Arab Republic of Egypt Country Economic Memorandum Egypt...

Report No. 1 6207-EGT

Arab Republic of EgyptCountry Economic MemorandumEgypt: Issues in Sustaining Economic GrowthMain Report(In Four Volumes) Volume IIMarch 15, 1997World Bank Resident Mission In EgyptMiddle East and North Africa Region

Document of the World Bank

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Country Economic Memorandum: Main Report World Bank Resident Mission in Egypt

Currency Equivalents

Currency Unit = Egyptian Pound (L.E.)

L.E. per US Dollar(Period Average)

1988 - 2.2301989 - 2.3891990 - 2.7081991 - 3.2961992 - 3.3231993 - 3.3341994 - 3.3731995 - 3.3941996 - 3.395

Fiscal YearJuly I - June 30

Vice President : Kemal Dervi,Director : Inder SudDivision Chief/Manager Khalid IkramStaff Member : Chang-Po Yang

Arab Republic of Egypt

EGYPT: Issues in Sustaining Economic Growth

Country Economic Memorandum

World Bank Resident Mission in Egypt


Table Of Contents

ABBREVIATIONS AND ACRONYMS

ACKNOWLEDGMENTS

EXECUTIVE SUMMARY

CHAPTER 1: EMPLOYMENT AND GROWTH-AN OVERVIEW ............................................ 1

A. INTRODUCTION ........................................................................ 1

B. SAVING, INVESTMENT AND GROWTH-A VIRTUOUS CYCLE ...........................................................3

C. TRADE OPENNESS AND INVESTMENT-FRIENDLY POLICIES FOR A HIGHER GROWTH

TRAJECTORY ....................................................................... 6

C*HAPTER 2: POST-STABILIZATION MACROECONOMIC POLICY: MANAGINGSUCCESS ...................................................................... 10

A. RECENT DEVELOPMENTS ...................................................................... 10

B. MANAGING SUCCESS: THE CAPITAL INFLOW PROBLEM ................................................................ 15

Why is there a problem ? ...................................................................... 15

Egypt's capital inflow problem ...................................................................... 16

Implications for fiscal and exchange rate policy ..................................................................... 19

C. RISK IN THE IMMEDIATE FUTURE ...................................................................... 21

Sterilization problem ...................................................................... 21

Issues in banking ...................................................................... 23

CHAPTER 3: LONG TERM POLICY CHALLENGES ................................................................ 26

A. DIVERGENT GROWTH SCENARIOS ...................................................................... 26

The Base Case Scenario ...................................................................... 27

The High Growth Scenario ...................................................................... 28

Benefits of Rapid Growth ...................................................................... 29

B. LONG-TERM CONSISTENCY ISSUES ...................................................................... 29

C. WHAT TO DO WHILE THE INVESTMENT EXPANSION LASTS ? .......................................................... 31

D. WHAT TO DO IF INVESTMENT EXPANSION DOES NOT ACCELERATE ? ............................................. 32


CHAPTER 4: BUILDING UP THE BASIS FOR LONG-TERM GROWTH .............................. 34

A. INCREASED SAVINGS FROM PRIVATIZATION AND PUBLIC ENTERPRISE REFORMS ........................ 34

The PE Savings-Investment Gap and its Roots ............................................................... 35Potential Gains in Savings from Reforms: A Simulation ........................................................ 39

B. FINANCIAL SECTOR REFORMS TO INCREASED PRIVATE SAVINGS ................................................. 42The Social Insurance System ............................................................... 43National Investment Bank ............................................................... 47The Insurance Industry ............................................................... 54The Capital Market and its Links with Savings ............................................................... 55Taxation of Saving ............................................................... 57

CHAPTER 5: PROMOTING OUTWARD ORIENTATION THROUGH EXPORTS .............. 60

A. THE ENVIRONMENT ............................................................... 60

Overview ............................................................... 61

Achievements ............................................................... 61The Agenda for Action ............................................................... 61

B. THE INCENTIVE REGIME-AYMMETRix PRICES BETWEEN IMPoRT AND EXPORT...62

Import Transaction Costs ............................................................... 63

Export Transaction Costs ............................................................... 68

C. CORE AREAS FOR ACTION ............................................................... 69

Infrastructure ............................................................... 70

Customs Reforms ............................................................... 71

Quality Controls ............................................................... 73

Maximizing FDI and its Benefits ............................................................... 74

Forging Buyer Seller Links ............................................................... 75

Creating an Export Mentality ............................................................... 77

LIST OF TABLES

Table 1.1 Selected Economic Indicators, 1990/91-1995/96 .1Table 1.2 Growth and Employment .2Table 1.3 Per Capita Income Growth Performance, 1980-93 .3Table 1.4 Average Tariff Rates in Egypt and Selected East Asian Economies . 5Table 1.5 Growth and Policies in 86 Countries, 1966-93/1 .6Table 1.6 Egypt and Indonesia, Comparative Indicators .7Table 1.7 Growth and Policies in Egypt and Indonesia 1966-93 .7Table 1.8 Regression Estimates .8Table 1.9 Growth Counterfactuals .8Table 2.1 Recent Developments in Savings and Investment .12Table 2.2 Distribution of Private Investment .13


Table 2.3 Tariff Duty to Import Ratio and Indexes of Effective Exchange Rates .................... 14Table 2.4 Indexes of Domestic Prices of Tradables and Non-Tradables .................................. 16Table 3.1 Outcome of the Two Scenarios ......................................................... 27Table 4.1 Estimated Increases in Savings from Reforming PE's: Total ................................... 41Table 4.2 Estimated Increases in Savings from Reforming PEs, by Government and Private

Sector .......................................................... 41Table 4.3 Estimated Increases in Savings from Reforming PEs: Origin of the Change ........... 41Table 4.4 Sensitivity Analysis ......................................................... 42Table 4.5 Social Insurance System Indicators ......................................................... 43Table 4.6 Comparative Public Pension Schemes and Demographic Indicators ........................ 44Table 4.7 Contribution Rates for Social Insurance (percent of wages) ..................................... 45Table 4.8 Public Pension Spending Indicators ......................................................... 46Table 4.9 NIB Funding Sources ......................................................... 47Table 4.10 Growth of Private Funds 1991-95 .......................................................... 49Table 5.1 Tariffs and Taxes ......................................................... 64Table 5.2 Expensive Port Services ......................................................... 65Table 5.3 Cumbersome Import Clearances ......................................................... 66Table 5.4 Restrictive Quality Control System ......................................................... 68Table 5.5 Export Transaction Costs ......................................................... 69

LIST OF BOXES

Box 2.1 Change in Debt Ratio ......................................................... 21Box 4.1 Methodology and Assumptions .......................................................... 40

LIST OF FIGURES

Figure 2.1 Average Growth Rates for Selected Stabilizing Economies ...................................... 10Figure 2.2 Term Structure of Deposit Interest ......................................................... 1 IFigure 2.3 Real Effective Exchange Rate ......................................................... 1 1Figure 2.4 Current Account Balance, Change in Reserves and Capital Inflows ......................... 17Figure 2.5 Composition of Capital Inflows .......................................................... 18Figure 2.6 Inflation, Inventory and Exports ......................................................... 19Figure 2.7 Domestic Debt as Percent of Total Public Debt Stock .............................................. 22Figure 2.8 Domestic Vs Foreign Interest Rate ......................................................... 24Figure 3.1 Distribution of Sales Proceeds ......................................................... 30Figure 3.2 Volatility of Egypt's Key Revenue Sources ......................................................... 30Figure 4.1 Savings-Investment Gap as a Percentage of GDP, 1987-93 ...................................... 36Figure 4.2 Saving-Investment Gao and its Sources of Finance in Egypt .................................... 36Figure 4.3 Saving-Investment Gap of PEs in Egypt .......................................................... 37Figure 4.4 Financial Performance of Public Enterprises in Egypt .............................................. 38Figure 4.5 Proceeds from Privatization of Law 203 Companies in Egypt, 1994-Sept. 1996 ..... 39Figure 4.6 Comparative Performance of Selected Pension Funds .............................................. 48

Country Economic Memorandum: Main Report World Bank Resident Mission in Egpt

ABBREVIATIONS AND ACRONYMS

BMP Black Market PremiumCA Current AccountCEM Country Economic MemorandumCPI Consumer Price IndexDB Defined BenefitDC Defined ContributionEISA Egyptian Insurance Supervisory AuthorityEU European UnionFDI Foreign Direct InvestmentGDP Gross Domestic ProductGNP Gross National ProductGNY Gross National IncomeICOR Incremental Capital Output RatioIMF International Monetary FundLLP Loan Loss ProvisionsNEER Nominal Effective Exchange RateNIB National Investment BankODA Overseas Development AssistanceOECD Organization for Economic Cooperation and DevelopmentPE Public EnterprisesREER Real Effective Exchange RateSIS Social Insurance SystemUJNCTAD United Nations Commission for Trade and DevelopmentWEF World Economic Forum

GLOSSARY

Bank Provisioning Bank capital set aside against doubtful loans.Defined Benefit Pension Plan - Pensions are determined by an actuarial computation that

incorporates salary and years of service.Defined Contribution Pension Plan - Pensions are solely determined by the accumulated

contributions to an individual account and on theinvestment performance of the fund.

Pay-as-you-go Pension Plan - Benefits received by current retirees are equal, on averageto contirubtions by current active workers.

Open Door Policy Introduced by Law 43 of 1974 (and its amendment Law 32 of1977) to encourage foreign investmnent, as a gradual shifttowards a private based economy through granting investorsprivileges including tax exemption, immunity fromsequestration and unrestricted repatriation of profits. This wasfollowed by trade liberalization through Law 118 of 1975 whichallowed the private sector to import goods except thoseidentified as important for hygienic and security purposes (e.g.wheat).

Saving - Rate of wealth accumulation.Savings - Stock of financial assets.Sterilization Sale of government securities by the monetary authority to

absorb excess liquidity in the economy.

County EconomicMemorandum: Main Report World Bank ResidentMission in Egypt

Preface and Acknowledgments

The Government of Egypt invited the World Bank Resident Mission to prepare this Country EconomicMemorandum (CEM) at a time when Egypt has resumed economic growth and accelerated itsstructural reforms. Against this background, the CEM has focused on areas where Egypt couldconsolidate its success of stabilization, build up long-tern saving as a basis for sustainable growth, andpush for rapid growth of non-oil merchandize export. This CEM consists of two parts: a sunumaryreport and a main report. It is also accompanied by an annex including the background studies, and anannex documenting the statistics.

The Bank team wish to acknowledge the guidance and support it has received from senior GovenrnentOfficials, in particular, we wish to thank:

H.E. Dr. Nawal El-Tatawy, Minister of Economy and International Cooperation;H.E. Mr. Zafer El-Bishry, Minister of State for Planning;H.E. Dr. Abmed Geweily, Minister of Trade and Supply;H.E. Dr. Youssef Boutros-Ghali, Minister of State at Cabinet;Mr. Ismnail Hassan, Governor of Central Bank of Egypt;Dr. Ibrahimn Fawzi, Chairman, Investment Authority;Mr. Abdel Hamid Ibrahim, Chainnan, Capital Market Authority;and General Ehab Elwy, President, CAPMAS.

We would also like to extend our gratitude to numerous other Govenmment Officials, private sectorrepresentatives, and scholars, and who have guided and assisted the mission including:

Mr. Ismail Badawi, Advisor to the Ministry of Planning/National Investmnent Bank;Dr. Faika El-Refaie, Sub-Governor, Central Bank of Egypt;Mr. Momtaz Said, Director General for the Budget, Ministry of Finance;Dr. Adel Beshai, Head, Departrnent of Economics at AUC;Dr. Taher Helmy, Partner, Helmy & Hamza (Baker & McKenzie);Mr. Omar Mohanna, Managing Director, Egypt Arab African Bank;Mrs. Fatma Ishac, First Undersecretary for Planning, Social Insurance Organization; andMrs. Ragaa Mansy, Consultant to the Minister of Social Insurance.

The Bank team that has prepared the CEM is consisted of Chang-Po Yang (Task Manager); DanielaGressani (Macroeconomics); David Dollar (Savings, Investment and Growth); Sweder van Wijnbergen(Consultant, Macroeonomics); Abmed Galal (Consultant, Privatization and Savings); Albert Martinez(Private Savings and Pension Reforms); Linda van Gelder (Export Development); Robert Crawford(Investment Promotion); Byom Larsen (Natural Resources), Alaa El-Shazly (Modelling and Statistics)and Sahar Nasr (Privatization). Georgette Mounir edited the documents and coordinated the meetings.

Messrs. John Page (Chief Economist, MENA Region, World Bank), Khalid Ikram (World BankResident Representative in Egypt) and Jayanta Roy (Lead Economist, MENA Region) provided generaldirection. Special thanks to Dr. Heba Handoussa (Director, Economic Research Forum) for her helpfulcomments and suggestions. The report on export issues also benefited from the following USAIDfunded studies:

"Quality Control to Quality Assurance in Egypt: A program for Change.""Egypt's Trade Policy Reform Plan.""Standford Research Institute Study on a Strategy for Egyptian Exports."

EXECUTIVE SUMMARY

i. Egypt achieved unprecedented economic growth during 1975-85, following theadoption of "open door" policies, boosted by sizable increases in foreign assistance, workers'remittances, and foreign direct investment. The rapid growth came to an end in 1986 as aresult of the limitation of a still inward-looking growth strategy, and a regional slowdownfollowing the decline in oil prices. Stagnation and severe macroeconomic imbalancesemerged. Both poverty and unemployment increased. The Government of Egypt respondedby adopting adjustment policies to stabilize the economy and to restore growth.

Growth has resumed, but long-term challenges remain

The stabilization policies have been highly successful. Inflation, which hoveredbetween 20 and 30 percent in the late 1980's, is now around 7 percent and falling. Growthslowed down in the first two years of the stabilization program, but it resumed by 1993/94.GDP growth for 1995/96 is estimated at around 5 percent. The stabilization effort broughtinflation down and was followed by a relatively fast recovery. Egypt ranks among those ofother economies having carried out successful stabilization (Figure 1).

i. Notwithstanding the achievement, Egypt's challenge remains daunting. Atpresent, official estimates of unemployment stand at about 10 percent. Over the next tenyears, there will be an annual increase of more than one million in the working-agepopulation. The labor force (assuming the constant participation rate) will expand at 2.8percent a year, with about 560,000 people entering the job market, more than one fourth ofwhich will be of the 15-24 age group--a segment with rising aspirations. Thus, the toppriority is to create jobs and income opportunities. The Government of Egypt has formulateda set of policies in order to accelerate economic growth to above 6 percent by the year 2000,and to expand employment.

ii. Egypt has a unique opportunity to achieve this growth target. World trade isgrowing at rapid rates, the European Union (EU) is seeking closer cooperation with theregion, and large amounts of international capital are available for financing productiveinvestments. Egypt, being close to the key world markets, could capitalize on thesedevelopments, and become a center of growth and investment for the region. This would,however, require effective tackling of two long-term structural problems:

* the reliance on exogenous resources (remittance income, Suez Canal income,exports of oil and gas, and foreign assistance) to finance domesticexpenditures, and consequent vulnerability to external shocks; and

* the low levels of domestic saving, and low levels of investment; the slowaccumulation of production factors, both human and physical, will cloudEgypt's long-term growth prospects.

iii. The lack of domestic saving has been associated with the reliance on exogenousresources, e.g. private and official transfers from abroad. This, in addition to the inward-

ii Main Report: Executive Summary

looking growth strategy, has entailed an incentive regime biased against production oftradables, in particular exportables, and lower domestic saving. The reasons are two fold.First, external transfers increase the domestic income, and hence the demand for both tradableand non-tradable goods. Since the prices of nontradable goods are relatively free to adjust,and prices of tradable goods are constrained by the forces of international markets, theexternal transfers result in a price regime in favor of nontradable goods, and indirectly anoffsetting deterioration of the current account balance, hence indirectly a lower level ofdomestic saving. Furthermore, the volatility inherent in the external transfers as shown in thereport (Table 3.3) also affects the level of domestic saving. Consumers tend to smooth theirconsumption over time. A sudden drop in their income need not lead to a proportional cuts intheir consumption, and saving would likely bear the brunt of the shock. Thus, achieving long-term self-sustaining growth implies that Egypt must tackle these structural problems, andadopt policies aimed at increasing domestic saving, and accelerating growth of exports.

Policies, good for growth and investment, are also good for saving

iv. How could Egypt achieve higher rates of growth? Experiences show that anecessary condition for rapid growth is high levels of investment associated with high levelsof domestic saving. While the causal relations among growth, investment and saving are notclear, it is clear that: growth, saving and investment are mutually re-enforcing, and thepolicies that promote growth and investment will also promote savings. Countries can jump-start and accelerate the growth process through pushing ahead with structural reforms andlock in the virtuous circle of higher growth, investment and saving. Our analysis shows thatEgypt could gain at least 2.7 percentage points higher rate of GDP growth per year byemulating good policies. These policies are: (i) fiscal and monetary policies which ensure asound macroeconomic environment, and high public as well as national savings; (ii) tradepolicies that encourage growth through outward orientation; and (iii) financial policies andinfrastructure that establish strong incentives for long-term private saving, and investment.This report has attempted to address issues in raising savings as basis for long term growth,and issues related to export are addressed in a parallel report.

Sustain growth by managing the success of stabilization

v. Egypt has been successful in stabilization. Indicators are strong on all fronts.Inflation has been under control and fiscal deficits were brought down to 1.3 percent of GDPin 1996 from about 17 percent in 1991. Investor confidence in Government policies is highand capital inflows have been strong. Foreign participation has grown recently to almost 40percent of the turnover on the Cairo stock exchange.

vi. Growth resumed quickly in response to stabilization. But, stabilization itself is notsufficient to accelerate growth to a higher trajectory. The success of stabilization andresumption of growth present their own challenges. In the short run, the recovery should beprotected from the adverse consequences of capital inflows, and should be sustained bymaintaining internally consistent macroeconomic policies. In the longer run, there is acritical need to raise the level of saving to build up the basis for sustainable growth.

vii. Capital inflows have brought upward pressure on the exchange rate. Attempts toavoid nominal appreciation, and to meet the monetary growth target were reconciled during

Main Report: Executive Summary iii

1991-94 through a strong sterilization: the monetary impact of foreign exchange purchases bythe Central Bank was offset by sales of domestic securities. As a result, the counterpart ofEgypt's high reserve position (at US$ 18 billion or 16 months of imports) has been asubstantial increase in its domestic debt. In addition, the upward pressure on the exchangerate that results in real appreciation poses a threat to the current recovery. Thus, coping withincreased capital inflows is a main post-stabilization challenge.

viii. Toward this end, the policies that are aimed at resisting upward pressure forexchange rate appreciation would be appropriate because the upward pressure on exchangerate seems now to reflect a portfolio shift in favor of LE-based assets, rather than a major risein demand for domestically produced goods and services. Resisting upward pressure on theexchange rate while maintaining tight monetary growth typically requires sterilization. But inlight of the fact that internal debt is already high, and that maintaining a robust fiscal stancerequires further reductions of internal debt, sterilization does not seem a realistic option. It istherefore recommended that:

* reserve requirements on foreign and domestic currencies should receive equaltreatment in interest remuneration, so as to eliminate the incentives for banksto borrow in dollars and lend in domestic currency;

* banks should be required to hold 100 percent of their reserves against foreigndeposits in assets to be held abroad so as to force banks to match capitalinflows with outflows in equal size; and

* pension funds should be encouraged to invest their assets in high-grade foreignfixed-income securities, and high-quality equity shares.

ix. Given that the domestic interest rates are still high relative to the rates on majorforeign currencies, the above measures, if implemented will complement the fiscal stringencytypically recommended for managing capital inflows. Another related issue is themanagement of internal debt. The size of internal debt is large at 50.6 percent of GDP, (theconsolidated public sector debt is larger at 58 percent of GDP, but the size of total publicsector liability could be even larger), and costs of servicing it is high at 4.7 percent of GDPcomparable with the size of the total civil service wage bill. Reducing the debt to GDP ratiodepends on the speed of growth, and the rate of real interest rates. Interest rate in excess ofGDP growth could result in debt financing via monetization with capital flight as itsconsequence. Thus, it is estimated that primary surplus at above 3 percent of GDP should bemaintained in order to reduce the ratio of intemal debt to GDP.

x. A further issue is the soundness of the banking system. The recovery to date hasbeen associated with real exchange rate appreciation, and persistently higher domestic interestrates above foreign rates. The interest rate differentials make it attractive for banks to borrowin US dollars and lend in local currency. The recent success of Egyptian banks in mobilizingfinancing from intemational markets highlights a likely growing trend in this regard. Crosscountry experiences show that foreign exchange exposure increases substantially with banksintermediating between local and foreign currencies; banks become extremely vulnerable to adevaluation. Even if deposits are matched with loans in the same foreign currency, the

iv Main Report. Executive Summary

problem remains; the borrowing firms may default on a bank loan after a devaluation, wipingout the banks' capital this way. Therefore, policy actions in parallel to those recommendedabove should include: (i) strengthening central bank supervision; (ii) implementingaggressive provisioning against bad loans and; (iii) maintaining extraordinary vigilance inpreventing excessive foreign exchange exposure in banks. These actions are absolutelycrucial in the post stabilization period so as to strengthen the banks or at least make the extentof their distress clear to managers and regulators alike.

Toward a trajectory of higher growth

xi. Solving the immediate problems outlined above will reduce Egypt'svulnerability to crises, but this is not sufficient to get Egypt on a path of rapid growthsupported by higher rates of savings and investment. In making this transition, threeissues need to be tackled: internally consistent policies over the longer term; supportingpolicies to sustain and accelerate the recovery; and adjustment policies that would benecessary if the recovery slows down.

xii. Consistency. The current fiscal stance appears internally consistent. The deficit issmall and interest rates and GDP growth rates are such that the current primary surplus ishigh enough to foresee a medium-term decline in overall debt-output ratios. However, thesize of internal debt limits the extent to which the government could apply an expansionaryfiscal policy in a slowdown, and the sustainability of internal debt could come into question ifgrowth does stagnate. More importantly, the large size of internal debt constrains the abilityof Government to allocate more budgets toward more productive ends such as those in healthand education. Egypt also faces continued uncertainty in its revenue sources, in particularthe likely decline in long-term external assistance. Furthermore, the scope for furtherexpenditure cuts is limited, as expenditures have already been reduced substantially. Thus,reducing internal debt is recommended as a central policy objective in maintainingconsistency. One specific action that could be implemented is to apply privatisation revenuestoward reductions of internal debt. So far, despite the achievement on privatisation, little hasbeen returned to the central government toward this purpose.

xiii. Accelerating the Recovery. The current recovery has been led by privateinvestment in nontradables (i.e. service and real estate sectors), and this should be cause forconcern. Egyptian enterprises working in tradables face the need to upgrade their capability,and to compete more successfully. Yet, they are receiving much less resources than the realestate sectors. The shift in relative prices in favor of, and concentration of investment in,nontradables undermine the ability of Egyptian industries to engage in production oftradables. This poses another threat to the current recovery. If there is a property marketcrash, or major realignment of relative prices, the resulting losses would have to be absorbednot only by investors using their own funds, but also by banks using funds from thedepositors. This threat reinforces the need for supporting policies to encourage production oftradables, to maintain vigilance against excessive bank exposure to the real estate markets,and to adopt sound provisioning against non-performing assets in bank's portfolios.

xiv. Another cause for concern is the speed of a major export recovery. The rise ofcapital good imports in the current recovery needs to be balanced by growth of export

Main Report. Executive Summary v

earnings, thus the speed of export recovery is critical. The successful export experiencesdemonstrate that a sound relative price incentive regime is necessary but not sufficient.Strong and responsive supporting policies are also needed to ensure quick and timely exportsupply response (the support policies are discussed in detail in the parallel report).

xv. A further cause for concern is the timing of the response in private saving. Asignificant lag in the response of private savings would necessarily be accompanied by awidening of the current account deficit, and upward pressure on domestic inflation. Whileincreased foreign savings could sustain the recovery, it will also increase Egypt's overallexposure to external shocks, which is already very high. Therefore, a critical longer-termissue is the increase of domestic saving.

xvi. In Case of a Slowdown. Should export response turn out to be slow, privatesavings remain insufficient, and concentration of investment in nontradables continue, thecurrent growth recovery may very well slow down. Such a slowdown requires a realexchange rate depreciation at some stage. But achieving a real depreciation whilemaintaining the fixed exchange rate is exceedingly difficult; it requires sustained inflationrates below the main trading partners' inflation. Thus, introducing an element of flexibility inthe exchange rate, for example through the adoption of a crawling band, should be consideredseriously.

