. Unsustainable debt raises the risk of future tax increases, which reduce private investors’ expected returns.

In addition to the risks due to an unstable macroeconomic environment, several “microeconomic” risks exist in Egypt. Microeconomic risks include those factors that raise the cost of doing business

Social return is estimated from output and input levels derived from the underlying production function, and valued at market prices absent any distortions.

Appropriability is the investor’s ability to realize for his private gain, a proportion of the social (intrinsic) value of returns to investment.

in Egypt by affecting individual firms’ profitability, such as widespread corruption, onerous labor regulations, policy uncertainties, fragile property rights (especially for land), costly tax rates and tax administration, and political instability. In the case of Egypt, these distortions are brought on by the intersection of economic and political monopoly that seeks to maximize the extraction of rent across sectors and over time. Rent extracting opportunities are created as power brokers, crony capitalists, and opportunistic bureaucrats leverage benefits and outcomes from counterproductive or ambiguous policies and burdensome regulation. As a result, long-standing, large and immovable barriers to entry have worsened, driving investors and entrepreneurs into the informal sector, increasing market concentration, and deepening the cycle of corruption.

Other consequences of high macroeconomic and microeconomic risks to private profit making are equally severe, especially in weakening firm dynamics. According to World Bank analysis, Egypt’s pace of formation of new enterprises is one-tenth of that seen in other Middle East countries, and one-twenty fourth of the average pace in 80 countries. Moreover, enterprises that are already operating in the economy have low probability of growing their employment.6 The private sector is dominated by aged large firms that are “connected” and can take advantage of policy and regulatory weaknesses, and small firms that cannot. With growing medium-sized firms critically missing, private sector performance in Egypt is characterized by low levels of risk-taking, weak investment, poor innovation, and low productivity, reducing the country’s economic growth.

The severity of this binding constraint discourages economic activity and investment demand. The data analysis conducted for the remaining areas of potential constraint covered in the HRV methodology, including cost of finance, infrastructure, human capital, natural capital, and market failure, showed that they are not binding. Observers of the Egyptian economy might argue that many of the potential constraints, especially human capital, infrastructure, and finance, would nonetheless seem to be problems in Egypt. The analysis, however, leads to a conclusion that weaknesses in these areas are more likely symptoms of weak investment demand stemming from the primary binding constraint of low appropriability. While each of these areas do require improvements, as a matter of priority, political will and reform ought to be focused primarily on the binding constraint identified here in order to accelerate economic growth in Egypt.

Recommendations Moving Forward:

The scope of this Growth Diagnostic does not include identifying specific interventions or policy reforms. Rather, its purpose is to help USAID and interested parties understand the most important barriers to faster growth, and to identify those key problems which, when dealt with, can spur rapid and sustainable economic growth in the Egyptian economy. Nevertheless, insights and conclusions provided by this analysis may be useful when designing a policy reform agenda around the issues identified.

1. Macroeconomic stability looms large as a concern for investors. Macroeconomic risks are a binding constraint to growth in Egypt because the deterioration in recent years of its fiscal deficit, inflation, public debt and foreign reserves poses a substantial threat—whether actual or perceived—to the ability of investors to retain and appropriate returns to their economic activity. Low appropriability acts as a binding constraint by limiting the anticipated ability of

World Bank Group. More Jobs, Better Jobs: A Priority for Egypt, June 2014 investors to realize social (intrinsic) returns, thereby affecting the level of investment and growth. Not only do Egypt’s macroeconomic indicators buttress this conclusion, but surveys of businessmen show that macroeconomic instability is viewed as the first or second-most pressing concern they face.

2. Preliminary unpacking of the microeconomic risks constraint points to a broad range of serious concerns. In a nutshell, Egypt’s private sector is dominated by a small number of large firms and a large number of small, informal firms. Large firms tend to be those with preferential access to shared public inputs (property rights, tax regimes, government procurement, subsidies, etc.), while small firms operate without these benefits and tend purposely to remain small to minimize their risk and costs (i.e., they choose to operate outside the formal structures of the regulatory/policy environment).