Building the basis for long-term growth

xvii. Sound macroeconomic management serves as a cornerstone in building the basisfor long-tt Im growth, however other building blocks are also critical. Two scenarios havebeen envisaged in order to illustrate the magnitude of the investment and saving effortsneeded to support moderate growth and high growth, as well as the pay-off--in terms ofemployment and income generation--from sustaining high growth as compared with moderategrowth. While sound macroeconomic conditions underpin both scenarios, the key policyactions leading to the high growth scenario include: rapid structural reforms in trade andfinancial sectors, rapid privatisation, and large scale private investment in infrastructure. Thecritical path to rapid growth is via quick integration in the global economy--for which tradeopening including a strong export push is crucial. Also essential is the mobilisation ofdomestic savings, and development of a solid financial system which efficiently intermediatesthe savings.

A. Export Push

xviii. Egypt's growth of export has lagged behind that of global trade. Had Egyptmaintained the same rate of export growth as the rest of the world during 1983 and 1993, itsexports should have reached US$6.3 billion rather than US$3.1 million. The accumulativeloss of export earning at US$3.2 billion was due to a combination of factors: inability to adaptto changes in market demand (US$2.3 billion), to maintain its shares in the expanding exportmarkets (US$0.7 billion), and to maintain cost competitiveness (US$0.2 billion). Egyptwould have to achieve growth of exports at 35 percent a year for five years to just to regain itsshare of the global export trade at 0.27 percent in 1970--but the 35 percent growth would stillbe a quantum leap.

vi Main Report: Executive Summary

xix. A key issue is to determine what policies and institutions can help to expandexports, and enable Egypt to catch up with the growing trend in globlization. Account mustbe taken of the changing external environment. The global trend towards a free trade andinvestment environment has changed the 'rules of the game'. The technological andmanagerial changes that have occurred in the last decade or so have induced the OECDcountries to adopt structural reforms to enhance the competitiveness of firms headquarteredon their territories. An increasing number of these firms have in turn become multinationals,sourcing from all over the world. Competition for markets, investment, and technology hasintensified.

xxi. In this context, the ongoing process of partnership negotiations with the EU is ofparticular importance', and can be argued to have reduced the options confronting Egypt.The extension of large parts of the EU integration mechanisms to partnership countries suchas Morocco, Tunisia, Jordan, Turkey and Israel implies that a Korean type of policy mix thatrelies on protection of the domestic market with a broad-based drawback mechanism to allowexporters to compete on world markets has become less feasible. The trend toward adoptingdeeper regional and multilateral trade and investment integration as well as trade disciplinesimplies that firms located in the partnership countries must become more competitive on aglobal scale. As more market friendly regulatory mechanisms are introduced and tariffs aregradually eliminated in the regional economies and worldwide, Egypt has little choice but tofollow suit. The issue is to what extent and over what time frame.

xxii. At this point, a forthcoming partnership agreement with the EU would givecredibility to Egypt's own trade liberalization efforts, and allow a transition period overwhich tariffs are to be gradually removed. Assuming that tariff reductions are on track, andcomplemented by trade opening to non-partnership countries as well, removal of non-tariffbarriers and reductions of the overhead business costs would become most critical. Formany, the non-tariff barriers to imports make domestic sales more profitable than export, andthe regulatory regimes impose excessive transaction costs on both import-competing andexport oriented industries, but the consequences for the latter are more severe, for a smallerosion of profit margin could result in a large loss of export in the fiercely contestedinternational market. Therefore, tariff liberalization without removal of the non-tariff barriers,and without the reductions of overhead operating costs may encourage more imports, andproduction for domestic sales without substantially strengthening the ability of export sectorto compete internationally. Hence, a strong export push is key to Egypt's success in theglobalization. Therefore, our recommendations as outlined below focus on the followingareas: (i) trade logistics and transportation; (ii) custom procedures; (iii) quality control andproduct standards; (iv) attracting FDI; (v) forging buyer-seller links; and (vi) creating exportmentality. Details and justifications in connection with these recommendations are providedin the parallel report.

xxiii. Actions to Improve Trade Transportation

* Start legislative process to terminate the legal and regulatory status of statemonopolies in port services.

"Maximizing the Benefits of Free Trade with the European Union--Challenges and Options for Egypt".

Main Report: Executive Summary vii

* Eliminate interlocking directorships and shareholdings between portAuthorities and operating companies or among port operating companies.* Relinquish monopoly control of air transport and ease regulations restrictingcompetition from non-Egyptian airlines and charters* Permit tourist charter flights to accept air freight on the backhaul.

xxiv. Actions to Simplify Custom Procedures

* Establish a green channel for imports by allowing exporters to import rawmaterials and capital goods through a "Green Channel".* Adopt a system for voluntary pre-shipment inspection by a small number ofaccredited international firms (such as SGS, Veritas, etc.) to be selected by thegovernment.* Develop comprehensive action plan for customs reform that would minimizeface-to-face contacts between importers and customs officials.

xxv. Actions to Reorient Quality Control for Safety and Health Reasons

* Revamp the inspection process by establishing a single authority forinspection and testing.* Focus testing on safety concerns rather than quality standards.* Recognize international standards certification for non-food imports; foreigntest results of-and certification by-internationally recognized bodies should beaccepted.* Reduce inspection levels to minimum spot checks; use compliance history asthe basis for the frequency of sampling and testing of imported products.* Fees for inspection services should be cost-based rather than specific as is thecase currently.* Support standardization of lab quality through the certification by the NationalInstitute of Standards.* Increase transparency and due process by: giving advance notice of anyproposed rules, providing an opportunity for public comment, establishing knownimplementation dates, and providing a clear appeal process.* Establish a 'certification fund' that can provide matching funds for ISO 9000certification and for the services of consultants to audit companies.

xxvi. Actions to Maximize FDI and its Benefits

* Create a small group of experienced sales professionals, perhaps reinforced fora short time by outside 'specialists' to deliver training and offer advice.* Privatize the entire FDI business by giving it to a group which works tospecific and agreed targets both by volume of investment flows and in other areassuch as aftercare development.

viii Main Report: Executive Summary

xxvii. Actions to Forge Buyer-Seller Links

* Create a single, one-stop shop export promotion center. This would requirethe centralization of Trade-Point, the EEPC, and the GOIE into one agency (subsetof actions and outcome of this proposed action are described in the parallelreport).

Creating an Export Mentality

* Set an ambitious export target and strive to meet it.

* Follow up with specific actions to help stimulate an "export mentality" and toeducate the public. The following types of action have been used in somecountries:

- The Prime Minister could hold a monthly TV press-conference where exportstatistics are announced. This can create an excitement and awareness aboutexports. It also contributes to a private sector friendly environment by ensuringthe timely availability of information.

- Conduct annual national contests that rewards entrepreneurs that open upnew markets or introduced new products. The President could present awards,and there could be substantial press coverage of the winners activities.

- A media campaign could be used to explain the importance of exports.

B. Increasing Domestic Saving

xxviii. Apart from the general conclusion that Egypt could achieve additional growth by2.7 to 3.7 percentage points per year by adopting sound policies, and that higher growth rateswould lead to higher rates of saving and investment, how much additional savings couldEgypt really expect from its reform efforts, and what are the financial policy and institutionalreforms that will be needed to stimulate corporate and private saving.

xxix. Additional saving could come from several sources. To begin with, Egypt's levelof saving is likely to be boosted by its demographic trends. It is estimated that the risingshare of working-age population, and the declining share of child dependency will bothcontribute to increases of saving in the next 15 years by about 24 percentage points, orroughly 1.6 percent a year. This demographic trend is likely to increase the operating surplusof the Social Insurance System (SIS, also see below), affording Egypt a good opportunity toimplement the much needed pension reforms now.

xxx. Other major sources of saving could come from the efficiency gains, andadditional investment that privatisation, and commercialisation of public enterprises couldbring about. The transfer of ownership to the private sector is associated with increases inproductivity. Increased productivity entails more resources which could be saved andploughed back into new investment. Privatisation could also generate more savings

Main Report: Executive Summary ix

indirectly. For example, proceeds from privatization sales could be applied to retire the publicsector debt, which in turn could result in reduced public expenditures, and increased publicsector saving. In addition, privatization could help boost the development of capital market--a key factor in financial intermediation, and in long-term growth. Our analysis shows thatprivatizing one half of the public enterprises in Egypt and commercializing the other halfcould result in additional saving at around 2.4 percent of GDP a year.

xxxi. Saving could also be boosted by reforms of financial policies and development offinancial institutions. Econometric work for this report shows a negative correlation betweenthe private saving and government spending on social security as shares of GDP. This findingis consistent with the increasing evidence from other countries that generous pay-as-you-gostate pensions tend to depress household saving, and that a mandatory saving scheme is mostlikely to increase household saving. Furthermore, sound contractual saving institutions, suchas the life insurance industry, tend to favor the formation of long-term financial assets overthe fixed assets such as in the real estate, therefore enabling households and privatecorporations to borrow long terrn; this may indirectly contribute to increased savings.Finally, the development of capital market supports and is supported by the development ofcontractual saving institutions. It could augment domestic saving by attracting foreignsavings.

xxxii. The Social Insurance System. The SIS provides one of the most importantsources of long-term saving in Egypt (with contributions at 3.5 percent of GDP in 1994/95),and it effectively works as a pay-as-you-go system. It has been producing operating surplusin the last ten years due to the high ratio of contributors to pensioners. The operating surplushas been invested via the National Investment Bank (NIB), in Government projects, and untilrecent years, in public enterprises as well. Social insurance funds (new and reinvested)accounted for 68 percent of the fund sources of NIB during the past five years.

xxxiii. NIB used to pay interest on the SIS funds at 5 to 6 percent per year, even thoughinflation was about three times higher. This represents significant erosion of the realpurchasing power of the reserves at the SIS and a net subsidy to NIB. Starting July 1992,NIB raised the interest rate on incremental social security funds (including reinvestedreserves) to 13 percent, providing a positive real rate of return given that the average inflationduring the period of 1992-96 was about 10 percent.

xxxiv. The contribution rates under the SIS are high (on the basic wage) relative to thepension benefits and the insurance it provides. The eligibility criteria for retirement in Egypt(age 60 for both men and women, under the major programs of Law 79/47) is lower than thatof OECD countries (whose average retirement age is 64.4 years for men and 62.9 years forwomen), but comparable with many developing countries. Redistribution has been made byproviding pensioners from the agricultural sector-about 45 percent of total pensioners in1995-with the equivalent of minimum wages (LE 45 per month), and by setting a minimumpension for those with a certain number of years' contribution.

x Main Report: Executive Summary

xxxv. Pensions on basic wage are fully adjusted, while those on variable wages are not.Over the period 1987-96, the legislature-mandated adjustments preserved the purchasingpower of the basic pensions for most of the 10 years, however, pensions on variable wagesare not automatically indexed or adjusted by the legislature, in line with inflation.

xxxvi. Private pension plans provide a strong complement to the social insurance system.The number of voluntary private pension plans have been increasing significantly-as of June30, 1995, there were 504 plans compared to 330 in 1991. These plans are typically set up byemployers on a defined benefit basis, with contributions made by both employers andemployees. The number of employees covered more than doubled during the period 1990-95,to almost 0.5 million. About 48 percent of the assets of the private funds are in fixed bankdeposits while another 42 percent are invested in government bonds. Only about 7 percentare invested in equities and real estate. Lack of professional investment managementcapacity, the dearth of financial instruments, and the risk-averse nature of these funds havebeen cited as the main reasons for the concentration of investments in bank deposits andgovernment paper.

xxxvii. Reforming the Social Insurance System - Short to Medium Term Measures.That the working age population will continue to grow, and SIS is likely to maintain itsoperating surplus provides a favorable environment in which reforms should be implementedwithout delay. The proposed reforms are aimed at improving the efficiency and solvency ofthe current system focusing on: (a) improving the transparency of government utilization ofSIS resources to ensure a neutral impact on government spending decisions; (b) developing aportfolio and investment strategy that supports capital market development withoutcompromising safety objectives; and (c) correcting certain design deficiencies to improve theefficiency and financial sustainability of the SIS. Specific recommendations include:

* eliminate the special access of the NIB to SIS funds and establish an investmentmanagement capability within SIS, these actions should result in increased returnson reserves;

* raise the normal retirement age from 60 to 65, and the early retirement age to 60;workers who elect to receive pensions between the ages of 60 and 64 shouldreceive benefits that are actuarially fair relative to the full benefit available atnormal retirement age;

* adjust pension benefits for inflation using a formula that takes into account wageinflation, rather than awaiting legislative action; and allow automatic adjustmentfor the amount of wages, subject to the contribution rates; and

* review the contribution rates with a view toward reducing them, after the neteffects are determined concerning: (i) the elimination of the special access of theNIB to SIS; (ii) the less generous retirement (eligibility) provisions; and (iii) themore responsive inflation adjustment in computing the pensionable wage. Theamount of government contributions to fund redistribution programs should alsobe reviewed.

Main Report: Executive Summary xi

xxxviii. Reforming the Social Insurance System-Longer Term Proposals. Acountry's social security system typically has three major objectives: (a) to enable thepopulation to shift some of their income from their working years to old age (savings); (b) toprotect those with low incomes by providing a basic income floor during old age(redistributive or poverty alleviation); and (c) to insure against certair types of risks, such asdisability, longevity, and inflation (insurance). In order to achieve all three objectives, it isrecommended that a multipillar systems be put in place consisting of: (a) a fully-fundedmandatory defined benefit (DB) public pillar that insures workers' earnings up to a certainlevel; (b) a mandatory defined contribution (DC) private pillar that insures workers' wagesabove a certain level; and (c) a purely voluntary scheme that could supplement the first twopillars. In addition, the development of a more competitive and stable insurance industryshould be encouraged to provide many accompanying services, such as life and disabilityinsurance and annuity products.

xxxix. The public pillar would provide a minimum retirement income while thecompulsory and voluntary private systems would enable workers to supplement the pensionfrom the public pillar. The three schemes should be portable across employers, and vestingshould be immediate for the DC private pensions while the DB public scheme would requirea minimum number of years of contribution. The public pillar would achieve the objective ofdealing with old-age poverty, which has elements of income redistribution. The privatepillars have the advantage of closely linking benefits to contributions, thus minimizing theproblems of evasion and manipulation. At the same time, as experienced in other countries,the private schemes should improve capital accumulation and financial market development.Details and justifications in connection with establishing the three-pillars are provided in thereport.

xl. Tax Treatment. The consumption tax principle should be fully applied to alltypes of contractual savings. This would imply either: (a) full tax deduction of pensioncontributions, and tax exemption of investment returns, while taxing pension benefits as anyother source of income; or (b) allowing no deduction of pension contributions while grantingtax exemption status to investment returns and pension benefits. The latter approach providescash flow advantages for the budget since no tax income is lost up front, but provides weakerincentives to workers to participate in voluntary pension funds. Currently, the Egyptian taxtreatment provides for both tax deduction of pension contributions, and tax exemption ofpension benefits. A review of this tax treatment should be made.

xli. The Insurance Industry in Egypt is still underdeveloped-life insurancepremiums to GDP were an insignificant 0.2 percent in 1995, compared to 6 percent foraverage OECD countries. Total assets to GDP of all insurance companies (life and non-life)in Egypt were about 4 percent in 1995, while life insurance assets alone were 38 percent ofGDP for average OECD countries. There are 10 insurance companies in Egypt, of whicheight transact all classes of insurance and business and two transact only non-life. Theindustry is characterized by a high degree of concentration. The largest state-owned companycontrols 50 percent of both life and non-life business, and the largest three state-ownedcompanies account for 93 percent of life and 89 percent of non-life markets, thus making thesector virtually under state control. In the past, direct foreign ownership was only allowed inthose companies operating in the free zones. Currently, regulations place a -9 percent limit onforeign ownership of direct insurance companies and no restrictions on foreign ownership of

xii Main Report: Executive Summary

reinsurance companies. Total investments of the insurance industry as of June 30, 1995 wasLE 5.4 billion, representing 2.6 percent of GDP. Lack of financial instruments andconservative investment policies have led to very high concentration of investments in bankdeposits and government securities.

xlii. A new Law on Insurance was passed in 1995, and in June 1996, a new set ofregulations was issued by the EISA. Among other things, the law requires a distinction andseparation of the reserves from life insurance, and non-life insurance businesses in companiesthat operate in both markets. The new regulations also deregulated the pricing of most of theinsurance products, replacing price control with price reporting. The deregulation of mostinsurance products shifts the focus of supervision to solvency monitoring. The regulationsare basically in line with international (especially EU) practices and definitions. However,solvency monitoring requires good information and technical capability on the part of thesupervisor.

xliii. The Reform Proposals. Following the regulatory reforms, and current efforts tostrengthen the supervision capacity, the next generation of reform efforts should focus on theissues in competition and ownership structure. Specific actions that EISA may considerinclude: (i) allow the entry of newfirms-includingforeign insurance companies-as long asthey meet the licensing criteria, to encourage more competition; this means that the 49percent maximum ownership by foreign firms should be abolished; (ii) provide a leveltreatment of both state-owned and private insurance companies; (iii) include all the state-owned insurance companies in the current privatization program; (iv) focus on disclosurerequirements to the public on prices and commissions to complement the liberalization ofproduct prices and commissions; (v) eliminate the obligatory ceding requirements and pricecontrols still imposed on reinsurance; (vi) make available to the public financial statementsof insurance companies, and have these statements audited by qualified and independentauditors; and (vii) provide accounting standards and auditing guidelines for insurancecompanies so as to improve the transparency of the sector.

xliv. The Role of Capital Market. The principal role of capital market is to makesavings more readily and cheapily available to investors through creation of liquidity and thereduction of transaction costs. From the point of view of the investor, liquid security marketsallow the acquisition of assets that can be sold quickly in case of a need. From the point ofview of the corporation issuing long-term securities, the markets can provide access to alarger pool of funds and better information about the relative cost of different ways offinancing an investment. Thus, investors have a wide range of instruments to financeinvestment, and savers have more alternatives than bank deposits, precious metals, or realestates.

xlv. The development of capital markets in Egypt both supports and is supported bythe development of contractual saving institutions. As discussed in the previous sections, theinvestments of private pension funds and insurance companies have been mainly ingovernment securities and bank term deposits. Capital markets would allow greaterdiversification and perhaps higher yields for these investments, thereby improving thefinancial performance of contractual saving institutions, which should result in greaterbenefits to savers in the form of lower contribution rates to pensions schemes and lower

Main Report: Executive Summary xiii

premiums for insurance. At the same time, the existence of pools of funds from contractualsaving institutions could be tapped through capital markets to finance investments.

xlvi. In addition, active capital markets provide an enabling environment for attractingforeign savings. The existence of liquid capital markets gives a foreign investor better exitoptions, thus encouraging more foreign direct investment. Foreign portfolio investors wouldfocus on actively traded securities in the stock market. With private capital dominating thetotal capital flows to developing countries and an increasing shift toward equity financing, thedevelopment of capital markets becomes essential in attracting private foreign savings. Butthe risks offoreign saving would be kept to a minimum ifforeign savings augment, ratherthan replace, domestic saving. The experience of two regions which attracted the greatestshare of private capital flows gives two different outcomes-foreign savings replaceddomestic saving in Latin America and the Caribbean, but augmented domestic saving in EastAsia. The positive experience of Asia is attributable to macroeconomic policies andinstitutions that encouraged domestic saving and investment.

xlvii. Finally, the development of capital markets and the process of privatization aremutually reinforcing. Capital markets provide more options for divestiture, whileprivatization increases the supply of securities in the market, thus providing the securitiesmarket with more depth. The deepening of capital markets-as reflected in increased marketcapitalization to GDP, greater liquidity (higher turnover to market capitalization), and lessconcentration of market activity on a few stocks-would enable capital markets to absorb theexpected increase in portfolio investments from both domestic and foreign sources, andmitigate against the extreme movements of asset prices, and the drastic reversal in portfolioflows.

1 EMPLOYMENT AND GROWTH-AN OVERVIEW

A. INTRODUCTION

1.1 Egypt achieved unprecedented economic growth during 1975-85 following theadoption of "open door" policies, boosted by sizable increases in foreign assistance, workers'remittances, and foreign direct investment. This ended in 1986, when the governmentimposed inward-oriented economic policies, and the decline in the price of oil brought aregional economic slowdown. Egypt experienced a dramatic fall in growth and severemacroeconomic imbalances. In the early 1990s, per capita income grew by a modest 10percent from its mid-1980s level. Both poverty and unemployment remain high.

1.2 The Government of Egypt responded by adopting adjustment policies to stabilize theeconomy and to restore growth. The stabilization policies have been highly successful.Fiscal deficits were reduced, and the external current account deficit was kept at low levels.At the same time, restrictions on capital movement and interest rate controls were lifted.With the effective fiscal adjustment and management of sound monetary policies, inflationwas brought down to below 10 percent in 1995. Macroeconomic stabilization led to a strongrecovery. GDP growth rose from the stagnation of the early 1990s, to 4.7 percent in 1995,and continued its upward momentum into 1996.

1.3 Notwithstandingthese developments, Tabl 1. Seiected Economic Indicators, 1990/91 - 1995/96Egypt's long-term (Pett oJGDP, unes otherwIse noted)challenge remains E 1991/92 19929 1993/4 199495J995/6tdaunting. At present, Real GDp growth rate (P/q) 346 1.9 2.9 3.9 4.7 5,0official estimates of Inflation (% change in CPI) 14.7 21.1 11.1 9.0 9.4 7.2unemployment stand Consunption 85.9 83.0 83.3 84.9 83.1 86.0

Investment 23.3 18.2 16.2 16.6 16.3 16.7at about 10 percent. Government Investnent 13.4 8.5 7.0 6.1 5.5 5.5

Over the next ten Domestic Saving 16.0 17.0 16.7 15.1 16.9 13.9years, there will be Overall Fiscal Balance (excl Grants) -18.1 -5.4 -3.5 -2.1 -1.2 -1.3

years, Current Account Balance 5.2 4.1 5.1 0.2 0.6 0.2yearly increases of (including transfers)more than one million Official Reserves $ billions 6.1 10.6 14.9 17.0 17.9 18.4in the working-age External Debt / GDP 107,7 89.5 69.2 58.0 5S.7 49.2

population. The labor Sources: Ministry of Planning, Ministry of Finance and Central Bank of Egypt

force (assuming theconstant participation rate) will expand at 2.8 percent a year, with about 560,000 new job-

2 Main Report: Employment and Growth -An Overview

seeking, more than one-fourth of which will be of the 15-24 age group-a most politicallyvocal and active segment of society. Thus, it is essential for Egypt to create jobs and incomeopportunities to meet the rising expectations of the younger generation. Economic growthoffers an effective response to this challenge. Our estimates show (Table 1.2) that Egyptcould reduce unemployment to 7 percent with GDP growth of 6 percent a year from now until2002. Otherwise, with GDP growth at the level of 2 percent a year, Egypt will have tocontend with unemployment rising to 16 percent by 2002.

1.4 The Government of Egypt has formulated a set of sound economic policies toaccelerate economic growth to above 7 percent by the year 2000, and to substantially reducepoverty and unemployment over the medium term. Egypt has the opportunity and thepotential to achieve the growth target set by the government. World trade is growing at arapid rate, regional peace seems to be evolving, the European Union (EU) is seeking closercooperation with the region, and large amounts of international capital are available forfinancing productive investments. Egypt, as a force for peace in the region, and being closeto key markets of the world, could capitalize on these developments and become a center ofgrowth and investment for the Middle East and North Africa region. This however, wouldrequire effective tackling of two long-term structural problems:

- the reliance on exogenous resources (remittance income, Suez Canal income,exports of oil and gas, and foreign assistance) to finance domestic expenditures,and the consequent vulnerability to external shocks;

* the low levels of domestic saving, and consequent low levels of investment; theslow accumulation of production factors, both human and physical, cloudsEgypt's long-term growth prospects.

1.5 The lack of domestic saving has; ;Table 1.2 Growth and Employment tbeen associated with the reliance on

1995 1997 ZO~ exogenous resources, i.e., private andUnemployment (0/: 9.6S x :o : t:::t official transfers from abroad. Domestic

Vn .m .omt 9 .. .

At :2% GDP Growth .. 11.0 20.0 investment levels have been quite low,At 4.5%/oGDP Growth .. 10.3 14.0 and foreign direct investment wasAt 6.5% ~GMPGrowth .. 9.0 6.4 -ot~ -ey assu : -opul.tion growth rate 2,1attracted mainly to resource extracting

lof: :eyassmpion: population growth:rate ef 2.Ievetp.;labor force grUwth of 2.5 percent p.a.; and a partcipation rate of industries such as oil and gas, and to47.2 percent. sectors well-protected from international

competition. This reliance on exogenous resources has entailed a relative incentive regimebiased against the domestic production of tradable and exportable goods. Thus, achievinglong-term self-sustaining growth implies that Egypt must adopt strategies that will tacklethese structural issues through increasing domestic saving, accelerating growth of exports,and diversifying sources of export income.

Main Report: Employment and Growth - An Overview 3

B. SAVING, INVESTMENT AND GROWTH-A VIRTUOUS CYCLE

1.6 How can Egypt achieve higherrates of growth? A necessary condition for Table 13 Per Capita Income Growthrapid growth is high levels of investment Performance, 1980-931(Table 1.3) associated with high levels of Per_Capita_Acmal_Investmentdomestic saving. This, of course, is not Growth ReCatcvet InVeBtrnentsufficient, since a country's economic % EXPCCted Ratiosgrowth can exceed or fall below the level Growth predicated by its level of investment. The China 8.2 4+ii+) 41predicated by ~~~~~~~~~~ ~~~~Korea 8.0 (+)34discrepancies as shown in table 1.3 reflect Hong Kong 5.4 (+- 27

the other important factors influencing Singapore 5.8 (+4) 44

economic growth. Thailand 6.5 (+) 40Indonesia 4.1 (.0 28Malaysia 3.7 (-) 33Chile 3.4 (. 26

1.7 Across countries and over time, Pakiste 3.2 (+) 21higher growth rates are associated with India 3.2 (-) 24higher investment; higher investment with STi Lanka 2.5 (-) 25

Nepal 2.4 (. 21higher saving; and higher saving with Egypt 2.3 (D) 17higher growth rates. Furthermore, (+. (, o( infiIcai acit growth wa higher, equal, orlowerhrn expected Y nwtb.

I the per capha icome growth equaton is tnimated as felows: gdtapa+bcountries with higher levels of per capita ODPC"US+cINVGDP+d OPEN+etabpop+CPRENR7f+t SCaNR70twhetegdpcapisG1W pe q.phegrmwth rates G1WCAPUS is percaptit GDP in suo mapic ronrc dative

income tend to save and invest a larger ta the United States at the bqginttin of time periods; INVODI is grn dnmnesic

fraction of their national income. While Wamer g1995); abpop is grwt n 1 focrcelatve to w i populaton:.. . . ~~~~~~~~~~PREtR70 is plimay enmllmem musc in 1971);-nd SCliNkX is secwdary cMntollwt

these empirical relationships are well ratesin 1970 The sami'is35lowandhicdceionsc rsontsiesinAsia, MiddlcEFt

established, there is little agreement 19 A0a3. and Latin Aneica. and is pooled fo the two e 19t and

among economists about how to interpretthem, in particular the exact interrelationships among saving, investment and growth, anddirections of causality. Policy makers do not have to be preoccupied with the exactmechanisms affecting saving, investment and growth; what matters is whether the samepolicies aimed at encouraging investment also encourage saving.

1.8 The answer appears to be strongly affirmative. Both theories and empirical evidencesupport the view that there is very little deviation of saving from investment rates. I Thisholds for both developing and developed countries. Hence, the same factors (countrycharacteristics and policies) that determine saving also influence investment in the samedirection. In other words, the factors that create a good climate for investment also create agood climate for saving. Although it is difficult to sort out at the macro level the differentdeterminants of saving and investment, a good model that explains investment acrosscountries and over time will also be a good model that explains saving across countries andover time. From this point of view, there is good reason to expect that higher saving(=investment) would lead to higher growth, and that increased saving provide more resources

Feldstein and Horioka (1980).

4 Main Report: Employment and Growth -An Overview

for capital investment, which accelerate growth at least temporarily and perhapspermanently.

1.9 While saving cause growth in this proximate sense, there is no agreement on whatcauses saving and whether there is reverse causality from investment and growth on the onehand, to saving on the other. Deaton (1995) explains how this could happen:

The international correlation between growth and saving rates comes from theresponse of growth to investment, as predicted by a variety of growth models.Saving responds passively to investment through mechanisms that are at present notwell understood. A likely candidate is the saving behavior of firms or smallentrepreneurs, who retain profits in order to finance investment. In any case, suchsaving is done, not by the mass of households, who play little part in the process ofaggregate accumulation, but by afew relatively well-offpeople or byfirms.

1.10 This view suggests a virtuous circle. High investment leads to rapid growth, whichincreases the profits of firms and entrepreneurs. As long as growth is anticipated to continue,these agents save and invest a large fraction of their profits. In this way, saving, investment,and growth are mutually reinforcing. If one accepts the "mutual causality" argument, thenthe policies that promote growth and investment will also be ones that promote saving.

1.11 It is easy to see how a virtuous circle can keep going once it has started, oralternatively, how a country can get stuck in a low saving-investment-growth trap. It is moredifficult to see how a country can accelerate growth once it is entrenched in a low saving-investment-growth trap. This question has been addressed by examining factors and policiesassociated with the emergence and maintenance of a virtuous circle.

1.12 Several policies and country characteristics, are associated with higher saving,investment and growth. First, macroeconomic instability-evidenced by high inflation, largebudget deficits, and overvalued exchange rates-was found to be detrimental to both thequantity and the efficiency of investment.3 Second, countries with rapid growth of privateinvestment and per capita GDP are ones in which the government invested in infrastructureand financed it out of its own revenue (that is, government saving). These are also countrieswith less non-productive government consumption and less non-infrastructure publicinvestment (i.e. in state enterprises). After controlling for these variables, various taxmeasures had no significant association with growth or investment. This latter findingsuggests that taxation is not an obstacle to investment if the resulting income is used forinfrastructure investment or productive expenditures on education or protection of property

2 Harrod (1959).3Fischer (1993).

Main Report: Employment and Growth - An Overview 5

rights.4 Third, there is a strong association between the degree of trade openness and rates ofper capita growth.S

1.13 While openness is good for growth, manyfear that large and immediate negative Table 1.4 Average Tariff Rates in Egyptconsequences will result from going from closed and Selected East Asian Econiesto open economies. The short-run effects of trade Country Average Taiff Ratesopening on aggregate output and employment (%)depend importantly on initial conditions, e 6including the macroeconomic situation and the Republic of Korea 4.00relative competitiveness of existing industries. In Malaysia 9.00the short run, the rate of job creation in expanding Thailand .30

Egypt O0sectors versus job loss in declining sectors is an Source: UNCTAD-TradeAnalysisandInoion

important factor. The production and investment System Da;ta on CD-ROM, 1995

decisions of enterprises that determine this are a function of the flexibility of the labormarket. The greater this flexibility, the more rapid the adjustment and the lower the net effecton employment. Hence the flexibility of labor markets is crucial for reaping the benefits oftrade reforms. Empirical studies suggest that the output response to significant trade reformcan be rapid, with per capita incomes rising in the period immediately following tradeliberalization.6

1.14 In the longer run, open economies tend to have more rapid capital accumulation,higher export growth rates and more rapid increases in real wages. Consequently, lower-income countries with open policy regimes tend to attain higher rates of per capita incomegrowth. Trade openness is associated with both higher output growth per capita, and higheroutput growth per worker. Countries with open policy regimes in 1970-89 had investment toGDP ratios that were 5 percentage points higher than those of closed countries, andexperienced per capita GDP growth rates that averaged 2.5 percentage points higher thanthose of closed countries after controlling for determinants of growth such as education andinvestment.7

1.15 In short, good economic management is associated with the virtuous circle of highersaving, higher investment and faster growth of GDP. Elements of good management include:low inflation, low fiscal deficit, public expenditures targeted to productive areas, and tradeopenness. The mechanism at work is probably that these good policies spur investment bymaking it more profitable, and also increase the growth impact of any given level ofinvestment by making it more productive. Over the long term, it may be that saving respondspassively in the way envisioned by Deaton above. Of course, some of the good policies spur

4 Easterly and Rebelo (1993).5Openness is usually measured by the extent of integration in the world economy, as reflected in variables suchas trade to GDP ratios, the level of trade barriers and the relative importance of foreign direct investment andintra-industry trade.6 Using a large cross-country dataset, Sachs and Warner (1995) found that economic growth increased by anaverage of 1.3 percent following the opening of the economy.7 Sachs and Warner (1995).

6 Main Report: Employment and Growth - An Overview

saving directly. The most obvious example is government saving, which is a directcontribution to national saving, according to the experiences of many countries. But otherpolicies, such as trade liberalization or reform of the regulatory regime, also have a directeffect on saving by increasing the returns to saving, strengthening property rights, or reducingtransaction costs.

C. TRADE OPENNESS AND INVESTMENT-FRIENDLY POLICIES FOR A HIGHERGROWTH TRAJECTORY

1.16 To what extent could Egypt boost itself onto a higher trajectory of growth by adoptingpolicies associated with the virtuous circle? The results of the empirical growth analysis usingpanel data8 from the World Bank and other sources9 can be used to analyze the key policiesthat have affected Egypt's growth performance and to identify areas of policy reform thatcould put Egypt on a higher trajectory of long-term growth.

1.17 The results of theTable 1.5 Growth and Pohies in 86 Countries,o' 1966.43/1 e growth anayes

from two different sources( 1)t ! (2); (g t(X 4)i i:i:i: (6 (Dollar 1996, and Sachs

iolcy variablesS :f0 40 006 i : -- ; 0.080t :t :00080 ; .6 0 W 0.07 P~1icyVWIabiS 0.060.08 008 0.0 0.08 1996) show that Egypt couldBudget Surplus (2.34)- (3.41) (3.19) (2.27) (2. 1achieve 2.7 to 3.7 percent

Qovernrnent 4.006 -0.0 9 .0.05 -07 -0702 higher per capita GDPConsumj,ten (2.16 (3.29) (.82) (2,8) (~77) growth by emulating

-0.1 0.2 -001 -- 0,2 -. 2 eomic policies adopted byInflation i (2.63) (3.42) (2.3 i5) (47) (3.11) the East Asian countries.

i -2.OE-6 0000-L6B -13404.O-600 l0-4. 0 -l;- :i-2.7E-600 Table 1.5 shows theBMP I (0.87) (067 0.31) (2.A4) (,f.06) regression results (Dollar,

1996) derived from the0,02 ~02 018 0.2 0.0 - grwth performnance of 86

ii (7.00) (7.29) (6.69) (7.j21) (70)countries over the period

0.27:4- 0.26 0.26: :0.261 0.27 0.18 1966-93. The results confirmle tpolicy variableS Sare dropped one-by-onen:order toBssess thie robustnieSs of the that a large fiscal deficit, high

results, wbich a tobe robusDependent variable: grot rate of eal per capita: GD government consumption,

countrs,7. tim prodfour-yearavges) and high inflation all have anegative relationship with

growth. A black market premium on the exchange rate as a proxy on inflation also has anegative relationship with growth.

8 The panel approach will enable us to pick up not just cross country variations, but also variations over timefor each country, thus giving increased confidence that the relationships being examined can be exploited bypolicy makers.

Dollar (1996), and Sachs (1996)

Main Report: Employment and Growth -An Overview 7

1.18 In analyzing growthperformance, the East Asian Table 1.6 Egypt and Indonesia, Comparative Indicatorseconomies are often taken as areference point to which other Egypt Indonesiacountries' policies and growth Population (millions) 56.8 190.4performance are compared. In Per Capita GNP (1994$) 3,720 3,600performance ar compared. In Gini Coefficient 32 32this report, Indonesia is taken Infant Moraity (per 1,000, 1994) 52 53

as a relevant comparator for Primary School Enrollment 1993Female 89 112

Egypt, since the two have Male 105 116

similar country characteristics. Secondary School Enrollment 1993

Table 1.6 provides some basic Fenale 69 39Male814descriptive data. Both are large Investment/GDP 1994 (%) 81 29

countries with similar per SavIGNpID 1994(%) 6 30capita GNP and social ODAJGNP 1994 (.) 2.3 4.2indicators, particularly very Exports/GNP 1994 (%) 84 22.9similar human capital bases. . 22.9They differ in that Indonesiahas been growing much more rapidly, with 6 percent per capita growth in 1985-94, comparedwith 1.3 percent for Egypt. Indonesia is also far more involved in international trade, withcommodity exports of 23 percent of GDP in 1994, and has an export base more diversifiedfrom exports of oil. The comparable figure for Egypt was only 6.4 percent. Finally, Egyptreceives far more foreign aid: 6.4 percent to GDP in 1994 compared to 1.0 percent forIndonesia.

1.19 Table 1.7 shows theextent to which Egypt could Table 1.7 Growth and Policies in Egypt and Indonesia, 196693boost its economicperformance by emulating the Egypt - dnonesia EstimatedImpactpolicies already adopted by Gowth of real per capita GDP 0.2- .4 -

Indonesia. The differences in Budget Surplus (% ofGNP,) -5.4 -lo - 0.3macroeconomic policies and Govt. Consiumption (% of NP) 14.1 95 0Q3Inflation (%/) 16.5 7.7 01in trade openness account for Black Market Premiumn(%) 11.6 10.7 0.0

an estimated 2.7 percentage Open no yes 2.0points in growth. The actual WOrd Total acof Policies 2.7difference in growth was 5.2percentage points. The impact of Egypt being less open to trade is estimated to result in a 2.0percent lower real per capita GDP growth rate per year over the period of 1966-93. Theimpact of other policies, the size of government saving, consumption, and macroeconomicstability as measured by the black market premium on the exchange rate, is estimated to be0.7 percent.

8 Main Report: Employment and Growth - An Overview

1.20 In an alternative empirical T 1 R

analysis of a sample of 49 counties, Tb 1.8 R Estimatesper capita GDP growth over the (Deendent variable: Real per capita GDP growth 1992-95)

period of 1992-95 is estimated as afunction of initial per capita income, Independet variables:~Log initial income -1. 17 (-2.58)the national saving rates, and an Saving rate 91995) 0.098 (2.20)

overall index of market efficiency,' 0 Efficiency index 2.75 (3.J7)

based on these indexes: openness of Constraint i459 (2.18)R20 .404the economy to trade and financial N. 42

flows; size of government; and Sourve.` Sachb (1I996)

degree of labor market flexibility. The overall index of market efficiency ranks the 49countries in terms of more openness, smaller government (as measured by governmentexpenditure as percent of GDP, and various rates of taxation), and more flexible labormarkets. Among the 49 countries, Egypt ranks 22nd on openness (with a rank of 1 being themost open), 31st on size of govermnent, and 40th on flexibility of labor markets. Theaverage score of the East Asian economies11 would rank 25th on openness; 3rd on size ofgovernment; and 9th on flexibility.12

1.21 The basic regression isTable 1.9 Growth Countertua tiuX shown in Table 1.8. As expected,

initial income enters with aEgp Seven Asiaii significant negative coefficient:

i aia EEonomie poorer countries tend to growLog Initial Income 2.77 3.670 Saving.Rate00flss 1995ft 1X0 l6.840 00305.01t X more rapidly, all other thingsEfflciency Index -4142 0.563 equal. Also, as expected, moreGrowth 1t992-95 ..2.26 *l 6.33 efficient economies (i.e. thoseNgYpt s predj icted1Sgr&wth:rate 1992-95= I :S: ;:: 2.61::n ::s::::: *. .-

Egypt'spredicte growt rate i92-f 2.61 with a higher score on thePredicte growth ilf Egyp ~had ernojcy index:: efficiency index) tend to growof the seven Asin economies: 2.6 1+1.94 i 4 4.55 more rapidly. According to this

PriedistedSgrvowthif Egypt jalso thad$thesavingldd000} ;000t00t equation, Egypt's growth is heldtate of thle tseven tAsian teconomies; 4:.:551.780 t6.330 back by its relatively poor rankingSource., "Saeft ( 7 i: i on the various components of

market efficiency. To estimate the growth consequences of Egypt's efficiency index,regression estimates were used to calculate two growth rates: (1) the predicted growth forEgypt given current income levels (GDP per capita at purchasing power parity in 1993) andcurrent market efficiency; and (2) the projected growth rate for Egypt for current incomelevels but an improved market efficiency index equal to the average for the East Asianeconomies. According to the regression estimates, improvement in Egypt's market efficiencyto East Asian standards would raise annual per capita growth by some 1.9 percentage pointsper year, to an overall predicted rate of 4.55 percent per year. If Egypt also had the saving

10 Based on data from the World Economic Forum's (WEF) Global Competitiveness Report.I Hong Kong, Korea, Taiwan, Thailand, Philippines, Indonesia and Malaysia.12 Sachs 1996.

Main Report: Employment and Growth -An Overview 9

rate of the seven Asian economies, per capita growth would reach 6.33 percent. Thecalculations are shown in the second part of Table 1.8.

1.22 Although the coefficients vary somewhat depending on which additional variables areincluded in the analyses, the general point is quite robust. Egypt could buy itself about 2.7-3.7 per capita GDP growth per year through emulating the policies adopted by the seven EastAsian economies, including of course Indonesia. The effects of these policies on saving maybe quite indirect, in that, for example, trade reforms and macroeconomic adjustments directlyspur investment and growth, and these in turn encourage saving. The evidence providedabove shows that these policy reforms are an effective way of spurring saving in the long run.

2 POST-STABILIZATION MACROECONOMIC POLICY:

MANAGING SUCCESS

2.1 If a sound macroeconomics environment is a necessary condition for achieving higherlong-run growth, has Egypt obtained this condition, and how could Egypt make it sustainable,and protect it from external shocks?

A. RECENT DEVELOPMENTS

2.2 Macroeconomic Balances. Egypt has gone through major changes since the reformprocess was initiated in 1991. Inflation, which hovered between 20 and 30 percent in the late1980's, is now around 7 percent and falling. Growth slowed down in the first two years of thestabilization program, but it resumed by 1993/94. GDP growth for 1995/96 is estimated ataround 5 percent. Thus, the stabilization effort brought inflation down to manageable levelswithout a major slowdown in output, and was followed by a relatively fast recovery. Egypt'sgrowth performance mirrors those of other economies having carried out successfulstabilization (Figure 2.1).

2.3 The program was set up alongFigure 2.1 Average Growth Rate for Selected orthodox lines: a strong improvement in

Stabilizing Economies fiscal performance, provided the leeway to

6.21 sustain a tight monetary policy. Fiscalstringency was brought about by both

3.52 4.07 expenditure restraint and revenue2.89 measures, and was further facilitated by

important concessions made by the Paris'I- JIlE~ 4 9 _Club on Egypt's external debt.

Mexico Argentina Egypt Israel

Main Report. Post-Stabilization Macroeconomic Policy Managing Success 11

2.4 The first phase of theFigure 2.2 Term Structure of Deposit Interest Rates stabilization program can now be

considered as successfully concluded.

Percent Investor confidence in the economicpolicies followed by the government

1 5 1999 pseems strong on all indicators. One

1 31 1-------- . _ ,such indicator is the strong international

interest in Egypt's capital markets. Over1I l , . 199-3 lthe past year, foreign activity has grown

9~ ____ ___to almost 30 percent of the turnover on9

99, IL the Cairo stock exchange. Several Egypt7 funds have been established and a large3-month 6month 12-month 5 -yC& number of investment funds have shown

interest in individual stocks. Well over100 funds are currently active in the

Egyptian stock market. Portfolio flows alone in the first half of 1996 amounted to about US$500 million.

2.5 Another indicator can be derived from the term structure of interest rates in Egypt.While interest rates on LE remain above US dollar levels, notwithstanding the firmly fixedexchange rate, long-term rates now lie below short-term rates. Such an inverted yield curvesignals expectations of future interest rate declines and thus confidence in continued lowinflation.

2.6 While inflation came downrelatively fast, it did not do so Hgz23 iaHJaiieE,dUV- einstantaneously, and the nominal (h 1 Isso=Ie"exchange rate has been remarkably stable since Egypt switched to effective 14D -. -..

current account convertibility and munified the exchange rate system. As aconsequence, the real exchange rate hasappreciated significantly over the pastfive years. This appreciation camne after (

a significant real depreciation prior to 4D

the reform process. The exchange rate 2

has not returned to its peak of the mid-1980s. o, X : _

2.7 The process of liberalizationhas now continued to the point where Egypt's exchange rate is fully convertible even on thecapital accounts. International and domestic investors have clearly interpreted the opening

12 Main Report: Post-Stabilization Macroeocnomic Policy - Managing Success

up as a sign of confidence, and have responded strongly to the continued interest ratedifferential in favour of LE securities. Capital inflows have been strong over the wholereform period, putting strong upward pressure on the exchange rate. Attempts to bothmaintain monetary strictness and avoid nominal appreciation could only be reconciledthrough a strong sterilisation effort. This was done in a straightforward manner: themonetary impact of foreign exchange purchases by the Central Bank was offset by sales ofdomestic securities. In effect, the counterpart of Egypt's high reserve position is asubstantial increase in its domestic debt.