In a previous (2007) IMF growth diagnostic, Klaus Enders concluded that in Egypt “inefficient bureaucracy remains an important obstacle to higher growth and reforms in this area should continue to have high payoffs.”7 In Egypt, the public sector and politically-connected private sector favor and benefit from an institutional and policy regime inimical to the general business interest. The harm imposed on private sector development is further aggravated by ineffective government and bureaucratic intransigence. For firms lacking preferential access to public inputs, their costs are relatively high and their supply may be unreliable. In turn, recent political instability further exacerbates the cost of these risks to investors.

Analysis of the microeconomic constraint examines its constituent dimensions such as access to land, labor regulations, taxation, regulatory quality and corruption. Egypt fares poorly in most of them, with its weak institutional quality a central feature.

3. It is important to distinguish between constraints to growth and symptoms of constraints—human capital, infrastructure and access to credit appear to be the latter.

Low appropriability stemming from risks associated with macroeconomic instability and microeconomic distortions is the core constraint binding growth in Egypt. It is important that any economic growth project working to promote growth recognizes whether it is addressing a root cause (i.e., core) or symptom (i.e., peripheral) issue. There can be well-designed and executed development projects with a positive rate of return addressing symptoms rather than root causes.8 Nonetheless, addressing directly the root causes of micro and macroeconomic policy issues that discourage private investment would likely be more effective in raising growth rates.

4. At this point in time, access to credit does not appear to be a binding constraint. It is commonly viewed that Egyptian firms, particularly SMEs, find it difficult to gain access to credit.

Evidence, however, does not suggest that aggregate investment in Egypt is impeded by high cost of finance. The real lending rate in Egypt is low compared to that in comparator countries. Even

Enders, K., 2007. “Egypt—Searching for Binding Constraints on Growth”, IMF Working Paper WP/07/57, International Monetary Fund, Middle East and Central Asia Department Pockets of opportunities to enhance growth may still exist within factors determined as not binding, but they are rather limited and cannot serve as engine of transformative growth for the entire economy. Engagements in these pockets of opportunities for growth need to be very strategic to be impactful.

at its peak of 11.2% in 2002, Rodrik, coauthor of the HRV methodology, expressed doubt that it is high enough to be binding. Since then, rates have been declining and have approached zero in most recent period. The low real lending rate, coupled with the supply of credit to the private sector exceeding demand, suggests that investors were not aggressively competing for limited savings. There is evidence to suggest that perceived lack of access relates instead to the binding constraint. Namely, there are other obstacles that impede business expansion and incentivize informality, thereby depressing demand for credit. In the future, if micro and macroeconomic policy issues are addressed and economic activities begin to accelerate, this situation may change and credit access may be more binding.

5. Infrastructure weaknesses do not presently constrain growth. In general, Egypt enjoys relatively high rates of access to networked goods and services—roads and transport infrastructure, electricity, water and ICT services—at costs that are almost uniformly below the economic resource cost of these goods. This distortion generally leads to overuse of these goods relative to the situation in income-group peer countries, including above-average use of fuel for transportation, electricity, and water. While there are some indications that the effective costs of some networked goods—electricity, especially—are high due to poor reliability of the system, firms do not seem to be spending large amounts to circumvent these constraints, and in fact firms that are more dependent upon access to electricity seem to be increasing as a proportion of GDP over time.

6. Despite many weaknesses, human capital deficiencies do not constrain growth. Because of the well-known weaknesses in Egypt’s education system, this growth diagnostic considered the topic carefully using a broad selection of evidence and recent information. There seems to be ample evidence to support two generalizations. First, the quality of both education and worker skill attainment is relatively poor, suggesting that the Egyptian workforce is—in general—not well-endowed with human capital. Second and more importantly, there do not appear to be high private returns for attaining higher levels of education in Egypt, suggesting that the labor markets in Egypt do not (or cannot) place a high premium to higher levels of education. Doing nothing but improving the poor quality of education in Egypt hence will, by itself, not improve economic growth by much. Additional and improved education would almost always improve the welfare of the average Egyptian, and may improve well-being in other domains (e.g., healthier children), but at the macroeconomic level there is not strong evidence that education (whether the quantity, quality, or both) is a binding constraint to growth.