2.8 Saving and Investment Balances. While growth has resumed, investment (as sharesof GDP) has not returned to its pre-1990 levels (Table 2.1). This points to the existence oflarge spare capacity at the beginning of the recovery and, perhaps, increased factorproductivity, thanks to reforms in the agriculture sector and the establishment of financialautonomy for Law 203 public enterprises. As the recovery progresses, however, sparecapacity will progressively be eliminated. Thus it can be expected that, without a robustrecovery of investment, growth cannot be sustained. In turn, a robust recovery of investmentwill require robust savings.

Table 2.1 0Recent iDevelopments- inSaving andJInvestment

(Saresal Cren Pries)1986/8 MM8/8 O9R18 198919 MOM/9 1991/02 1992(93 1993 1994/9 95

shalres of GDP%Gross Doniesticlnvestinent 026.1 135.9 36 29.1 21.9 2 18.2 16. 1.6 16.3 16.6 Gross National Saving 0.9 318 27.4 24.9 20.7 24.7 23.0 t 15.4 15.9. 15.Foreign Savngs 6.2 41 5.2 CI Lt3 1 6.5 -6.8 L.2 03.5 I

iros iDomestic Ivestment 23 31 .9 29.3 26.7 20.1 17.10 14.8 1. 15.5 16.0Pu00fhb1igiiti00000fffitiStitme15 0A55 207,T 0 ,&13.6 13.60 12.50 10.00 8.2 7. ;51 6.6 6.5A

Private Investment 8&.8 11.3 ~15.7 13.0 7.6 7.1 6. 8.3: 8.9: RA:Gross National}t ;;0 00 Sav: 0 : if i17. 238.$ 24.6 22.7: 19.1 23.1 20.9 14.7 15 14.9iPuiblic Saig407 -2.9 40. -0.2 -1.3 3.1 2.5 3.33.7 3.7:l?rnvatSavuig-g 1i8.: ;AJA31.1 25A 22.9 20.3 20.0 194 I1. 11.4 11.2::

Foreign Savisngs 5.5 36 4.7 3.9 1.1 -61 -6.2 1. 0.5 1.1. Memo:: GDPGNY 8g.6 89.0 90.0 91.5$ 92.1 93.6 91.2 95.5: 95.1 96A.

TTh~ public: WecOW inclu4e omntrl endIWOO~ governnient.public authiorities atnd public enterpnses.tTipbsESecbn elpd b ISort aDcollvewe ss 0 00;00

Source: stimhates based on daoto prded bythe Egyptian Msiat of Planning CnalBank and Public Enteirvhse

2.9 Table 2.1 reveals that aggregate gross domestic investment as a share of gross nationalincome (GNY) has been growing moderately, reflecting contracting public investment and asignificant recovery of private investment-by almost 3 percentage points of GNY between1993 and 1996.13 It also shows that the increase in private investment has been accompaniedby rising public saving and a modest current account deficit. Private saving (excluding Law203 enterprises, which since 1994 have experienced an increase in net operating profits and

13 It should be noted that the definition of private investment used here excludes Law 203 enterprises, whoseinvestment has contracted modestly in real terms during the last three years. Law 203 enterprises are owned bythe Government but subject to the same regulatory framework as private enterprises.

Main Report: Post-Stabilization Macroeconomic Policy. Managing Success 13

thus savings) is not yet showing signs of recovery, remaining at around 11 percent of GNYsince 1994.

2.10 The increase in public saving is particularly encouraging and indicative of the strengthof stabilization. This increase resulted mostly from the reduction of budgetary subsidies andcurrent transfers (as well as from a decline in the interest expenses), and from the improvedfinancial performance of Law 203 enterprises, which recorded aggregate profits in 1994-96.If these trends are sustained and consolidated, public saving should continue to grow, thoughonly up to a limit. Significant further increase in public saving is unlikely to take place until acomprehensive reform of the civil service is undertaken and privatization transfers the bulk ofstate enterprises and economic authorities to private ownership.

2.11 The decrease of public investment is also encouraging, as it resulted mostly from areduction of public involvement in the commercial sphere. This decrease took place througha contraction of budgetary investment in economic sectors such as tourism, as well as thedecline in investment by non-financial state enterprises (from over 4 percent of GDP prior to1992 to about 1.5 percent during the last three years). It is now unlikely that these trends willcontinue, as further significant reduction in public investment could not take place withoutjeopardizing the ability of the government to provide basic services and infrastructure.

Table 2.2 Distribution of Private Investment

(shares ofppnvate investment at current prices)

1986/87 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95Petroleum and Petroleum Products 20.0 19.7 20.8 22.6 26.5 25.5 19J1 20.1 14.0Non-Oil Tradables' 39.4 46.4 40.9 41.0 36.8 35.6 32.5 31.7 50.7Non-Tradablese 40.7 33.9 38.4 36.3 36.7 39.0 48.4 48.2 35.3

ofwIHousing 25.3 21,0 26.5 23.3 23.7 25.3 26.8 27.9 18.5Total Private Investntnt(LE millfon)3 5699 7569 9508 9705 10758 11666 11547 12895 21051r Including: Agriculture, irrigatio and land reclamation; manufacturing and mining; transportation, communications, tourism and Suez Canal.2 Including: Electricity and energy; construction; trade, finance and insurance; and social services.

3 Total does not exactly match figures from National Income Accounts.

2.12 Data are not available to determine the extent to which the lower private saving is dueto weak household or corporate saving. However, it is likely that corporate saving has beenincreasing, since the recovery of private investment appears to be financed largely by retainedearnings.'4 It is thus likely that the stagnant performance of private saving is to be ascribed tothe behavior of households, an issue to be addressed in Chapter 4.

14 The share of credit to the private sector in total domestic credit fluctuated around 55 percent between 1993and 1996.


2.13 On the other hand, data are Table 2.3 Tariff Duty to Import Ratio and Indexes ofavailable on the composition of Effective Exchange Rates (1990=100)private investment (Table 2.2), Yea Tariff REER' NEER-X' NEER.M) TradeBias Index

which sheds some light on the Duty/import: (NEER-XNEHaR-M)-100

determinants of its recovery and 1985 0.25 74 31 42 741986 0.20 73 38 48 79future prospects. Abstracting from 1987 0.14 69 42 S 84 ;

developments in the petroleum l9S88 0.13 62 43 51 84sector-which are dominated by 1989 0.12 69 58 64 90

1990 ~0.11I 100 100 100 100external factors-private investment 1990.10 121 145 136 107

has been increasingly concentrated .1992 0.14 113 149 144 103in non-tradable sectors. Although 1993 0,14 98 136 137 99

1994 0. 17 95 1 37 143 96the data display significant year-to- 1.995 0.16 94 142 148 96

year variation, this trend appears to ' Real ffectiveexchangerate;,decreasetis realappreciation.

hold generally for all nontradable Expxt-wighted lomintal efective exchange rate.3Import-wlighted nominal effective exchange rate, adjusted for import duty.

sectors. So"rces. CBE and IMF, Direction of Trade Statistics Yearbook 1996.

2.14 Among the possible causes underlying the increased concentration of privateinvestment in non-tradable sectors, relative price changes played an important role. Asshown in Table 2.3 and Table 2.4, relative prices between tradables and non tradables-measured by the CPIs-have shifted in favor of nontradables since 1991, reflecting the largeexchange rate appreciation. However, the relative price shifts are negligible whencomparison is made between 1987 and 1995. In any case, caution should be used ininterpreting these price data. It is in fact likely that the CPIs underestimate the rate ofinflation of nontradable prices, owing to the dominance of administered prices, such as forfood, housing and public utilities, which are not relevant for private investment decisions.

2.15 Factors other than relative price changes may also have played a role in promoting theconcentration of private investment in nontradable sectors. First, the current privateinvestment recovery may be dominated by the establishment of new, small, labor-intensiveenterprises.'5 Second, concentration of state-owned enterprises in certain sectors-e.g.textiles, food processing, construction materials, where state enterprises account for morethan 40 percent of total output-may discourage private firms from entering because of theexpected collusive behavior on the part of the state-owned enterprises. Third, high andprobably increasing "sunk costs" of producing for export markets (owing not only toobstacles to "breaking in" to foreign markets related to quality and marketing, but also toadministrative compliance, customs, and shipping) may make these activities substantiallyless profitable than nontradable activities. Fourth, investment in housing and connectedservices may be responding to overall demographic and urban concentration trends,repatriation of savings accumulated abroad by migrant workers since the devaluation of 1991and the Gulf War, and government incentives to develop "new cities" (which are not capturedby relative price shifts).

15 This is consistent with data on business registration, which show a large increase in the number of newenterprises, and with the data on posted job vacancies, which show no significant change; new, small businessesare in fact less likely to post vacancies to recruit, relying usually on family members or business relations.

Main Report: Post-Stabilization Macroeconomic Policy: Managing Success 15

Table 2.4 Indexes of Domestic Prices of B. MANAGING SUCCESS: THE CAPITALTradables and NonTradables (1987=100) INFLOW PROBLEM

Year T'alables CPI Non-Tradables CPI Salter Ratio(TCPI) (NTCPI) (rCPl/NTCP)*lo0 2.16 Having achieved stabilization and

1985 69 85 81 increases in private investment, Egypt now1986 80 91 818 seems well placed for a take-off to sustained

1988 121 110 110 growth. However, as other successful reform-1989 145 120 121 cum-stabilization countries have experienced,1990 178 139 1281991 202 164 123 success presents its own challenges. Post-1992 240 208 116 stabilization macroeconomic policy is1993 255 259 991994 277 285 97 surprisingly difficult, as Mexico and several1995 308 300 103 other Latin American countries recently learned.

'GDP, tradables sectors.2 GDP non-tradables sectors. Success breeds investor confidence and theSources: Ministy of Planning and CAPMAS. capital inflows such confidence generates. These

inflows are at the root of the difficulties in managing the macroeconomics of success; most ofthis chapter will analyse post-stabilization macroeconomic problems. In addition,concentration of private investment in non-tradables, and lower levels of private saving mayrestrain the extent of recovery. Unless private saving rapidly catches up with the growth ofinvestment, and investment shifts toward tradable and exportable activities, Egypt's present

recovery may go under.

Why is there a problem?

2.17 Capital inflows after a favourable shift in confidence put upwards pressure on theexchange rate, but the real appreciation that results may abort the recovery newly underway.If renewed optimism, justified or not, pushes the exchange rate up, while lingering downwardwage/price rigidity prevents the fall in wages and prices that could offset the appreciation'simpact on product markets, a slide back into recession becomes inevitable. This in turn maythreaten the hard-won success of stabilization; a recession undermines fiscal stringency as taxrevenues fall, and slower growth magnifies the impact of any given deficit on the debt-outputratio, a key indicator of creditworthiness.


2.18 A key question is whether upward pressure on the exchange rate is necessary toaccommodate a booming economy, or whether it results simply from anticipation of futurewealth, with a corresponding impact on capital inflows. Strong spending on home goods, byforeigners or domestic residents, will make a real appreciation unavoidable. If the nominalexchange rate does not accommodate such pressure, high inflation will bring it about anyway.If, however, the appreciation is purely the result of a portfolio shift into the country,downward pressure on inflation will result, as the rising real exchange rate makes homegoods uncompetitive, and output will go unsold as exports slow down and domesticexpenditure switches to cheaper imports.

2.19 Inflationary pressure and inventory levels thus provide key signals. If inflationcontinues its downward path, and inventories start rising in relation to sales, indications arethat asset markets are the driving force and that the appreciation thus needs to be resisted. Ifinflation is reigning and capacity fully used, with inventories falling, tight fiscal policy and anaccommodation of the appreciation is needed.

2.20 The Latin American experiences indicate that the banking sector is a serious threat tostability in such circumstances. With the exchange rate appreciating and monetary policystill tight in the aftermath of the stabilization, domestic interest rates will remain highcompared to foreign rates plus ex post nominal devaluation. Thus it becomes highlyprofitable for banks to borrow in dollars and lend in local currency. Of course, if adevaluation does happen, banks take a capital loss and may in fact become insolvent, ashappened both in Chile in 1982 and in Mexico in 1994.

2.21 Such exposure may be hidden if the spread is shared with firms through passing ondollar loans at a significant mark up, but one that still leaves them cheap compared to localcurrency loans. While this may seem a balanced position in foreign exchange for the banks,the firms now carry the exchange risk and are more likely than not to default if things gowrong and a devaluation occurs. Thus the exchange risk persists, but in the guise ofcommercial risk.

Egypt's capital inflow problem

2.22 The strong appreciation of the real exchange rate and the continuing capital inflowspose a new set of policy dilemmas for policy makers. In a sense, Egypt's problems havebecome a sort of "embarrassment of riches" common to all successful stabilizers. Tightmonetary policy and a clear nominal anchor based on a stable exchange rate send clearsignals as to the government's resolve; but once that signal has been convincinglyconveyed, a portfolio shift back into the country brings in such a large inflow of capital thatthe monetary policy or the exchange rate come under threat, in seemingly inconsistentdirections. The choice is between letting the nominal rate appreciate or letting moneygrowth exceed its targets. Sterilization is an attempt to avoid that choice.


2.23 Egypt's recent experience clearly demonstrates the issue. The fiscal and monetarystringencies adapted in 1990/91 have restored current account balances (Figure 2.4) andentailed a substantial rise in capital inflows, particularly private capital inflows (other capitalin Figure 2.5). In addition, removal of restrictions on the capital account and liberalization of

Figure 2.4 Current Account Balance, Change in Reserves and CapitalInflows

USS Million

8000

7000

6000

5000 U Current Account Deficit

40000 Change in Net Intemational

3000 Reserves

2000 U Capital Inflows

1000 _ _ _ _ _ _ _ _ _ _ _

0

-1000

-2000

1990 1991 1992 1993 1994 1995

interest rates encouraged a major shift in favor of holding LE-based assets, and dollarizationdeclined from 51.8 percent to 29.4 percent in 1995.

2.24 Capital inflows may be an "embarrassment of riches", but ignoring the issue may wellcause serious problems later on. Mexico financed huge current account deficits withremarkable ease through a continuing flood of short-term private capital inflows after asuccessful debt reduction restored investor confidence. However, short-term private capitalinflows have a minus side too: if the confidence declines, rapid reversals can take place andlead to severe crises.

2.25 Egypt's current situation is different from Mexico's in 1994 in several importantaspects; in particular, Mexico's crises was due to a sustained effort by its government to maskthe impact of political uncertainty on investor confidence, and to offset reserve outflowsthrough a rapid issue of dollar-denominated debt in an effort. When a huge refinancingrequirement of nearly US$ 30 billion approached, anticipation of refinancing difficultiesbrought the exchange rate down in late 1994.

18 Main Report: Post-Stabilization Macroeocnomic Policy -Managing Success

Figure 2.5 Composition of Capital Inflows

US$ Million

8000

7000

6000

5000 a Other Capital Flows

4000 I3 Official Capital Grants

3000 * Net Foreign Lending

2 Prvate Investment (net)

0

199 199 199 199 199 199

2.26 Egypt has an external debt comparable to Mexico's at that time. But thanks to theresult of Paris Club negotiations, Egypt has a remarkably smooth debt-service schedule.Unlike Mexico, Egypt faces no refinancing peak in any year between now and far into thenext century, thus Egypt's dollar liabilities signal no future crisis. Moreover, the fiscalposition seems more firmly based than Mexico's was. Social and health expenditure havebeen largely exempted from the retrenchment. Tax reform may bring further consolidation,and, importantly, the pension system in Egypt is actually generating surpluses.

2.27 For all the differences, Mexico's experience does contain some lessons. Mexico was inno way insolvent in 1994; its public debt was less than half of what it was prior to the debtcrisis. Moreover, its stabilization effort had gained considerable credibility, with inflation setto go into single digits for 1994. What this suggests is that several years into a successfulstabilization program, the policy challenges change. Early on, the key objective is to convinceinvestors of the consistency and sustainability of the reform program, and to demonstrate thegovernment's resolve, hence the importance of fiscal restraint, tight money and a rigidadherence to a nominal anchor strategy, for example through a fixed exchange rate.

2.28 Once this program is widely believed, the priorities change. While fiscal stringencyremains important to provide long-term confidence, flexibility and robustness against externalshocks may become more of a challenge. Lower debt creates more room for expansion ifneeded later on, but flexibility to insure the program's ability to survive unforeseen setbackstakes on additional importance-this is especially so for Egypt, given its large reliance onexogenous resources.

16 Total Government expenditures as share of GDP declined from 45.3 percent in 1991 to 28.4 percent in 1995while Government expenditures on health and education increased from 3.8 percent to 4 percent of GDP.


Implications for fiscal and exchange rate policy

2.29 A need for flexibility does not necessarily imply a wholesale move away from fixedexchange rates. Mexico went for a flexible rate after the collapse of its exchange rate regimebecause its loss of reserves during the crisis and reduced credibility afterwards left it no otherchoice. But Egypt is in a much stronger position; it has avoided many of Mexico's errors andcan take the necessary precautions.

2.30 There are strong arguments against increased flexibility in the exchange rate at thistime. In the presence of asset market uncertainty or, as in Egypt now, clear shifts in investorconfidence, nominal flexibility will lead to spurious real volatility. This problem is mademore acute by the privatization drive, which apparently is attracting substantial foreigninterest. Such capital inflows may be difficult to manage, given Egypt's relativelyunderdeveloped capital markets, withupward pressure on the nominalexchange rate thus becoming ever harder Figure 2.6 Inflation, Inventory and Exports

to resist. Sterilization, with Egypt'sdomestic currency debt already high, will Percentbe difficult, and in fact increasingly 30

expensive, as interest rate differentials 251 Inflation l

persist. 15 A,

10 L- Inventory/Sales - -0

2.31 However, if the exchange rate 5 A. .

pressure is real, i.e. driven by a boom oin goods markets rather than a portfolio -5 Oil Expots'

shift into Egyptian assets, the correct -15

response then would be to tighten fiscal -20

policy so as to create room for export 1990 1991 1992 1993 1994 1995

production; but this is unlikely.Inflation has shown no sign ofincreasing, and some indicators pointtowards rising inventories. All this evidence points to an asset market explanation for theupward pressure on the exchange rate, justifying the government's determination to resistfurther appreciation and accommodate any downward pressure that might develop.

2.32 Fiscal policy is severely constrained by the need to maintain confidence in thestabilization program's continued success, and by Egypt's high level of internal debt.Ultimately, the credibility of restrictive monetary and exchange rate policies is determined bythe fiscal backing they receive. If debts spiral out of control (although that is NOT happeningnow) because of interest rates in excess of the nominal growth rate of GDP, monetizationbecomes the likely alternative to debt finance, with all the consequences for capital flight thatwere seen in Mexico in 1994. Thus, maintaining a fiscal deficit that will lead to a gradualdecline in debt-output ratios is imperative, whatever the exchange rate system.


2.33 A second issue is the level of Egypt's debt. Clearly Egypt is not insolvent. Itsextemal debt, at about 47 percent face value, is actually around 30 percent of GDP once itsconcessional nature is taken into account.17 More worrisome is the internal debt; a largeshare is short term and at high real interest rates. Currently the debt stands at around 50percent of GDP, for a total external debt of around 80 percent of GDP (taking theconcessional nature of some of Egypt's external debt into account). For comparison, theMaastricht criteria call for a 60 percent debt ratio. Of course, such numbers are arbitrary; itis obvious from the strong investor interest in Egypt and in Egyptian Government paper thatthe government's solvency is not in doubt. At current growth and interest rates, the debtoutput ratio will decline: the nominal interest rate, at around 11 percent, is roughly equal tothe nominal growth rate of GDP (in fact, currently slightly lower, since the latter isprojected at 12 percent for 1996/1997).

2.34 Concems arise nevertheless for two reasons. One, the high debt level clearly restrictsthe government's ability to engage in more sterilization efforts on a large scale. Thesterilization effort of 1992-94 led to an increase in marketed government debt equal to 12.7percentage points of GDP by 1995; repeating that experience would, given the differencebetween the cost of intemal debt and the return on foreign assets, start to seriously underminefiscal stringency.

2.35 A second issue concems potential liabilities that are not explicitly counted asgovernment debt. Currently, it is not known how much of such liabilities exist. Claims onstate enterprises by external parties may ultimately become the government's liabilities;promises to make up for high purchase and low selling prices for cotton to tradingcompanies have not yet been met; liabilities of public enterprises to the utilities, and thesize of non-performing assets in bank portfolios are, for the time being, unknown. Equityand real estate are undervalued in bank portfolios, but loan losses may not be adequatelyprovisioned for. Treatment of government guarantees in loan loss provision calculationsare another concem.

17 By convention, the present value of contractual debt service --which takes into account the concessionalnature of external debt-has been calculated using a discount rate of 10 percent in future service payments. Theratio of present value to face value of debt stock was 64 percent for 1995.


2.36 A third issue concernsvulnerability to a downturn. Aslowdown in economic growth is Box: 2.1not likely, but not impossible ... the change in the debt ratio (d) is equal to.

either. Further turmoil in theMiddle East might undermine + (real intemret rate - gto)th (ste) x d

tourism revenues even if, as iSThis equation, which is the key to understanding debt dynamics,

likely, Egypt stays out of direct has a simple intuitive explanation. The noninterest-deficit has to be financed

confrontations. If growth slows with nlew debt to the extent that this deficit exceeds the amnount of moneycreation by the central bank. In addition, nominal interest expenditures have

down, the comparison between to be refinanced with new debt. But since the denominator of the debt ratio is

interest rates and nominal growth nomninal GNP, the debt ratio will decline either with inflation or with real

rates of GDP turns distinctly IGNP growth in the absence of new borrowing.

unfavourable. At zero growth, The dynarnics of debt and the sustainAbility of deficits areparticularly affected by the diffeence between the real interest rate and the

there is a 5-percentage-points growth rate of GNP. Assume first that the real interest rate on debt exceeds

difference opening up at short the growth rate. Then debt dynantics are unstable, atnd it becomes inpossibleto run a permanent primary deficit that exceeds the amnount of revenue the

maturities. At current debt levels, Government can obtain through seignorage. The conclusion deserves

that requires a primary surplus of emphasis: if the Governtment is running a primary defcit larger than theamount otseignorage it can obtain, and if the real interestrate exceeds the

between 3 and 5 percent of GDP econonmy's growth Tate, the debt to GNP ratio will conttinue rising without

for stability (see Box 2.1). If limit. At sone point it will be imnpossible for the Government to sell its debt,and the process will have to be brought to an end by cutting the budget

growth slows down, problems defisit.

could arise from this.Source: Stanley Fischer and William Easterly (1990), Anand and vanWijnbergen, 1989.

2.37 Slow growth will lead to lessprivate saving, less tax revenues, and pressure for more expenditure. All this will lead tolarger external deficits and larger fiscal deficits, thus making debt a more serious problem.For this reason, an active policy-while growth is still high-to reduce the debt output ratioto much smaller numbers is called for, to make the government less vulnerable to a crisisfrom external shocks.

C. RISK IN THE IMMEDIATE FUTURE

2.38 The discussion so far suggests that with stabilization and resumption of growth, policyfocus should shift toward raising national saving, and protecting the success of stabilization.Higher national saving would provide a solid foundation for Egypt to cope with long-termexternal shocks. In the immediate future, however, two specific risks require attention.

Sterilization problems

2.39 The large inflows in 1993 and 1994 were sterilized in classical fashion. The monetaryimpact of the Central Bank's foreign exchange purchases were offset by sales of domestic


currency denominated securities. As a consequence, Egypt's LE debt shot up (Figure 2.7) asreserves accumulated.

2.40 Holding such a high level of internal debt, at interest rates substantially in excess ofthe return on the equally high foreign reserves, is obviously undesirable from a fiscal pointof view. A reasonable estimate of thereturn on dollar assets would be at most 5 Figure 2.7 Domestic Debt as Percent of

percent, the short term US T-bill rate. But Total Public Debt Stock

internal debt now goes at more than 10 Percent

percent while the exchange rate is stable 55

against the dollar. If we double the 50

reserves for imports from a safe level of 45

three months coverage to six months, this 40

would still be only about one third of what 35

Egypt is currently holding, indicating that 30

the CBE has excess reserves of around 25

US$11 billion, or about 16 percent of 1990 1991 1992 1993 1994 1995

GDP. At a 5-percentage points interestdifferential, that makes for an annual loss of about 1 percent of GDP. If the return on assetsis lower, the loss is correspondingly larger, with a maximum loss of 2 percent of GDP if theforeign assets earn no return at all. A cautious strategy to reduce reserves would thus becalled for, rather than further debt-financed reserve accumulation, as will happen iftraditional sterilization strategies are followed.

2.41 A dangerous alternative would be to reduce reserves through encouraging a largercurrent account (CA) deficit, for example through import tariff reduction that is not offset byother equivalent revenue-raising measures. While running a larger CA deficit might slowdown the reserve accumulation, it would significantly increase Egypt's vulnerability to acrisis. The resulting pattern could be very much like Mexico's in the period leading up to itscrisis, where high but volatile capital inflows were funding a large CA deficit. The inflowsmay easily be reversed, but the CA deficit is much harder to eliminate. Over time, reserveaccumulation should be stopped by eliminating undue incentives for capital inflows, and, forexample, by widening the pension system's ability to invest abroad (Chapter 4).

2.42 One key incentive that unduly encourages capital inflows is the asymmetric treatmentbetween bank loans funded from foreign sources and loans funded from domestic sources.Domestic deposits face a 15-percent reserve requirement over which no interest is paid. Sincedomestic interest rates are over 10 percent, this greatly raises the cost of funding loans fromdomestic deposits. On the other hand, while reserve requirements against foreign exchangedeposits are also high at 15 percent, they are remunerated at LIBOR. This makes for adifferential cost of almost 1 percentage point, or a large fraction of the banks' profits perpound lent. l8

18 Fifteen percent at zero rate adds 176 basis points to the cost of a loan (10 percent of 15 percent over I minus15 percent). Foreign funding, as long as the exchange rate remains stable, costs only 88 basis points per poundlent (5 percentage points interest differential over a 15 percent reserve requirement, scaled up by (I minus 15


2.43 Through this asymmetry, banks are encouraged to borrow in dollars; and because ofthe persistent interest differential in the face of a stable exchange rate, they have a strongincentive to lend in local currency. Thus, this asymmetry not only encourages capital inflows,but also puts the capital of the banks at risk by providing undue incentives to increase foreignexchange exposure. A strong policy recommendation is to either start paying interest onreserves against domestic deposits, or to stop paying interest on reserves against foreigndeposits.

2.44 An approach followed in Jordan, before the Palestine switch out of JDs triggered theircurrent reserve problems, was to require banks to hold 100-percent reserves against foreignexchange deposits in assets to be held abroad. This forced banks to match capital inflows withoutflows of equal size. A third policy measure (that should be considered for other reasons,but that will have an impact on reducing net capital inflows) is to allow the pension system toinvest in high-grade foreign assets such as US Government paper or blue chip equity. Thiswill allow the funds to better spread risks, and has the added advantage of encouraging capitaloutflows when inflows are too high from a macroeconomic point of view.

Issues in banking

2.45 Banks, whether state owned or private, are the Achilles heel of many reformprograms. A recession in the early phases of a stabilization program will lead to adeterioration in the quality of loan portfolios, as firns, in distress because of the recession,stop servicing their debts. In the upturn that follows, the real exchange rate typicallyappreciates, and long periods persist when nominal rates on domestic currency stay aboveforeign rates plus the ex post rate of devaluation.

2.46 Such interest differentials, in turn, make it attractive for banks to borrow in US dollarsand lend in local currency. As long as the exchange rate stays fixed, profitability will stayhigh, but, of course, foreign exchange exposure opens up, and the banks become extremelyvulnerable to a devaluation. Even if dollar deposits are matched with dollar loans, theproblem remains. While the banks will then be matched in foreign exchange, typically theborrowing firms are not, so they will default on bank loans after a devaluation, wiping out thebanks' capital. In this case, exchange risk remains, but is transformed in foreign exchange-related commercial risk. This happened during the banking crisis in Chile in 1982, during thebig Mexican crisis in 1982 and again in 1994.

percent). The cost difference between foreign and domestic sources of funds is thus a full 88 basis points (0.88percentage points) per unit lent!!


2.47 Thus, careful bank supervision and aggressive provisioning against bad loans isabsolutely crucial in the post-stabilization period, so as to strengthen the banks, or at leastmake the extent of their distress clear to managers and regulators alike. The CBE needs to beextraordinarily vigilant in preventing excessive foreign exchange exposure in banks. Simplymatching dollar assets with dollar liabilities etc. is not enough; the quality and foreignexchange exposure of the borrowing firms will have to be considered explicitly. This issue isbecoming acute, as pressure by bank clients to give US$ loans is apparently mounting, therisk of devaluation notwithstanding.

2.48 The extent to which these two Figure 2.8 Domestic vs Foreign

problems exist is not altogether clear in Interest Rate

Egypt. The four main state banks (with Percent

70 percent of the loan portfolio) are 25 1

clearly exposed to a substantial number 20

of bad loans, since they are the lenders to 'O / f Domestic Interest Rate

state enterprises. On the other hand, they 15 -5

seem to have made substantial profits 10 Rate Adjusted LIBOR

during the sterilization period of 1992- 5

94, most of which were used forprovisioning. Their true capitalisation 0 - -

c2nnot really be assessed on published 1990 1991 1992 1993 1994 1995

data alone; a careful audit on IAS basis isvery urgent to bring out their true capitalisation. This in turn will indicate whether costcutting and improved loan approval and credit quality control procedures are enough, orwhether more drastic measures need to be undertaken.

2.49 What is to be avoided at all costs is straight recapitalization without more drasticreform in the incentive structure the bank and its officers face (not to mention managementchange). A recapitalization without further reform signals to the bank that the behaviour thatled to the problems is rewarded with subsidies; the behaviour will thus continue, and allproblems will reappear with a vengeance within, as experience tells us, one year. Hungary isa good example. The state banks were recapitalized in 1992, 1993 (twice) and 1994, eachtime for US$ I billion, for a cumulative total equal to 10 percent of Hungarian GDP. Aftereach recapitalization, banks continued their poor loan quality control, and the problems wereback in less than a year. A pure recapitalization merely gives bank management moretaxpayer money to squander.

2.50 What is needed, first of all, is a hard-nosed audit by an experienced foreign auditcompany; Egyptian companies may be competent, but may also be concerned about futurebusiness of the bank in question or its clients. A foreign auditor without an office in Egyptfaces no such incentive problem. The audit should assess the adequacy of Loan LossProvisions (LLP) and thus report on the accuracy of the current value of capital. This is acrucial question: almost all major banking crises in the West and the East involved banks thatseemed adequately capitalised (Continental Illinois, Credit Lyonais, and Banesto all hadcapital adequacy ratios in excess of the Basle norm of 8 percent on the day of their collapse).What was wrong was the grossly inadequate provisioning for specific loan losses.


2.51 This may also be a problem in Egypt, although modem loan classification schemesand provisioning rules were introduced in 1993, and are apparently enforced-at least for theprivate banks. First of all, it is not clear how stringently these rules are being enforced for thestate banks; second, LLP must come out of current profits. This makes it highly unlikely thatbanks have been able to sufficiently provision against the portions of their portfolios thatapparently went bad prior to 1993. A final issue concerns the tax treatment of LLP. LLP arenot deductible under corporate tax; presumably losses can only be taken when loans areactually written down. Allowing at least a partial tax deduction on LLP would obviouslystrengthen the incentives to adequately provision against specific loan losses.

2.52 A second issue concerns the criteria used to classify a loan. If part of the amortisationpayments are not met, the entire loan has to be downgraded, not just the missed amortisationpayment. But missed interest payments that are simply rolled over are apparently no reasonfor downgrading, and this is a major issue. This rolling over of interest presents auditors witha difficult problem, one that is currently ignored in Egyptian audits. Is rolling over simply amatter of maintaining credit relations with a creditworthy client, or an early warning sign ofborrower distress? Is the risk of the loan portfolio as a whole adequately assessed? All loansto the construction sector are now probably good, but if they all withdraw tomorrow, thisoutlook will change. Can subjective criteria (instead of the objective one of missedpayments) be used to downgrade a loan? Finally, foreign exchange exposure, both of banksthemselves and of their major US dollar borrowers, needs to be carefully monitored and keptwithin manageable bounds.

3 LONG-TERM POLICY CHALLENGES

3.1 Solving the immediate problems outlined above will reduce Egypt's vulnerability tocrises, but much more needs to be done. Three groups of long-term challenges presentthemselves. First, even if current circumstances continue, and in particular if privateinvestment remains strong, will the government's macro policies remain internallyconsistent? Second, while the private investment expansion lasts or even accelerates, aresupporting policies necessary-especially given the absence of a strong recovery in privatesaving and the concentration of private investment in nontradable sectors (as indicated inChapter 2)? And finally, what if investment or other important expenditure categories slowdown for any reason?

3.2 Long-term consistency issues centre around fiscal balance and external financing.The other two centre around two key questions Egypt will have to face. If investmentremains strong or accelerates, as is necessary if growth is to nudge further up (as envisagedin the high-case scenario below), the exchange rate may be sustainable from a real sectorpoint of view; strong continued expenditure will support an appreciated real exchange rate.But external balance is likely to deteriorate, and a Mexican situation may develop, withprivate capital inflows financing a large current account deficit. While this may besustainable for a long time, the Mexican experience amply demonstrates that this is avulnerable situation. If the investment expansion does not accelerate, or if otherexpenditure categories slow down too much to sustain output on a high growth path, wouldthe exchange rate require a downward adjustment? If so, how can that be achieved withouttriggering a balance of payments crisis?

A. DIVERGENT GROWTH SCENARIOS

3.3 Two medium-term scenarios have been envisaged in order to illustrate the magnitudeof the investment and saving efforts needed to support moderate growth and high growth, aswell as the magnitude of divergent pay-offs-in terms of employment and income growth-from sustaining high growth as compared with modest growth. Macroeconomic consistenciesare assumed to underly both scenarios, whereas substantial structural reform efforts willunderpin the growth of saving and investment and the productivity gains envisaged in thehigh-case scenario (para.3.10-3.13).

Main Report: Long-term Policy Challenges 27

The Base-Case Scenario

3.4 The Base-Case Scenario (the "Base Case") is predicated on the condition that themacroeconomic policies are intemally consistent. Fiscal stringency will be maintained, andexternal debt to GDP ratio will continue to decline, thus increasing headroom for managinginternal debt and expansionary policies if needed in the future. Growth of aggregateexpenditures will be slow, with the current account in balance. Growth of broad money willbe kept below growth of nominal GDP. Inflation will be comparable to those of OECDcountries. Real GDP growth will be at around 4.5 percent, and extemal financingrequirements at a minimum. By choosing to maintain its current levels of internationalreserves (at more than 12 months of imports), Egypt would be able to cope with extemalshocks with relative ease.

Table 3.1 Outcome of the Two Scenarios

(In Percem)1995196 1996X97 1997/98 199819 1999/2000 2000-2002 200-2005

1. Base Case ScenarioGDP at market price, real growth rate 4.9 4.4 4.4 4,5 4.5 4.6 4.6Inflation, GDP Deflator 7.4 5.3 5.0 4.8 4.7 4.5 4.4GNP, real growth rate 5.0 4.6 4.5 4.5 4.6 4.6 4.7Gross nati. disposable income, real growth rate 4.5 4.2 4.2 4.6 4.4 4.4 4.5GDP per capita, real growth rate 2.7 2.2 2.2 2.4 2.4 2.5 2.6Unemployment: % of labor force 9.7 10.3 11.1 12.0 12.9 14.0 17.0Consumptiont/GNP 84.2 84.3 84.5 84.9 85.0 85.2 85.3Gross investment/ONP 20.7 20.0 19.6 19.5 19.1 18.5 17.6Gross domestic saving/GNP 17.0 16.7 16.4 16.0 15.9 15.7 15.4Gross national saving/GNP 20.8 20.2 19.7 19.4 19.1 18.7 18.0Overall budget deficitlGDP -1.3 -0.9 -1.3 -0.3 0.0 0.3 0.6Current account balance/GDP 0.1 0.1 o.1 -0. I 0.0 0.1 0.4Non-oil merchandise exports, growth rate 5.0 5.0 5.1 5.1 5.1 5.2 5.2M2 growth rate 13.0 10.0 9.7 9.6 9,5 9.3 9.2

II. High Case ScenarioGDP at market price, real growth rate 4.9 5.7 6,0 6.3 6.5 7.0 7.5Inflation, GDP Deflator 7.4 7.0 6.7 6.5 6.4 6.0 5.5GNP, real growth rate 5.0 5.9 6.2 6.3 6.5 7.0 7.5Gross natl. disposable income, real growth rate 4.5 5.4 5.7 6.4 6.3 6.8 7.3GDP per capita, real growth rate 2,7 3.5 3.8 4.1 4.4 4.8 5.4Unemployment, % of labor force 9.7 9.2 8.6 7.9 7.2 6.4 6.0Consumption/GNP 84.2 85.5 84.0 83.0 81.5 80.0 75.0Gross investmneDt/GNP 20.7 21.2 21.6 23.8 24.5 25.6 26.0Gross domestic saving/GNP 17.0 15.6 16.9 18.1 19.6 22.0 28.0Gross national saving/GNP 20.8 19.0 20.0 21.2 22.3 24.5 29.0Overall budget deficit/GDP -1.3 -0.9 -0,6 1.4 2.3 3.0 4.0Current account balance/GDP 0.1 -2.1 -1.7 -2.6 -2.2 -1.7 2.2Non-oil merchandise exports, growth rate 15.0 15.0 16.0 16.0 16.0 17.0 17.0M2 growth rate 13.0 13.2 13.2 13.3 13.4 13.5 13.5

Source: World Bank staff estimates

28 Main Report: Long-term Policy Challenges

3.5 This scenario is therefore characterized by two main features. First, while themacroeconomic policies will continue to be internally consistent, structural reforms willmove slowly; thus the fundamental problems impeding growth of saving and investment willremain. Divestiture of public sector interest will be limited in scope, and the current recoveryof private investment will not accelerate. Second, Egypt would choose to limit foreignborrowing (on a commitment basis) to the range of US$ 1.0-1.5 billion a year during 1996-2002. This means that the debt stock will decline in real terms, and relative to output as well.Egypt would find itself denied an opportunity to attract private and foreign investmentthrough rapid structural reforms. The constrained private sector investment will lead tolimited growth in job and income opportunities, and therefore further increases inunemployment. Furthermore, slow growth of non-oil merchandise exports (at 5 percent) willlimit the scope for Egypt to reduce its reliance on exogenous resources, despite the largeforeign exchange reserves that it holds against external shocks. The large fiscal costs arisingfrom the holding of reserves limit the headroom for expansionary policies.

The High-growth Scenario

3.6 The High-growth scenario is based on the vision that Egypt should and must growfaster, and that the benefits of rapid growth outweigh the potential risks. This scenario ischaracterized by the following features. First, Egypt would maintain internally consistentmacroeconomic policies strengthened by vigorous structural reforms in trade, capital andlabor markets, privatization and deregulation, as well as by strengthened incentives to raiseproductivity growth. In particular, a rapid and large-scale privatization program will becomplemented by rapid growth of private investment. Second, fiscal stringency would giverise to increased public sector saving, which would contribute to rapid increases in domesticsaving. Private saving would be boosted subsequently by rapid per-capita income growth andother structural policy reforms. However, the increased domestic saving would not be largeenough to finance all the investment requirements; a significant gap would still have to befilled with portfolio and foreign direct investments and with foreign borrowing.

3.7 The simulation indicates that, in this scenario, GNP in real terms would reach agrowth trajectory of about 7 percent, and nominal export earnings (of non-oil merchandize)would grow at more than 15 percent a year. It also shows that while the debt stock wouldgrow with increased foreign borrowing, the growth of GNP would be much faster, thereforekeeping the growth of debt stock well behind the increases of Egypt's capacity to carry andservice debt. As under the first scenario, the debt problem would be well contained (Egyptremains "moderately indebted"). The decline in foreign exchange reserves (to no less than 9months of imports) will be moderate, as the enlarged current account deficits are expected tobe financed also by increases in foreign borrowing. Nonetheless, the viability of thisscenario depends on the level of domestic saving. To the extent that saving does not risesufficiently and quickly to support the growth of private investment, foreign savings willhave to be relied upon, and inflationary pressure will emerge, leading to heightened concernfor vulnerability.


Benefits of Rapid Growth

3.8 Overall, the high-case scenario would imply an investment/GNP ratio of 22-25percent and an ICOR of 3.8, in contrast to 18-20 percent and 4.4 respectively in the base case.Gross domestic saving as percentage of GDP would be in the 17-18 percent range in the highcase, against 16-17 percent in the base case. While the fiscal deficits as shares of GDP areestimated to turn to surplus by the turn of the century in both cases, better budgetary resultsare expected earlier in the high case, as the privatization process gathers pace and governmentspending is prioritized to provision of basic social services (including a social safety net) andinfrastructure development. Real exports of agricultural and manufactured goods would growat about 10-15 percent in the high growth scenario, compared to 5-7 percent in the base case.Export earnings from sources vulnerable to external shocks and depletion of naturalresources, such as tourism, the Suez Canal and petroleum, are expected to grow at similarrates in both scenarios. More specifically, the divergent outcomes from the two scenariosinclude:

* addition of national income in the magnitude of US$ 37.3 billion over the next sixyears;

* addition of about 5.9 million jobs;

* a rise in the level of trade integration (export plus import) to 33.1 percent of GDPby 2002 (compared with 25.2 percent in the base case);

* reduced vulnerability to external shocks, as a result of decreases in exogenousresources as a share of GNP from 12.6 percent in 1996 to 8.7 percent in 2002(compared with 9.4 percent in the base case); and

* increases in per capita income to that of US$ 1,650 a year by 2002 (compared withUS$ 1,465 in the base case).

3.9 Rapid growth, as envisaged in the high-case scenario, requires, of course,maintaining macro policy consistency, as well as adopting the supporting policies necessaryto sustain growth on a path firmly supported by increased domestic savings.

B. LONG-TERM CONSISTENCY ISSUES

3.10 The current fiscal stance of the government appears internally consistent. Thedeficit is small, and interest rates and growth rates are such that the current primarysurplus is high enough to foresee a medium-term decline in overall debt-output ratios (asimplied in both scenarios above). An issue that will come up, however, is the likely declinein long-term external assistance. The current level of US$2 billion per annum willobviously not continue indefinitely. If Egypt's reform process continues, private inflowswill doubtlessly take the place of diminished external official flows. But an open question iswhether such a structural dependence on volatile private inflows is in fact desirable. A


case can be made that it is not, and that therefore measures to increase saving are required.We will consider three groups of measures below.

3.11 These measures will also need to include fiscal measures if it turns out that internaldebt is not falling sufficiently as a percentage of GDP. While Egypt is not insolvent, thehigh level of internal debt restricts the government's ability to use expansionary fiscalpolicy in a slowdown. And its sustainability could come into question if, for whateverreason, growth does slow down. Thus a strict fiscal policy, aimed at significantly reducingthe level of internal debt with respect to GDP, should be recommended.

3.12 Applying privatisation revenues to debt reduction may help and should beconsidered, although it is unlikely to be enough. In fact, the last three years saw noproceeds from privatization being applied toward reducing government debt (see Figure3.1). The practice of using privatisationrevenues to prop up ailing state Figure 3.1 Distribution of Sales Proceeds*enterprises, as has happened through re-investment, and restructuring (Figure 3.1), Uncollected Financial

is a very bad one. Propping up those installments restructuring

enterprises merely postpones their 34% 23%

adjustment to new realities and simply Re-investment

wastes taxpayers' money; once the 13%

privatisation comes to an end, the hard * fron iKt~,f assets to'J hl7i ANated at

measures will have to be taken, and the LE 5.37 billion forlsperiod of 1994 to May 199Q%

proceeds of privatisation will have beenwasted. A strict policy of applyingprivatisation revenues to debt reduction,rather than to funding state enterprisedeficits, is thus strongly recommended.

3.13 Much has been done in the last few years to reduce the size of public expenditure,

Figure 3.2 Volatility of Egypt's Key Revenue Sources and the scope for further decline isFigure 3.2 Volatility of Egypt's Key therefore quite limited. The

Figure 3.2 Volatility of Egypts Key government has now initiated aRatio Revenue Sources program to carry out civil service

0.18 0.17 reforms in the medium term. While a0.16. 0.14 successful reform could reduce the0.12 . 09 0.10 dead weight on the economy, one has0.08 U0o.oa 0.07 0.05 _ to be cautious with regard to the size0.064 of fiscal saving that could be0.020 a generated in the short term. In the

OilandGas Suez Canal Tourism Workers' Official Grants meantime, Egypt may have to copePermttances with uncertainty in its key revenue

sources. Figure 3.2 demonstrateshigh volatility of key revenues derived


from foreign aid, the Suez Canal, and oil exports. This highlights the need for Egypt toreduce internal debt so as to increase the headroom for coping with external shocks.

C. WHAT SHOULD BE DONE WHILE THE INVESTMENT EXPANSION LASTS?

3.14 If investment remains strong, or accelerates to levels necessary to achieve the 6 to 7percent growth rates required to absorb the new entrants Egypt can expect to its labourforce, increasing external deficits can be anticipated on the current account. Once again,private capital inflows are most likely to be available to fund such deficits, but such aconfiguration will make Egypt highly vulnerable to reversals of investors' confidence.Thus, measures to increase saving at least closer to East Asian levels are stronglyrecommended.

3.15 Most saving come from one of three sources, and government measures can beclassified accordingly. First, theory notwithstanding, there is ample practical evidence thatraising public saving raises aggregate saving. The private sector may offset some but notall government saving. Thus, further measures to increase fiscal surpluses and reducedeficits will certainly help. This is, however, not the first area where measures arerequired, since so much has already been done in this field.

3.16 The second main source of saving is corporate saving. In most countries, retainedearnings is the main source of funds for investment expenditure. Two groups of measureswill encourage companies to retain more earnings. The first group makes privateinvestment more attractive and therefore funding for it more valuable. Privatisation,improving the regulatory and competitive environment, simplifying the government's still-complex administrative procedures, and using explicit tax measures, will all contribute tothis end.