7. Egypt’s natural capital endowment supports growth, although relative scarcity of arable land and water will dictate areas of comparative advantage for economic activity. Market-oriented pricing and other steps to ensure efficient allocation of these two resources will be important to maximize benefits from relatively scarce endowments of arable land and water.

Otherwise, Egypt’s endowments of energy and other natural resources, plus its geographic location, low incidence of natural disasters and benefits derived from the Suez Canal, all favor investment and growth.

Final Observations:

The nature of binding constraint suggests several cautionary notes as reform programs are designed.

Addressing constraints entails significant work on the part of all participants within a society— requiring both a top-down and bottom-up approach. Policies enacted to address the constraints must be implemented with an eye to the end result and have a long-term plan to get there. If reforms are done piecemeal, without transparency, or with too much discretion in the hands of non-reform minded actors, the effort will yield little or even fail. Policies must not only be pushed down from the highest levels of leadership, they must also be supported and pushed by those actors needed for their success, whether it is the department heads, middle managers, employees, external support organizations, international donors, or the people of Egypt themselves.

Addressing the binding constraints identified in this report would require an extensive and urgent reform agenda. Prioritization and sequencing of interventions must be done thoughtfully. In any country, there is a limited supply of financing, institutional capacity, and political capital to address complex reforms. This prioritization is derived from an understanding of the causal pathways through which the identified binding constraints impact the economy. Because of the immediacy of Egypt’s macroeconomic risks, the priority in the short run should be to restore macroeconomic stability, particularly fiscal solvency (macroeconomic risk) of the GOE so it can continue to provide basic public services. The Egyptian government has already taken some steps in this regard—more will be needed to restore investor confidence.

A longer-term effort is also urgently needed to reduce the cost advantage given to some firms and open the Egyptian market to greater competition. Policies have been preferentially applied to grant an unbridgeable cost advantage to some large firms, thereby suppressing healthy competition.

Medium-sized firms are unable to compete and are often driven to exit the industry. This has created a bimodal distribution of firm sizes with a few large firms dominating their sectors due to profits derived from their preferential access. Many small firms survive by working in niche or local market opportunities. Egypt lacks both a healthy rate of new firm creation and growth of innovative firms into the middle and larger sized ranks. A dynamic base of risk-taking, innovating small and medium firms, which in other countries serves as the engine of growth and job creation, is missing in Egypt.

As a result, industries are characterized by weak firm dynamics, which explains the low aggregate investment and weak demand for inputs such as infrastructure, human capital, and natural capital.

Moreover, the adoption of policy regimes that have introduced distortions over a long period of time has created an economic structure with deeply embedded inefficiencies; this will require an even longer-term effort to remedy. This includes an electricity generation infrastructure that is primarily fueled by petroleum products, the development and growing share of capital and energy intensive sectors in the economy, and adoption of capital and energy intensive technologies by firms.

Misallocation of resources is evident in the economy, and the wide differences in capital and labor intensity across sectors may be partly blamed for the poor labor market outcomes that accompanied periods of growth in the Egyptian economy.

Although the prioritization of these constraints may suggest that they are independent, they are actually linked in a dynamic causal manner. That is, addressing the policy reform (e.g., food and fuel subsidies) is necessary to restoring and sustaining fiscal solvency of the GOE. More importantly, policy reforms that correct market distortions and eliminate opportunities for rent-seeking can also lead to a meaningful restructuring of the economy. This, in turn, will promote efficiency and competition—the drivers of productivity gains and job growth in the long-run.

The analysis that follows is a snapshot of the binding constraints that are evident in the first half of 2014. Although the relative bindingness of the different constraints may change over time, the problems outlined here will take considerable time to address comprehensively. Rather, it will take a coherent strategy and sustained effort for years to remedy the basic problems of economic governance failure and entrenched interests benefiting from differential treatments. The breadth of detail and depth of analysis is intended to make the whole of this report a useful tool for its readers for an extended period. The authors have made every effort to use the most up-to-date data and contextualize information within recent events. The authors hope that this analysis will contribute to USAID’s work in partnership with the government and people of Egypt to foster shared prosperity through a faster growing and more inclusive economy.