3.17 Second, explicit tax measures to promote or at least end discrimination againstretained earnings should be considered. One example is the practice to allow deduction offictitious interest expense over statutory capital, but not over retained earnings. Sincestatutory capital is fixed, this deduction has no useful incentive effects once the size ofstatutory capital has been decided upon, and retained earnings are discriminated against.Alternatives, such as extending this privilege to retained earnings, could be considered.Some countries extend investment credits explicitly limited to investment financed fromretained earnings, so as to encourage corporate saving.

3.18 The third source of national saving is private saving. Much has been done toencourage saving by those with considerable surpluses: Egypt's capital markets now offer awider choice and higher returns than ever before, with improved transparency and investorprotection available. The recent rise of private investment also offers further optimism. If,as argued in Chapter 1, an environment good for investment is also good for saving, thenthe current rebound in private investment will likely bring about a rebound in privatesaving as well. This prediction is supported not only by the current sound macroeconomic


stance, but also by the declining public investment in commercial activities (Chapter 4,para.4.9), and by further development of the capital market.

D. WHAT SHOULD BE DONE IF INVESTMENT EXPANSION DOES NOT

ACCELERATE?

3.19 Despite this optimistic outlook, there are causes for concern. Since the recovery hasbeen led by private investment in nontradable activities, there is a danger that the recoverymay be held back by the size of the domestic market.19 In addition, to the extent that theconcentration of private investment in nontradable activities is a result of lack of competitionin tradable sectors, the productivity of private investment will suffer, thus limiting furthergrowth.

3.20 The concentration of investment in nontradables, in particular real estate assets, is acause for concern. The enterprises working in tradables face the need to upgrade theircapability and to compete more successfully. Yet they are receiving much less resources thanthe real estate sectors. The shift in relative prices (Tables 2.3 and 2.4) since 1990 and theconcentration of investment in nontradables undermine the ability of Egyptian industries toengage in production of tradables. This may bring about another problem. To the extent thatinvestment is intermediated through the banks, the banks are assuming considerable risks.The real estate boom is expected to end as soon as the demand is satisfied and marketeuphoria is over. If there is a crash or a drastic realignment of relative prices, the resultinglosses would have to be absorbed not only by investors using their own funds but also bybanks using funds from depositors.

3.21 Another cause for concern is the speed of major export recovery. The above scenarioenvisages increases in capital good imports, and a rise in private investment in tradables inresponse to the improvement of price regimes and supporting policies.20 The rise of capitalgood imports needs to be balanced by growth of export earnings, thus the speed of exportrecovery is critical. The successful export experiences demonstrate that a sound relative priceincentive regime is necessary but not sufficient. Strong and responsive supporting policiesare also needed to ensure quick and timely export supply response. In the case of Egypt, twotypes of investment could be considered: first, investrnent of a long gestation, characterizedby relative high capital and skill intensity; or second, investment with short gestation andquick payoff, and with relatively high labor and low capital intensity. The supportingpolicies indicated in this report and the companion report are aimed at generating investmentwith quick export payoff.

3.22 A further cause for concern is the timing of the response of private saving. Even inthe high-case scenario outlined above-where the strong recovery of private investment itself

19 Egypt, with total national income of about US$ 60 billion, is equivalent to that of a metropolitan area inEurope.20 Price and non-price issues regarding export development are addressed in a parallel report to this CEM.


brings about an increase in private saving-a significant lag in the response of private savingwould necessarily be accompanied by a widening of the current account deficit. Whileresumed growth and stabilization may enable Egypt to attract a large amount of foreignsavings to further finance the recovery, there is a limit; Egypt's overall exposure to extemalshocks is already very high-owing to the large contribution of oil exports, workersremittances and foreign grants to the current account-and would be increased by higherreliance on foreign savings.

3.23 Should export response turn out to be slow, rise of private saving insufficient, andconcentration of investment in nontradables continue, the current growth recovery mayvery well slow down. The long-term response to a slowdown in investment, and to theneed to actually sell the goods the recently constructed capital helps produce, is key tolong-term success. Such a slowdown requires a real exchange rate depreciation at somestage. But achieving a real depreciation while maintaining the fixed exchange rate isexceedingly difficult; it requires sustained inflation rates below the main trading partners'inflation. Thus, introducing an element of flexibility in the exchange rate, for examplethrough the adoption of a crawling band, should be considered seriously, before the fixedrate is perceived as a matter of prestige. A crawling band sets rates of change to both anupper and lower bound, within which the exchange rate can move freely.

4 INCREASING LONG-TERM SAVINGS TO BUILD

THE BASIS FOR GROWTH

4.1 Three issues have emerged as central to getting on a path of higher growth: first, fiscalstringency is needed to maintain internal consistency, and to increase the headroom formanaging short-term risks (through reducing internal debt); second, supporting policies mustbe adopted to substantially increase resource allocation to production of tradables andexportables, therefore reducing the current account imbalances that are likely to emerge if thecurrent investment expansion accelerates; and third, a long-term response to the volatility ofexternal inflows, and to support consistently high domestic investment to encourage domesticsaving. Addressing these three issues is the starting point for establishing the basis for long-term growth.

4.2 This chapter will address two issues in this context. Given the limited scope ofexpenditure reductions, and the volatility in fiscal revenues (Chapter 3), how, and by howmuch, could public sector saving be increased? Furthermore, given the favorabledemographic trend in Egypt, i.e. a stable elderly population, and rapid growth of the working-age population ', how could private saving be encouraged? (The supporting policies neededto give a strong export push are discussed in a parallel report.)

A. INCREASED SAVINGS FROM PRIVATIZATION AND PUBLIC ENTERPRISE

REFORMS

4.3 It is often thought that countries like Egypt are unable to compete in a moreglobalized world because they are saddled by large and inefficient PE sectors. The irony isthat the same countries can be said to have an opportunity to gain rapid productivity growthby shifting the assets of public enterprises (PEs) to more efficient use. The fact that the gainsfrom reforms, especially in terms of savings, can be substantial suggests that some countrieshave a real opportunity to break the vicious circle, and begin a process of catching up with thefast-growing economies. Egypt is one of those countries.

4.4 Privatization could increase savings, in part because the transfer of ownership to theprivate sector is associated with higher productivity.22 Higher productivity, in turn, generatesmore resources, which can either be consumed or saved. In addition, privatization couldattract savings from abroad, which may not occur without privatization. This typically

21 Shi and Yang (1996).22 For evidence, see, for example, Galal et al., (1994); World Bank, 1995).

Main Report: Increasing Long-term Savings to Build The Basisfor Growth 35

happens when specialized multinational firms buy such enterprises as telecommunications.Beyond these first-round effects, privatization could stimulate saving indirectly. For example,if the proceeds from sales are used to retire public debt, this could lead to a reduction in thesize of government through lower taxation, with favorable effects on public saving (Sachs,1996).23 Another example relates to the favorable effect of privatization on thecompetitiveness of other industries if it were to lower the cost of producing intermediategoods and services (e.g., power, telecommunications services). Finally, privatization couldcontribute to saving indirectly by boosting capital market development, which has beenshown to contribute positively to growth.24

4.5 The positive link between privatization and saving has important implications forcountries keen to grow fast but unable to wait for savings to accumulate from economicgrowth. To such countries, privatization, along with other reforms (e.g., of pension funds),can help jump-start the growth process, thereby creating a virtuous circle of saving,investment and growth. An important question in this context is: how is it possible to raisesaving from reform of PEs, and what is the magnitude of the potential addition to savingsfrom privatization? The methodology used in addressing these questions is based oncomparing the saving from the PE sector under continued public ownership and its saving

25under the counterfactual scenario of privatization and commercialization. Details onmethodology and key assumptions are provided in the appendix. Because the potential gainsin saving depend on the initial conditions of the PE sector (including its level of efficiencyand size), we start by measuring the past performance of the PE sector, and exploring the rootsof the problem.

The PE Saving-Investment Gap and its Roots

4.6 Availability of consolidated accounts for the entire PE sector in Egypt limited theanalysis below to 356 enterprises.26 These enterprises operate in almost all branches of theindustrial sector, but the few missing PEs, known as the "economic authorities" in Egypt, arerelatively important ones, and include such large entities as the Suez Canal,telecommunications, power and the railway. The bias in the sample favors PEs, given thatprevious analysis has shown that the economic authorities tend to perform less well than otherPEs on average (World Bank, 1987).

23 From a welfare perspective, it has been argued that $1 in the hands of government is worth less than $1 in thehands of the private sector, because raising $1 by government through taxation is distortionary. For furtherdiscussions of this point, see Jones, Tendon and Vogelsang (1990).24 Levine and Renelt (1992).25 Privatization refers to the transfer of ownership and/or control to the private sector. Commercialization refersto a package of reforms: increased competition, hard budget constraints, regulation of monopolies, financialmarket reforms, and incentives to managers to perform efficiently.26 The number of PEs in the sample declined from 364 in 1991/92 to 356 in 1992/93, which CAPMASattributes to liquidation and privatization.

36 Main Report: Increasing Long-term Savings to Build The Basisfor Growth

4.7 The PEs' S-I gap is defined as the difference between the PEs' current surplus, beforetransfers to or from the government, and their fixed capital formation. Current surplus isdefined as operating revenues minus operating expenditures, plus net non-operating incomebefore taxes anddividends. For thesample analyzed, thd gap Figure 4.1 Saving-Investment Gap as a Percentage of GDP, 1987-93for the PE sector in

P.ro.nt of GDPEgypt averaged -2 2

percent of GDP over the .46 deveoping

period 1987/88-1993/94(see statistical appendixfor details)27 . This gap isnotably higher than the -2 * * -

average of 0.4 percent -Egpt

for 46 developingcountries (Figure 4.1), -4

but the Egyptian PEs did . ,better over time. The S-I -6gap reversed from -7.3percent of GDP in Source: Developing countries: Bureaucrats in Business, 1995; Egypt: Computed from:1987/88 to a surplus in CAPMAS, Financial and Economic Statistics of Public Companies1987/88 to a surplus in1991/92 - 1993/94. Sincethen, the PEs in Egypt have been self-sufficient, generating most of the resources they neededfor operation and expansion.

4.8 Of course,whatever gap Egypt's Figure 4.2 Saving-Investment Gap and its SourcesPEs accumulated in the of Finance in Egypt,past had to come fromelsewhere in the 1987/88-93/94economy: the

MaliobOfl OLE

government budget, fooo .domestic saving, foreignborrowing, or a mix of 4000 0-.Id, _all three. As can be seen 2000 -

from Figure 4.2, thegovernment clearlycarried the bulk of the 2005 _

burden, although the 4000 -. '- " %

budget's contribution fell 0 .h., " _ _ -

dramatically in recent 6000

years. The banks were Source: Calculated from data from CAPMAS, Financial and Economic Statistics of Public

the second major Companies, different issues.

contributor to PEs, andthis contributionincreased in recent years

l xcluding 1992/93 because the reported data show a sharp drop in gross fixed assets.


to partially offset the reduction in budgetary transfers dictated by tighter fiscal policies. Theshift of financing from the government budget to the banking sector is problematic, given thatbanks are also publicly owned; this means that commercial criteria may not have beenfollowed in allocating these funds.

4.9 While a smaller PES-I gap is desirable Figure 4.3 Saving-Investment Gap of PEs in Egypt,because it frees resourcesfor the more productive 1987/88- 93/94private sector, the way this

P.rcnt oI OP

gap is reduced matters. 10 - IUnfortunately, the N improvement in the S-I en

gap of the PE sector in 4 _. -4 S. 'VI~9 a

Egypt came primarilyfrom a reduction in capital 2 -_ . -,

expenditures, rather than 0 - - i .

from an increase in saving , 6 * - - , -

(see Figure 4.3). Capital 4 _

expenditures were cutsharply twice (in 1988/89and 1991/92), and never Source: Calculated from data from CAPMAS, Financial and Economic Statistics of Public

recovered since. At the Companies, various issues.

same time, saving as apercentage of GDP hasdeteriorated between the beginning and the end of the period.


4.10 The reasonsfor the deterioration Figure 4.4 Financial Performance of Public Enterprises in Egypt,in saving - are low 1986/87-93/94rates of return on

Pe-ntcapital and low Percent

- - ~~~~~~~~~Net operatinproductivity. 1 , , . -- rplOyod -a

Egyptian PEs were Tnot net losers on 10 Profit/Networth

average, but they amade only modest 6 _~ - ___

rates of return on 4 sorphs/Capital

capital (Figure 4.4) 28

Between 1986/87 and1993/94, theiroperating surplusrelative to capital Source: Calculated from data from CAPMAS, Financial and Economic Statistics of Public

employed was 11.9 Companies, different issues.

percent, which is relatively low given that the surplus represents the returns both to theowners as well as the lenders. Profits net of taxes and subsidies to net worth reflect anaverage return below the deposit rate over the last few years. Finally, the rates of return onrevalued capital only averaged close to 5.5 percent during the period.

4.11 Productivity is difficult to measure for the entire PE sector, in part because nomeaningful composite price indices exist for outputs and inputs. However, a comparisonbetween real per unit variable cost and operating surplus to sales of the PE sector in Egyptand a sample of eight countries (Figure 5, a and b in the Appendix) indicates that the PEsector in Egypt is an average performer. Moreover, the performance of the sector lagssignificantly behind those of such successful reformers as Korea, Chile and Mexico.

4.12 The roots of the modest performance of PEs in general are relatively well known:

* Government has over-extended itself in commercial areas not suited for public ownership;

* managers of PEs face little incentives to behave efficiently and to respond to consumertastes and market conditions.

28 Returns to capital are measured using three indicators: (1) the ratio of operating surplus to capital employed,which measures the returns to all contributors (the government as equity holder, recipient of taxes, andcreditors), (2) the ratio of profit before taxes and other transfers to or from government to net worth, whichreflects the returns to the government, as if it were a private owner, and (3) the ratio of current surplus beforetaxes to revalued capital employed, where capital is revalued using the perpetual inventory methodology. (Seestatistical appendix for more details.)

Main Report: Increasing Long-term Savings to Build The Basis for Growth 39

4.13 To be sure, the

government has attempted Figure 4.5 Proceeds from Privatization of Law 203 Companies into address the two causes of Egypt, 1994-Sept. 1996the problem of PEs inEgypt. With respect to Mllions of LE

privatization, a process was 1600 _

initiated a few years ago, 1400

and it has picked up more 1200 l

steam in 1996. Not only ,oo have the proceeds fromsales increased in the firstnine months of 1996, but 600 1 Ithe nature of privatization t { _

has changed in favor of the zo0sale of majority stake, in o -_ - -

some cases to anchor -

investors. So far, thegovernment has sold stakes Source: Public Enterprise Office.

in 39 companies, of whichthe private sector acquired a majority of the shares in 18 (4 acquired by anchor investors andthe remaining 14 sold on the stock market). In addition, the government has sold a majorityof the shares in 11 companies to employees, along with the partial sale of 21 enterprises onthe stock market. The total proceeds from sales to date are just below $1 billion.

4.14 As for commercialization, the government has also made substantial progress. Itincorporated PEs under Law 203, and provided a framework in which a legal distinction hasbeen made between ownership and management responsibilities. In this context, budgettransfers to PEs have been reduced, and the banking sector is being encouraged to lend to PEson commercial grounds. Competition has been enhanced by opening up the economy andallowing the private sector to participate in many sectors previously reserved for PEs. Finally,17 holding companies were formed with a view to giving managers more autonomy indecision making.

4.15 Notwithstanding the progress on privatization and commercialization, success inreducing the relative size of the sector to restore a healthy balance between the public andprivate sector in the economy remains to be seen. On the commercialization front, some PEsstill receive subsidies. The hard budget constraint was imposed by cutting investment, withlimited progress on measures to improve saving. Banks have not been prudent in lending toPEs. The holding companies are proving to be less than keen on privatization, as it diminishestheir power. In short, despite the improvement in the PE S-I gap in recent years, the sharp cutin investment and the relatively low rates of return on capital suggest that there is some roomfor squeezing more savings from reforming the PE sector.

Potential Gains in Savings from Reforms: A Simulation

4.16 Assuming that the government undertakes the necessary reforms to improve theperformance of the PE sector, how much additional savings will such reforms bring about?


Box 4.1 Methodology and Assumptions

The potential gains in savings from privatization and commercialization of the PE sector are obtained bysubtracting the NVP of profits before taxes under continued public ownership (or the factual scenario) from the NPV ofprofits before taxes under privatization and commercialization (or the counterfactual scenario). To this end, three scenariosarefirst constructed:

The No Reform scenario, in which the current performance of the sector is projected into the future byextrapolating the sector's revenues, costs and investment according to their historical trends. The projections are madeforall items in the income statement and balance sheet. Profits before taxes are then discounted at 10 percent to obtain the NPVunder the No Reform scenario.

The Privatization scenario, in which the periformance of the sector is also projected into the future, but under theassumption that productivity will improve annually by 1.5 percent and investment will increase annually by 20 percentrelative to fixed operating assets. (The rationale for these assumptions is discussed in the appendix). The same procedurewith respect to discounting is then applied as in the No Reform scenario. The result is another NPV of the sector,representing one extreme counterfactual scenario (100 percent privatization).

The Commercialization scenario, in which the performance of the sector is projected into the future, assuming thatcommercialization will lead to an improvement in productivity of I percent per annum, accompanied by no change ininvestment behavior. (The rationale for these assumptions is also elaborated in the appendix). The result is a NPV of thesector, representing another extreme counter factual scenario (100 commercialization).

From these three NPV's the addition to savings is estimated by making the realistic assumption that thegovernment will sell only half !the sector and commercialize the operation of the rest. In all instances, the NPVs arecalculated by discounting::the stream of benefits and costsover thefirm's lfehime. The benefits can be seen as the sum of thereturns to the buyers and sellers. The costs are the resources used to generate the benefits, including the cost of labor,capital and interrnediate inputs.

In answering this question, the emphasis is centered on the addition to savings as a result ofprivatization, rather than on the budgetary impact of privatization. This means that whatmatters is whether or not privatization and commercialization generate additional resourceswhich could be consumed or saved by the public or the private sector.29 As argued at theoutset, these additional savings could come from behavioral changes at the firm level, such asimproved productivity and increased investment. The next section elaborates themethodology followed to estimate the addition to savings.

4.17 Result. Based on the assumptions (see Box 4.1), privatization and commercializationof the sample of PEs analyzed are expected to bring about additional savings to Egypt with amagnitude of 2.4 percent of GDP (Table 4.1). For reasons explained above, the gains fromprivatization (2.1 percent of GDP) are much more substantial than from commercialization(0.4 percent of GDP). More significantly perhaps, given that the PE sample analyzed onlyrepresents about a third of the PE sector in Egypt, the addition to savings could be much

29 Where the budgetary impact of privatization is the main concern, it is important that all flows to and from thetreasury are taken into account. In particular, two flows of funds have to be compared: (1) the flow of fundsfrom the private sector to the government (in the form of sale price and taxes from privatized firms, minus thecost of privatizing), and (2) the flow of funds the government gives up by privatizing (including the taxes anddividends from PEs minus the subsidies and other transfers made to PEs).


more. Indeed, short of diminishing returns to the gains in savings, these gains could be ashigh as 7 percent of GDP, which is about the gap Egypt needs to increase itssaving/investment ratio to GDP to match the fast-growing economies.

4.18 The gains in savingsfrom privatization and Table 4.1 Estimated Increases in Savings from Reforming PEs-

commercialization will be made totalboth by the government and theprivate sector. Table 4.2 shows NPVof profits Total increase Annual increase

the distribution of these gains before taxes in savings in savings

between the two of them, (fMiqf199A5 ) (%of1950GDP)

without taking into account the Base case: No reform 89S79

price to be paid by the private 50% privatization 132095 42216 2.1%

sector to the government for thepurchase of 50 percent of PEs in 50 % commercialization 97516 7937 OA.%the sample. The effect on 50% privatizationsaving is positive (2.4 percent of & 0 o 1 5 2'4%(TDP). "Souri. (calculated from data fron I

4.19 Finally,Table 4.2 Estimated Inwreases in Savings from Refording PEs, Table 4.3 shows the

by Government and Private Sectorgains in savings

Total Increase in Savings Annual-Increase in Savings privatization(Millions of 1995 LE) tPercentage of 1995 GDP) and

GovenMnt =te Tota OoVentet Private Total commnercialization50% ivatization -17751 1 ,< seto% "' by origin. The gains

50°% privatization -17751 59967 45216. .9 2.9: 2.150% comenrcialization 7937 0 7937 0.4 0.0 04 are split almost50% privatization +9914 59967 50153. -,05. 2.9 2.4 evenly between& 50%commercialization investment andSource: Calculated fdm data Kom CAPMAS, financial and Eonomic Statistics ofj= lic: productivity. MoreCompanies, different issues.

interestingly,

however, the gains to the country are greater when both behavioral differences are presentbecause of synergies, or the interaction between productivity and investment. When both arepresent, a larger stock of resources is used more efficiently, and there is a compounded effecton performance, and thus on savings.

Table 4.3 Estimated Increases in Savnl#gs from Reforming PEs: Origin of the Change

Total increase in savinigs Annual increase in savings(Million of 1995 LE) (Percentage of 1995 GDP)

Productivity Additional Synergiae Total Productivity Additional Synergies Totalimprovement investment improvement investmnt

50% privatization 11966 23300 6950 42216 0.6% 1.1%. 0.3% 2.1%

50% commercialization 7937 0 0 7937 0.4% 0.0%,E 0.0% 0,4%

500SO privatization & 50%commercialization 19903 23300 :6950 50153 1 .0% 1.1% 0.3% 2.4%Source: Calculated from data from CAPMAS, Financial and Economic Statistics of Public Companies, different issues.

42 Main Report: Increasing Long-term Savings to Build The Basis for Growth

4.20 Sensitivity analysis. Given that the results depend on the assumptions made, it isuseful not only to separate the effect of each assumption from the effect of the other, but alsoto explore the sensitivity of the results to these assumptions. The separation of the impact ofeach assumption has already been done, and can be used by the reader to accept or reject anyof the assumptions and still obtain useful results. The remaining issue is to explore thesensitivity of the results to the key assumptions. This is done here, and presented in Table 4.4.The table shows the results under two extreme scenarios: full privatization of the sample ofPEs analyzed, and full commercialization. For each of these scenarios, the results are shownfor various discount rates (8, 10 and 12 percent), various productivity differentials (1.0, 1.5and 2.0 percent for privatization and various investment possibilities (15, 20 and 25 percentof net fixed assets).

4.21 Two broadTable 4.4 Sensitivit Analysis conclusions can be

0(Annual increase in isaviPangs aspercent of G drawn from Table

1:::7::80iwestxiiei@tb ProdUe7:t:ivityc :::::t7 :Disount:: 7r:t t tit:4.4. First, reforms25: 20 15 2 .5 1:2: J:: i of the sample of7.7 4.1 1.7 4.7 41 35 39 4.1 4. l0%Ptivatizion PEs investigated0.8 0. 008 1.22 0.8 0. 0.75 .0.770 .80 100% Commercialization here can produce4.3 2.4 L.2 3.0 2.4 1.9 2.3 A2.4 26 50% zPaiv atalion

and50Cotsnrcaliaton gains in savings ofa.l ncreases int savings include theAinteraction *of c:a nd changesiinvestmn1pr tm* of GDPb.Annual growth rates of productivity undar privatization. 'The d conspondig rates:undat at a minimum, and

cotnmercialization ar.5%, 1%, and l.5%,) respectivtey a asC~Percent of net fixed' ahgh4.

Saurce: Calculated from data from C ,MAS Financial and Economic Stastc of Puc opanies, percent of GDP.; 00different issues.: 0 000000000 0 000 0 ;:00 f:0f : 004 : 0;0Second, the results

are least sensitive to variations in the discount rate. They are moderately sensitive tovariations in productivity, and most sensitive to variations in investment. This not onlysuggests that the gains from investment in the course of privatization are significant, but alsothat care must be taken to ensure that investment will be forthcoming. The design ofprivatization transactions should commit the new owners to an investment program, whereappropriate, to maximize the gains to society.

B. FINANCIAL SECTOR REFORMS TO INCREASE PRIVATE SAVING

4.22 Saving is affected in various ways by different financial policies and institutions.Four policy areas that could increase the rate and improve the composition of private savingwill be addressed in this section: reforming the pension system, restructuring the insuranceindustry, developing capital markets, and improving the tax system.

4.23 There is increasing evidence that generous pay-as-you-go state pensions tend todepress household saving. Econometric work for this report shows a negative correlationbetween private saving and government spending on social security as shares of GDP. It alsoshows that a mandatory saving scheme is most likely to increase household saving.Furthermore, the contractual saving institutions, such as the life insurance industry, have aclear impact on the composition of savings, by favoring long-term financial assets (invested


by financial institutions), over fixed assets such as real estate, precious metals, and land(invested by individuals), even though it is not clear whether sound contractual savinginstitutions lead to higher aggregate saving. With well-developed contractual savinginstitutions, households and private corporations are able to borrow long term. The insuranceindustry also supports pension reform by providing specialized products and services such asannuities and life/disability insurance. To the extent that pension reform and privatizationprograms increase household and corporate saving respectively, capital market developmenthas an impact on the level of private saving. In addition, capital markets, under certainconditions, attract private foreign savings. Finally, tax policies that are biased in favor ofinvestment and against consumption could encourage saving by both household and thecorporate sectors, even though the empirical evidence still appears unsettled.

The Social Insurance System

4.24 Background. The Egyptian Social Insurance System (SIS) has an important impacton several macroeconomic and welfare issues, such as saving, redistribution, capital marketdevelopment, social protection and public finance. In 1994/95, contributions by employersand employees to the pension fund amounted to 3.5 percent of GDP, equivalent to about 21percent of gross domestic saving. Benefit payments and fiscal transfers (wage taxes andinvestment income) to the pension fund were 2.5 percent and 1.5 percent, respectively (Table4.5). SIS inflows (including investment income) less outflows was 5.3 percent of GDP in1994/95, and accumulated reserves were 33 percent of GDP in mid-1995-by way ofcomparison, combined market capitalization in both stock exchanges was about 13 percent ofGDP at end-1995.

Table 4.5 SocialInsuranee System Indicators 4.25 Because the(percent of GDr?) surplus from the SIS

~~~~~~~~~~~;.atd is __Invested via NIBConftil,utions Benefits Transfr from Annual Accumuae sivse i ITreasuv SUrU SS urplus in government

1985186 5.1 2.5 1.2 5,g 38.2 projects, and in the1986/87 4.4 2.3 1.0 5.1 36.6 :1987/88 4.3 2.3 0.9 5.6 36.2 past i public1988/89 4.D 2.2 1.0 4.8 33.9 enterprises, the SIS1989/90 3,6 2.0 9.9 4.6 317 effectively works asI1990/91 3.5 2.1 1.0 4.5 31.91991/92 3.1 2.1 L. 3.6 29.0 a pay-as-you-go1992/93 3.3 2.2 1.3 4.5 30.2 system. The national1993/94 3.5 2.5 1+5 5.4 32.5 reserves of the SIS1994/95 3.5 2.5 1.5 5.3 33.1 a

Source. Mission calculations based o* data fTom Ministi of Soeial lince - - at the NIB representpublic debt due in

the future when the SIS starts incurring a deficit. Access to cheap funds appears to increasethe propensity of governments to spend, and crowds out the private sector-during the period1970-94, the public investment share of total investment in Egypt averaged about 68 percent.The saving effect of a mandatory scheme is therefore offset by increased governmentspending. On the other hand, a truly fully-funded system that invests in financial instrumentsat market rates has the potential of developing financial markets-even if the system investsin government securities, government borrowing becomes a transparent process. Funded


systems that strengthen the link between benefits and contributions (such as definedcontribution plans) eliminate many of the distortions of a pay-as-you-go system.

4.26 SIS provides pension benefits and insurance against disability, death, and loss ofearnings due to unemployment or illness. The SIS covers a high proportion of the workforce 0, about 83 percent in 1994.31 There are more pensioners than persons over the age of60-a ratio of 146 percent-which is out of line compared to the other regions, including theOECD; this indicates a system that is quite generous or lax in its eligibility requirements.The ratio of pensioners to contributors (the system dependency ratio) is high relative to otherdeveloping countries, and to the ratio of population over 60 to that aged 20-59 years(demographic dependency ratio). Table 4.6 gives some comparative public pension schemeand demographic indicators.

Tle4.6 Compraiv 6uliWPnso Schm ad Dem gahic Inidicaitor

-_io Ctot0Wor Poisionerst0 0 0 Peiinrt poptala0 tionv6to4onsTe SISre coseryhig co butionI Ovres 60-(s topabio wagesOECD 93.9 3~~~ ~ ~~~~9.2 t4 3.

LACg, im 38 3 21r eah 1baicNAn 1.3 27 57f5 13w

employee,. fu5 214, 12. cof totalYPT( ~ . 8.ax ...... 37e7 a 46.3&UareesMiniO of SoiXA1tir;Wol Bank

4.27 Contributions. The SIS reaches very high contribution rates on (basic) taxable wagesrelative to benefits. Social security contributions must be paid on workers' basic and variablewages, with a maximum taxable amount for each category of wages (LE 450 per month forbasic and LE 500 per month for variable). The average total taxable wage in 1994/95 was LE267 per month for civil service employees and LE 149 per month for non-civil serviceemployees, far below the maximum taxable amounts. In 1994/95, basic wage was 42 percentof total taxable wage for civil service employees and 46 percent for non-civil serviceemployees.

4.28 For those covered under the main program (Law 79/47), total contribution rates32 onbasic wages are 41 percent for private sector employees, 39 percent for public enterpriseemployees, and 36 percent for governmnent workers. Workers contribute 14 percent, theTreasury 1 percent, and the employer pays the remainder. The contribution rates on variablewages are lower, since no contribution is assessed on job exit indemnity. Nonetheless, thecontribution rates are too high in relation to the benefits. Table 4.7 provides the contributionrates for both basic and variable wages for different types of workers covered under Law79/47.

30 Work force includes Egyptians working abroad, which in 1995 numbered 2.7 million out of a total workforce of 19.1 million.31Contributors to the Social Insurance System during 1994/95 to labor force in 1995.32 Different contribution rates are assessed for different types of benefits, such as old age pensions, disability,death, unemployment, and end of service indemnity.


Table 4.7 Contribution Rates for Social losurance(percet of wages)

Basic Wage Variable WageProgram (up to LE 450/month) (up to LE 500/month)

Worker Employer Gov't Total Worker Employer Govt Total

Ptivate Sector Enterprises 14 26 1 41 1 1 24 1 36

Public Sector Enterprises 14 24 1 39 11 22 1 34

Govemnment Offices 14 21 1 36 11 19 1 31Source; Ministry of Social Affairs

4.29 Eligibility Criteria The eligibility criteria for retirement is a major variable indetermining the financial viability of any defined benefit plan. The normal retirement age forEgypt (age 60 for both men and women, under the major programs of Law 79/47) is lowerthan that of OECD countries (whose average retirement age is 64.4 years for men and 62.9years for women), but is in line with many developing countries. Given the increasingproductive life spans, many countries are improving the financial viability of their pensionsystems by raising the retirement age.

4.30 Redistribution occurs in two main areas. First, pensioners from the agriculturalsector-about 45 percent of total pensioners in 1995-are provided the equivalent ofminimum wages (LE 45 per month). Given the very low flat contributions by agriculturalworkers and farmers (currently LE 1 per month), the benefits are higher than what thecontributions would afford. Second, within Law 79/47, which covers civil service employeesand the formal sector, the pension formula sets a minimum pension for those with a certainnumber of years' contribution.

4.31 Benefits. Pensions on basic wages are fully adjusted, while those on variable wagesare not. The ratio of average monthly pensions to average covered monthly wages(replacement rate) indicates that social insurance provides monthly benefits that represent ahigh percentage of average taxable wages, 102 percent for civil service employees and 147percent for non-civil service employees in 1995. In 1986, the replacement rates were 89percent and 103 percent respectively. Inflation adjustments on pensions have been greaterthan the growth of average wages of contributors, with the differential greater for non-civilservice workers.4.32 The determination of the pension amount at retirement dependscritically on the treatment of wage and price inflation. The method of computing for thepensionable amount for variable wages is particularly sensitive to the inflation rate, since thebasis used is the average wage during the covered period adjusted by an annual inflationfactor of 2 percent. At a 10 percent annual inflation rate, the pensionable variable wage for a30-year contribution period would only be 55 percent of real wages.

4.33 In addition, there is no automatic indexation of benefit payments during retirement toprotect the value of benefits from inflation. Prior to 1987, the purchasing power of pensionsdeclined significantly, because the government did not raise basic pensions regularly.However, over the past 10 years, annual basic pension adjustments were made to prevent thedecline of basic pension benefits in real terms. Over the period 1987-96, the legislature-


mandated adjustments preserved the purchasing power of the basic pensions for all but threeof the past 10 years. However, pensions on variable wages are not automatically indexed oradjusted by the legislature. Thus, in addition to the adverse impact of inflation on thecomputation of the pensionable variable wage on which the initial pension benefits are based,the resulting variable wage pensions are not protected from inflation during retirement.

4.34 Financial Conditions. During the period 1985-95, the SIS has been producingoperating surplus (contributions less outlays) due to the high ratio of contributors topensioners. Because the inflation adjustments on basic pensions approved by Parliament arefinanced from general revenues, total receipts by the SIS come from three sources: wagetaxes, investment income (fiscal transfers), and general revenues. Table 4.8 shows the sharesof the different sources of financing for the SIS. Among other things, Egypt also has thebiggest differential between public pension spending to GDP and public pension receipts toGDP.

Table 4.i Public Pension Spending fndicatorst(latestfyear when datas was availabl:)

Region Public Pension Public Pension. Share of Receipts from

Spendingto GDP Receipts to GDPi Wage axes Investmlncome Geneatti:Revenues

OEMD .29 57.4 .11.0. 35.LAC 2.0 .2 4 63.8 23.0 13.0]ECA. 8.0 7.9 68.6021.

MENA 2.8 4.4 63.1 1.1..AFR . 0.5... 0.7 77.8.. .20.3. 1.5iASIA I.9 ~ 5.2 ~ 61.3 24.2 I141Egypt (1995 i2.5 77 4573 354 191-'T S okrce.Wld atoC.:Note: Regional numba ate simple.averages Of samplecountry data.

4.35 Operating surpluses of the insurance funds are invested in the National InvestmentBank (NIB), a government-owned institution which finances primarily government projects.During the period 1980-90, NIB paid interest on the funds at 5 to 6 percent per year, duringwhich period the CPI was increasing by about 18 percent per year. Had the insurancereserves been earning a zero real return, the reserves would have been 60 percent more thanthe amount in 1 995-the reduction in value of reserves over the 10-year period is equivalentto more than seven years of (1995) benefit payments. This represents significant erosion ofthe real purchasing power of the reserves and a net subsidy to NIB.

4.36 In July 1992, NIB raised the interest rate on incremental social security funds(including reinvested reserves) to 13 percent, which is the current rate. This rate is higherthan current bank term deposit rates (12 percent) but lower than interest on NIB investmentcertificates (17 percent). Average inflation during the period 1992-96 was about 10 percent,providing a positive real return on incremental and reinvested funds.


National Investment Bank

4.37 NIB is responsible for evaluating and financing the government's investmentprogram. Funds are disbursed to various public sector entities, including central and localgovernments, service agencies such as hospitals and universities, and economic agencies suchas the public utilities. In the past, NIB also financed the PEs, but since the adoption of Law203, NIB's exposure to the PEs has gone down to almost zero. NIB provides long-terrnfinancing to public investment projects approved by the Parliament, and charges interest torecover operating costs. In the 1980s, interest rates charged to government projects and PEswere negative in real terms, due to cheap funds from the SIS. However, with the increase ininterest rates on social insurance funds to positive real rates since 1992, the NIB has alsoincreased interest rates on its lending, thus raising the hurdle rates for investment projects.Currently, interest rates paid by NIB for social insurance funds and postal savings funds are13 percent and 13.25 percent, respectively.

4.38 The SIS is the main source of funds for NIB. As of June 1995, SIS reserves in NIBwere LE 67 billion, about 33 percent of GDP. Social insurance funds (new and reinvested)accounted for 68 percent of the fund sources of NIB during the past five years. Investmentcertificates (10 years with 6-month coupons) issued to the public made up another 29 percentof funding sources, while deposits of postal savings funds contributed 3 percent (Table 4.9).Over the past 10 years, SIS funds available for lending averaged 4.1 percent of GDP-SISwas a major financier of public investment. With a policy objective of increasing the share ofthe private sector in total investment, the role of the NIB and the utilization of SIS funds needto be reviewed.

Table 4.9 NIB Funding Sources(tEr mXllnm)

1990-91 1991-92 1992-93 1993-94 1994-95 ToWalSocial Insurance Fund 67% 64% 67% 53% 4S% 56%Postal Savings Fund 2% 2% 2% 3% 3% 3%Investment Certificates 11% 3% 23% 33% 29% 23%Bank's Surplus 14% 19% 1% 7% 17% 12%Credit 4% 10%Y . 7% 4% 4% 5% .Others 2% 2% 1% 1% 2% 1 %

Total 6,477.4 8,203.3 9,555.4 14,365.3 20,548.2 59,149.6Source: National Investnent Bank

4.39 What is the effect of using pension funds to finance government investment? Theprivileged access to public pension funds is a less transparent way of financing governmentprojects, without the disciplining effect of capital markets. The negative real interest ratesduring the 1980s probably encouraged more public investments than market-based rateswould induce. In many countries, publicly-managed funds required to invest a major portionof their portfolios in government securities (including lending to PEs) tend to charge below-market rates, imposing a hidden tax on contributing workers. On the other hand, privately-managed funds tend to achieve higher real rates of return. Figure 4.6 shows comparativereturns for selected pension funds during the 1980s.

Figure 4.6 Comparative Performance of Selected Pension Funds

Penu .374 (1981-88)

Turkey -23.

Zamba -234 (1980488)

Venezuela .15.3 '1980-89)

Egypt 1981489)

Ecuador -10.0 (1980486)

Kenya -3.8 (1980-90)

India (1980-90' 0.3

Singapore (1980-90) 3.0

Malaysla (1980-90) 4.6

U.S. Publicly managed (1980.90) 4.8

s (occupational) Privately mianaged (i98090) 67

(1980-90 8.0U.S. (occupational)

(1 8-9 8.8UK. (occupational)

(1981-90 9.2

Chile (AFPs)

-40.0 -35.0 -30.0 -25.0 -20.0 -15.0 .10.0 -5.0 0.0 5.0 10.0 15.0

Percentage rate of turn after lntiaon

Source: World Bank


4.40 Private Pension Plans in Egypt. To complement the social insurance system,voluntary pension plans have emerged in Egypt. These plans are typically set up byemployers on a defined benefit basis, with contributions made by both employers andemployees. Private pension plans in Egypt are governed by Act No. 54 (1975) and ExecutiveRegulations Decree 78 (1977), and are under the supervision of the Egyptian InsuranceSupervision Authority (EISA). Efforts are under way to update the law and introduceappropriate regulatory and supervision arrangements.

4.41 The number of private pension plans has been increasing significantly-as of June 30,1995, there were 504 plans, compared to 330 in 1991. The reserves held by these funds (LE3.3 billion as of June 30, 1995), while representing only 1.6 percent of GDP, have beengrowing by about 30 percent per year over a five-year period. The number of employeescovered more than doubled during the period 1990-95, to almost 0.5 million. Contributionsto the funds in 1994/95 were LE 600 million, less than 1 percent of GDP, but with an annualgrowth rate of more than 30 percent over a five-year period. Table 4.10 provides data on thegrowth of private funds.

Table 4.10 Growth of Private Funds 1991-95

90/9 1 91192 92/93 93/94 94/95N-umber 330 376 408 471 504Contributions (LE 000) 256,662 369,511 380,310 585,333 602,063Reserve Fund (LE 000) 1,379,768 1,717,928 2,129,265 2,727,855 3,300,921Coverage 203,201 216,885 292,403 408,421 496,386

Source: Egyptian Insurance Supervision Authority annual repots

4.42 A majority of these funds were established by public sector organizations, although arecent decree forbids contributions by government organizations to these funds. Less than 10percent were set up by private sector companies. Nearly all of the private pension plansoperate on a defined benefit principle, where the majority of the plans provide salary-relatedbenefits in return for salary-related contributions.

4.43 About 48 percent of the assets of the private funds are in fixed bank deposits, whileanother 42 percent are invested in government bonds. Only about 7 percent are invested inequities and real estate. Lack of professional investment management capacity, the dearth offinancial instruments, and the risk-averse nature of these funds have been cited as the mainreasons for the concentration of investments in bank deposits and government paper.

4.44 Private funds are covered by Law 54 (1975) and regulated by Decree No 78 (1977).Private pension funds must be registered with the EISA, which requires that each fund submitannually a financial statement audited by an external auditor, and every five years a financialstatement prepared by an actuary registered with the EISA, which may request an externalactuary to review the submissions. Investment regulations prescribe minimum and maximuminvestments in different types of investment vehicles.


4.45 To deal with the rapid growth of private pension funds, and their likely changes ininvestment strategies in response to developments in the capital market, the legal andregulatory framework would have to be revised, and the supervision capacity of EISAdeveloped. In particular, the new law and regulations should deal with the emergence ofdefined contribution plans, individualized accounts, professional fund managers, fundadministrators, custodians, auditors, and actuaries. Prudential guidelines on investmentsshould be developed, consistent with the development of capital markets and financialinfrastructure. The regulations should deal with pricing (fee structure), portability, andmarketing issues. Also, a decision on guarantee arrangements would be necessary.

4.46 Reforming the Social Insurance System-Short to Medium Term Measures. Thereare several reform initiatives that could be undertaken in the short to medium terms toimprove the efficiency and solvency of the current system. These reforms focus on: (a)improving the transparency of government utilization of SIS resources to ensure a neutralimpact on government spending decisions; (b) developing a portfolio and investment strategythat supports capital market development, without compromising safety objectives; and (c)correcting certain design deficiencies to improve efficiency and financial sustainability of theSIS. This section focuses on these initiatives, while a following section gives the longer-termreform recommendations for the pension system. These short to medium term reforms wouldserve as a foundation for the longer-term reforms described below.

4.47 The most critical reform initiative in the short to medium term should be to improvethe management of social security funds to achieve both rate of return and security objectives.This would entail the elimination of the special access of the NIB to SIS funds, and theestablishment of an investment management capability within SIS. The SIS already has plansto develop portfolio management capability, and has requested technical assistance from theWorld Bank. In addition to the hiring and training of personnel, some of the tasks necessaryto ensure proper management of the reserves include development of investment objectives,designing an investment strategy by targeting a certain portfolio mix, identifying investmentvehicles and participating financial intermediaries, and putting in place a control system.NIB would have to strengthen its competition for the SIS funds by paying market rates (i.e.,rates paid by the NIB certificates). A transition plan would have to be put in place to reducethe amount of social security funds held by NIB. A spillover benefit of this reform is theincreased supply of long-term savings to be intermediated by the capital market and others tothe private sector. The SIS should pursue technical assistance in this area.

4.48 Another area of reform is the retirement provisions. First, the normal retirement ageof 60 should be increased over time to 65. Given the present trend of improved mortalityrates, the current retirement age implies an increasing dependency ratio, thus increasing coststo the system. Second, the early retirement provisions should be revised by raising the earlyretirement age to 60. Workers who elect to receive pensions between the ages of 60 and 64should receive benefits that are actuarially fair, relative to the full benefit available at normalretirement age.

4.49 A third area of reforn is the treatment of inflation. The current method of usingvariable wages during the worker's entire career, adjusted at 2 percent per year for inflation,results in a defective pensionable wage. On the other hand, using the average of the last two-cars' basic wage does not take inflation into account, and also introduces an incentive for


manipulation (e.g., raising wages sharply right before retirement). One solution to consider isa formula that uses the average career earnings adjusted for wage inflation, although thisrequires a better information system. Pension benefits should be adjusted for inflationautomatically, using a formula that takes into account wage inflation, rather than awaitinglegislative action. The amount of wages that would be subject to the contribution ratesshould also be automatically adjusted.

4.50 Finally, the contribution rates should be reviewed. Improved returns on reserves andless generous retirement (eligibility) provisions should result in lower contribution rates,although the impact of revising the pensionable wage computation to better account forinflation would result in higher costs. The net impact of all the above reforms on thecontribution rates should be determined. The amount of government contributions to fundredistribution programs should also be reviewed.

4.51 Reforming the Social Insurance System-Longer-Term Proposals. A country'ssocial security system typically has three major objectives: (a) to enable the population toshift some of their income from their working years to old age (saving or wage replacement);(b) to protect those with low incomes by providing a basic income floor during old age(redistributive or poverty alleviation); and (c) to insure against certain types of risks, such asdisability, longevity, and inflation (insurance). In order to achieve all three objectives, acombination of systems (the multipillar system) is recommended, since one system cannotefficiently achieve all objectives.

4.52 The Multipillar Approach. The reform of the pension system in Egypt should moveto establish three pillars to assure adequate retirement incomes: (a) a fully-funded mandatorydefined benefit public pillar that insures workers' earnings up to a certain level; (b) amandatory defined contribution private pillar that insures workers' wages above a certainlevel; and (c) a purely voluntary scheme that could supplement the first two pillars. Inaddition, the development of a competitive and stable insurance industry would provide manyaccompanying services, such as life and disability insurance and annuity products.

4.53 The public pillar would provide a minimum retirement income, while the compulsoryand voluntary private systems would enable workers to supplement their public pensions.The three schemes should be portable across employers, and vesting should be immediate forthe DC private pensions, while the DB public scheme would require a minimum number ofyears of contribution. The public pillar would achieve the objective of dealing with old-agepoverty, which has elements of income redistribution. The private pillars have the advantageof closely linking benefits to contributions, thus minimizing the problems of evasion andmanipulation. At the same time, as experienced in other countries, the private schemesshould improve capital accumulation and financial market development.

4.54 The Public Pillar. The public pillar is recommended to be a fully-funded DB schemewith a required contribution from employees and employers. In order to make a smoothtransition to the new system, the current basic pension scheme could be modified to form thepublic pillar. Under this plan, the variable pension scheme would be replaced by themandatory private pillar discussed below. Thus, the public pillar would be built on thecurrent basic wage pension scheme, which would be modified by reviewing contributionrates, maximum taxable amounts, redistribution objectives, automatic adjustment for


inflation, and the minimization of fiscal transfers. The SIS should undertake technicalassistance to review the current system and develop a short- and medium-term reform plan inthe context of the longer term design. The contribution rate for the public scheme woulddepend on the average replacement ratio (average pension payments to average coveredwages), the dependency ratio (the ratio of pensioners to active workers), mortality rates,disability rates, the level of desired funding, and the rate of return on accumulated reserves.An actuarial review would be necessary.

4.55 Redistribution is achieved by introducing a minimum basic pension to those with lowincomes. The current minimum is 50 percent of reference wage, assuming a minimumnumber of 20 years' contribution; the minimum pension would be correspondingly lower ifthe number of years of contribution is lower. It may be prudent to review whether thisformula achieves the safety net objective.

4.56 Mandatory Private Schemes. The second pillar would be a privately-manageddefined contribution scheme, involving compulsory contributions from earnings in excess ofthe public pensionable wage but below some maximum. The mandatory private pillareffectively replaces the variable pension scheme of the social insurance system. Thecontribution rate should allow the attainment of a certain replacement target, say, 70 percentof pensionable wages. Under a DC scheme, the determination of such a contribution ratewould largely depend on the real returns on the contributions. Disability and survivors'benefits could be purchased from insurance companies, and would have to be financed froman additional contribution, about 3 percent in many countries. The contribution rate inrelation to the target replacement rate should be much lower than is currently the case forvariable pensions. A contribution rate of 10 percent (plus 3 percent for disability and deathinsurance, and 1 to 2 percent for management) to a fund that earns 5 percent in real terms(i.e., 4 percent over the real wage growth rate), would achieve a replacement rate of 70percent of wages over the retirement period of 16 years (indexed to wage inflation), assumingthat the pensioner contributed for 32 years.

4.57 The contribution of the employers to the variable pension scheme could be merged aspart of the compensation of the employees, and, to the extent that the required contributionsby the employees are less in the new system, workers would effectively get a pay increase.Past contributions to the variable pension scheme of the SIS could be converted into a bondcarrying a market interest rate, which would mature when the worker retires. Transitionissues would have to be reviewed carefully.

4.58 Under a private system, participating private pension funds and fund managementcompanies would have to be licensed and regulated. Workers could choose among thelicensed funds managed by professional management companies, and mandatorycontributions would be automatically withheld from wages by employers and placed inindividual accounts. Workers could change employers without any impact on pastcontributions, thus improving labor mobility. Workers should also be able to move theiraccounts from one fund to another with minimal cost, thus ensuring competition among thefunds. Because the system is susceptible to fraud and mismanagement, appropriateregulatory and supervisory systems should be in place, including good information flow toparticipants.


4.59 As recommended above, given that that there is a growing number of private pensionfunds, EISA should recommend the replacement of the 1975 Law on Private InsuranceFunds, and adopt appropriate prudential regulations to cover the development of individualaccounts under DC schemes managed by licensed fund professionals. This would provide thefoundation for the development of a mandatory private pension scheme managed by theprivate sector. Since the transition to a mandatory private system would probably take sometime, the development and experience of current regulatory efforts and private fundmanagement constitute a pilot from which lessons could be learned, allowing adjustments tobe made before the mandatory private system is put in place. Furthermore, capital marketdevelopment would have to advance, creating a more liquid and deeper financial market.

4.60 Voluntary Private Funds. Under the third pillar, workers would be able to makevoluntary contributions with a cap, in addition to the mandatory contributions. Uponretirement, workers would be able to combine their accumulated funds with their pensionaccounts, increasing the size of their pensions. This would allow firms to offer pension plansin excess of the mandatory ones, as is currently the case. These funds would be subject to thesame regulatory framework as those in the mandatory schemes, and may in fact be one andthe same fund.

4.61 Tax Treatment. The consumption tax principle should be fully applied to all types ofcontractual savings. This would imply either: (a) the full deductibility of contributions tocontractual savings and tax exemption of investment returns, while taxing pensions as anyother source of income; or (b) not allowing the deduction of contributions while granting taxexemption status to investment returns and pension benefits. The latter approach providescash flow advantages for the budget, since no tax income is lost up front, but provides weakerincentives to workers to participate in voluntary pension funds.

4.62 A third alternative, currently used in the Czech Republic and Australia, would be tooffer a government contribution (credit transfer) to pension members, instead of a tax creditor exemption. This alternative would be more redistributive than the other approaches, sinceit would also benefit nontaxpayers. In addition, it would offer a strong incentive to low- andmiddle-income workers, irrespective of whether they pay income tax, to save for theirretirement. The credit transfer could be limited to active workers, and could be paid only tothose workers who save a specified percentage of their income and do not withdraw theirbalances until they retire. As the credit transfer would be added to the individual retirementsaving account of each worker, this approach would generate a higher level of long-termfinancial resources than a tax treatment based on deductibility.

4.63 Currently, the Egyptian tax treatment provides for tax deductibility of contributionsand tax exemption of pension-fund investment income and pension benefits. A review of theissues of tax treatment should be made.


The Insurance Industry

4.64 Introduction. The insurance sector can play a very important part in the developmentof the private sector, the emergence of a private pension system, and the modernization of thesecurities markets. By covering certain economic and financial risk, it enables enterprises tobetter manage their financial affairs, and protects households from financial losses arisingfrom accidents or injuries. In addition, the industry, especially the life insurance sector,mobilizes long-term savings that can facilitate the financing of both enterprises andhouseholds with resources that have a much longer maturity than traditional loans from thebanking sector. In most developed countries, the insurance industry is a significantcomponent of the economy; life insurance companies' reserves to GDP range from 13 percentto 34 percent, and premiums to GDP range from 3.0 percent to 10.1 percent.

4.65 Egypt's Insurance Industry. The insurance industry in Egypt is underdeveloped-life insurance premiums to GDP were an insignificant 0.2 percent in 1995, compared to 6percent for a sample of developed economies. Total assets to GDP of all insurancecompanies (life and non-life) in Egypt were about 4 percent in 1995, while life insuranceassets alone were 38 percent of GDP for the developed economies sample. There are 10insurance companies in Egypt, of which eight transact all classes of insurance and business,and two transact only non-life. All are publicly-quoted joint stock companies. Two havebeen set up as joint ventures with foreign investors to operate exclusively in free zonebusinesses and are not allowed to offer their services to the rest of the market.

4.66 The industry is characterized by a high degree of concentration. The largest companycontrols 50 percent of both life and non-life business, and three companies account for 93percent of life and 89 percent of non-life markets. The three largest insurance companies andthe sole re-insurance company are state owned, thus making the sector virtually under statecontrol. The state-owned insurance companies also own shares in five of the privateinsurance companies. In the past, direct foreign ownership was only allowed in thosecompanies operating in the free zones-the exception was granted under the Investment Law,which allowed for the creation of companies as joint ventures, to encourage companies tooperate in the free zones. Currently, regulations place a 49 percent limit on foreignownership of direct insurance companies and no restrictions on foreign ownership ofreinsurance companies.

4.67 Investment. Total investment of the insurance industry as of June 30, 1995 was LE5.4 billion, representing 2.6 percent of GDP. Over the period 1990/91 to 1994/95, investmenthas been growing by 18 percent per year. The state-owned insurance companies accountedfor 91 percent of investment. The reserves of non-life business accounted for 60 percent oftotal reserves in 1995, compared to 68 percent in 1991.

4.68 The insurance companies invested the bulk of their funds in bank fixed-term deposits(39 percent of total) and government bonds (38 percent). Another 18 percent was invested incorporate paper. The rest was used to purchase real estate and provide loans to policyholders. Lack of financial instruments and conservative investment policies have led to theconcentration of investment in bank deposits and government paper.


4.69 Legal and Regulatory Framework In 1995, a new law on insurance was passed, andin June 1996, a new set of regulations was issued by the EISA. In addition to solvencyrequirements, the regulations impose certain regulations on investment by insurancecompanies, making a distinction between reserves from the life insurance business andreserves from the non-life segment. The law requires separation of the reserves between thetwo businesses in companies that operate in both markets. The new regulations alsoderegulated the pricing of most insurance products, replacing price control with pricereporting. The only exceptions are in the fire and motor vehicle insurance lines, which willbe deregulated in 1999. The deregulation of most insurance products shifts the focus ofsupervision to solvency monitoring. The regulations are basically in line with international(especially EU) practices and definitions. However, solvency monitoring requires goodinformation and technical capability on the part of the supervisor.

4.70 Reform Proposals. With the changes in the legal and regulatory framework and theongoing institutional development of supervision capacity, the next generation of reformefforts should focus on the issues of competition and ownership. As mentioned earlier, thereis a high concentration level in the industry, which is indicative of problems of competition.To encourage competition, EISA should allow the entry of new firms-including foreigninsurance companies-as long as they meet the licensing criteria. This means that the 49-percent maximum ownership by foreign firms should be abolished. EISA should also ensurea level treatment of both state-owned and private insurance companies. Finally, the state-owned insurance companies should be included in the current privatization program.

4.71 On the regulatory aspects, to complement liberalization of pricing of products andcommissions, EISA should focus on disclosure requirements to the public on prices andcommissions. The obligatory ceding requirements and price controls on reinsurance shouldbe eliminated. Tight regulations on employment of foreigners should also be relaxed toenable insurance companies to acquire needed expertise quickly. Finally, to improve thetransparency of the sector, financial statements of insurance companies should be available tothe public, and these statements should be audited by qualified and independent auditors.Accounting standards and auditing guidelines for insurance companies should be provided byEISA.

The Capital Market and its Link with Saving

4.72 Capital markets affect economic activity through the creation of liquidity and thereduction of transaction costs. From the point of view of the investor, liquid securitiesmarkets allow the acquisition of an asset that can be sold quickly in case of a need to accesssavings or alter a portfolio. From the point of view of the corporation issuing long-termsecurities, it has access to a larger pool of funds and has better information about the relativecost of different ways of financing an investment. Thus, a corporation has a wider range ofinstruments to finance investment, and savers have more alternatives than bank deposits,precious metals, or real estate.

4.73 Many studies conclude that the impact of stock markets on the level or rate ofdomestic saving is ambiguous-savers may merely shift funds from one saving instrument(such as bank deposits) to securities. However, some studies have shown that there is a


positive relationship between private saving as percent of GDP and financial sectordevelopment, which includes capital market development, although the channels throughwhich this relationship is defined are numerous. For example, stock markets are seen toincrease investment, thereby increasing national income, and thus increasing the level ofdomestic saving.

4.74 But what is unambiguous is that the composition of saving is improved by theintroduction of liquid capital markets. Savers purchase long-term securities, which offerhigher expected returns and enable risk diversification. In the process, more financingopportunities become available to corporations to implement projects with long-term pay-offs. Long-term investors need not relinquish their saving for long periods-liquid capitalmarkets allow them to divest quickly and inexpensively.

4.75 In several countries, securities markets have developed in parallel with-and havesupported-two initiatives that have an important impact on private saving: one is pensionreform (such as the transformation of pay-as-you-go to fully-funded systems), and the other isprivatization of state-owned enterprises. To the extent that pension reform and privatizationprograms increase household and business saving, respectively, securities marketdevelopment has an impact on the level of private saving.

4.76 In the case of Egypt, the development of capital markets both supports and issupported by the development of contractual saving institutions. As discussed in the previoussections, investment by private pension funds and insurance companies has been mainly ingovernment securities and bank term deposits. Capital markets would allow greaterdiversification, and perhaps higher yields, for these investments, thereby improving thefinancial performance of contractual saving institutions; this should result in greater benefitsto savers in the form of lower contribution rates to pensions schemes and lower premiums forinsurance. At the same time, the existence of pools of funds from contractual savinginstitutions could be tapped through capital markets to finance investments.

4.77 In addition, active capital markets provide an enabling environment for attractingforeign savings. The existence of liquid capital markets gives a foreign investor better exitoptions, thus encouraging more foreign direct investment. Foreign portfolio investors wouldfocus on actively traded securities in the stock market. With private capital dominating thetotal capital flows to developing countries, and an increasing shift toward equity financing,the development of capital markets becomes essential in attracting private foreign capital.But the risks of foreign savings would be kept to a minimum if it augments, rather thanreplaces, domestic saving. The experiences of two regions which attracted the greatest sharesof private capital flows had two different outcomes-foreign saving replaced domestic savingin Latin America and the Caribbean, but augmented domestic saving in East Asia. Thepositive experience of Asia is attributable to macroeconomic policies and institutions thatencouraged domestic saving and investment.

4.78 Finally, the development of capital markets and the process of privatization aremutually reinforcing. Capital markets provide more options for divestiture, whileprivatization increases the supply of securities in the market, thus providing the securitiesmarket with more depth. The deepening of capital markets-as reflected in increased marketcapitalization to GDP, greater liquidity (higher turnover to market capitalization), and less


concentration of market activity on a few stocks-would enable capital markets to absorb theexpected increase in portfolio investments from both domestic and foreign sources, andmitigate against the extreme movements of asset prices.


Action Plan for Social Insurance System Reform

Area of Reform Short to Medium Term Actions Medium to Long Term Actions

* Improve retums on surplus . Develop portfolio management capability * manage all SIS funds* Develop plan to place funds currently with NIB

under the management of SIS* Develop an investment strategy, focusing on the

identification of investment objectives

* Adjust benefits for inflation * Review formula for treatment of inflation indetermining initial benefits for both basic andvariable pensions

* Index benefits automatically to wage inflation* Review how to adjust maximum taxable wage

automatically

* Reduce contribution rates * Review actuarial assumptions and determinewhether there is scope for reducing contributionrates for both basic and variable pensions

* Introduce mandatory private pillar * Develop infrastructure for mandatory private pillar * convert variable pension scheme to mandatory definedby strengthening legal, regulatory, and supervisory contribution plan managed by the private sectorframework for voluntary private pension schemes,strengthening the insurance industry, anddeveloping capital markets

* Develop new legal framework * Introduce new law that allows for defined benefitindividual accounts and sets a flexible frameworkfor the regulation

* Strengthen regulatory framework . develop and issue new regulations, to include * adjust regulations as necessarycoverage of fund managers, administrators,custodians, auditors, and actuaries

* Strengthen supervision capacity . implement institutional development of EISA


Action Plan for Insurance Industry Reform

Area of Reform Short to Medium Term Actions Medium to Long Term Actions

* Improve structure and competitive conditions . privatize one or two insurance companies * privatize the other state-owned insurance companies

* allow more entry, including foreign firms

* Deregulate prices * allow competitive pricing of fire and motor vehicle TPL

insurance

* Improve supervisory capacity * implement recommendations from intemationalconsultants (Coopers and Lybrand)

* Ensure neutrality of tax treatment on saving * Eliminate stamp duty for life insurance and reduce * Review income tax rates of insurance companies in the

stamp duty for nonlife insurance context of an overall tax review

* Increase supply of listed securities * Continue privatization process

* Improve financial infrastructure * Develop custodial depository and improve paymentsand settlement services under private sector

initiative

* Improve information quality and access * Ensure proper accounting and auditing of financial

accounts

* Automate information on listed companies

* Develop prudential regulation and strengthen * Coordinate regulation and supervision of investment

supervision capacity managers with EISA

5 PROMOTING OUTWARD ORIENTATION

THROUGH EXPORTS

A. THE ENVIRONMENT

Overview

5.1 Egypt is trying to create at least half a million productive jobs each year. To succeedin this endeavor, Egypt needs an internationally competitive economy that produces world-class goods. Focus on exports in critical to achieving such competitiveness, as it provides themechanism to modernize the economy and enhance productivity-not only in the exportsector but in the domestic sector as well. To be competitive on world markets, producersmust have access to raw materials and inputs that allow them to produce goods of the qualityrequired by consumers in any given market at a price that is the lowest available. Producersmust have access to world class inputs at world prices.

5.2 In recent decades, Egypt has been essentially an import oriented economy, whereforeign exchange necessary for imports are being earned primarily through services and otheractivities. The existence of other sources of foreign exchange (Suez, worker remittances,tourism, oil) has been both an advantage and a disadvantage. While these resources created abigger domestic market, this large domestic market absorbs supply that otherwise would beexported-especially since domestic market is protected (profitable) in potentially exportablesectors.

5.3 Using CMSA (constant market share analysis), one calculates that if Egypt's exportsgrew at world rates from 1983 through 1993, then exports should have reached US$6.3billion rather than US$3.1 billion. Egypt's "under-performance" amounted to an annual lossof US$3.2 billion in 1993. The causes of this lag are the failure to change to export marketsthat were growing rapidly (loss of US$0.7 billion), not adapting the composition ofcommodity exports to changes in world demand (loss of US$2.3 billion), with the residualmeasuring the loss in international competitiveness (US$.2 billion). While it is encouragingthat Egypt has not suffered a major loss in competitiveness, exporters' inability to adjust tochanging product demands and to penetrate new markets points out a lack of agility inEgypt's manufacturing sector.

5.4 For Egypt's non-traditional exports to reach $10,000 million by the year 2000 (anoften cited government target), merchandise exports would need to grow at an estimatedannual rate of 35%. At such a 35% growth rate, it is estimated that Egypt would capture0.25% of world merchandise exports within 5 years (almost catching up to Egypt's share in1970 which was 0.27% and approximating the share of Thailand in 1970). Sustained for 10years, Egypt would be a world player-capturing 1% of world merchandise exports (the level

Main Report: Promoting Outward Orientation Through Exports 61

of Brazil in 1972; Korea in 1978; and Thailand today). This clearly requires a quantumleap-making export promotion high on the government's agenda.

Achievements

5.5 The trade liberalization effort of the last five years provides a good basis on which tomove further towards integrating Egypt into the world economy. The Government has done agreat deal to reduce the magnitude of import restrictions, enhance the transparency ofapplicable trade policies, and eliminate export disincentives. The foreign exchange systemwas decontrolled and unified, and the foreign exchange quota system for public enterpriseseliminated. The number of imports requiring Prior Governmental Approval were reduced tozero, as compared to 55 prior to 1989. All suspensions of letters of credit for imports werelifted. Legislative efforts have been undertaken to eliminate the discriminatory treatment offoreign trading companies, allowing them to operate on an equal footing with domesticcompetitors as far as exports are concerned. Controls by the General Authority forInvestment and the General Organization for Industrialization on imports of equipment wereabolished, as were import restrictions maintained by the Ministry of Military Production andthe jurisdiction of the Industrial Monitoring Authority over imports.

5.6 The tariff level was reduced, and tariff structure rationalized. Greater transparencywas achieved through the adoption of the Harmonized Commodity Classification and CodingSystem (HS). The Government's most recent economic program, as delineated in the IMFSBA, shows a continued commitment to tariff reduction and using exchange rate as a policytool, albeit at a pace that Government feels is politically sustainable. At the same time,efforts have been made to maintain the exchange rate competitiveness against the upwardpressure brought about by the large inflows of capital. This stance is likely to continue toprevent the erosion of Egypt's export competitiveness (for further details, see the reportparallel to this one).

The Agenda for Action

5.7 A key question is to determine what policies and institutions can help to expandexports, and thus help to achieve the Government's objectives of raising GDP growth andemployment' Account must be taken of the changing external environment in designing thetrade policy component of this growth strategy. The trend that can be observed in the worldat large towards moving to a free trade and investment environment for both goods andservices has changed the 'rules of the game'. The technological and managerial changes thathave occurred in the last decade or so have induced the OECD countries to gradually initiatestructural reforms to enhance the competitiveness of firms located on their territories. Anincreasing number of these enterprises have in turn become multinationals, sourcing from allover the world. Competition for markets, for investment, and technologies has intensified.

335.8 For Egypt the ongoing process of European integration is of particular importanceand can be argued to have reduced the options confronting it. The extension of large parts ofthe European integration mechanisms to countries such as Morocco, Tunisia, Jordan, Turkeyand Israel implies that a Korean type of policy mix that relies on protection of the domestic

33 "Maximizing the Benefits of Free Trade with the European Union--Challenges and Options for Egypt".

62 Main Report: Promoting Outward Orientation Through Exports

market with a broadbased drawback mechanism to allow exporters to compete on worldmarkets has become less feasible. The trend toward adopting more and wide-reachingbilateral and multilateral trade disciplines implies that firms located in these countries mustbecome more competitive on a global scale. As more market friendly regulatory mechanismsare introduced and tariffs are gradually eliminated in the regional economies and worldwide,Egypt has little choice but to follow suit. The issue is to what extent and over what timeframe.

5.9 Despite the reform program pursued by the Government, investment and productiondecisions continue to confront a distorted incentive structure. Levels of tariff and nontariffprotection remain high. For many producers and traders the protected domestic marketremains much more profitable than exporting. Perhaps more importantly, the regulatoryburden that affects the private business sector in Egypt-whether import-competing, export-oriented or non-tradable-is high. Trade and tax policies and their administration, themonopoly provision of port services, administratively cumbersome and complex import andexport procedures, and uncertainty regarding the objectives and planned policies of theGovernment are important disincentives to investment, and thus export-oriented production.

5.10 Reducing the burden of regulatory oversight, improving the predictability andtransparency of customs administration, and allowing more competition in the service sectorare key to accelerating export growth. A more efficient service sector is a necessarycondition for firms to be able to compete on international markets. Interviews with privatesector firms suggest that export development has been constrained by the low quality/highcost of support services, by the absence of adequate information on foreign markets; aninability to satisfy foreign technical specifications or standards; and inadequately trained orskilled work force and management. These are to a greater or lesser extent all 'service issues'in that greater competition in the service sector could eliminate or help offset suchweaknesses. The threat of foreign competition-while very powerful-is rarely sufficient toensure that internal markets will become more competitive. Supporting actions are required.Experience in numerous countries suggests that such actions include privatization, theintroduction of hard budget constraints for public enterprises, and de-monopolization ofservices.

B. THE INCENTIVE REGIME-

ASYMMETRIC PRICES BETWEEN IMPORT AND EXPORT

5.11 Successful competition in both international and domestic markets requires thatEgyptian products be of low cost and high quality, which are, unfortunately, both lacking intheir current operation. Egypt has been dubbed a "high cost" economy. Domestic prices canbe even higher than world market prices. As a result, many producers and traders are short ofincentives to sell in the world market and prefer to adhere to the domestic market for betterprofit and less pressure. All these seem rather unusual for a developing country like Egyptwhich possesses superior natural resources (high-valued agricultural products, sufficient oiland gas reserves), abundant cheap labor force (Egypt's labor rate at minimum of $0.55 perhour is only one-third of that in Cyprus at $1.88 or Turkey at $1.72 per hour, and one-tenth ofthat in Israel or Tunisia) and convenient geographical location (Suez Canal andMediterranean ports), and yet does not occupy a clear competitive niche on the world market.


Similar economies with even less favorable endowment, like Singapore and Indonesia, havealready achieved successful exportation and rapid growth. Nevertheless, a cursory study ofEgypt's economy reveals, not surprisingly, that the twin effects of import substitution anddomestic monopolization have been the major culprit for this "high cost" character. Importsubstitution prevents foreign competition from accessing Egypt's market, domesticmonopolization stifles internal competition from emerging. As lack of competition breedslack of competitiveness, Egyptian products command a high price but deliver a low quality.

5.12 This Chapter details many of the existing transaction costs in the process of importand export that attribute to the high domestic price in Egypt relative to the fixed, low worldmarket price. Should this asymmetric price prevail in its current form, domestic market willremain to be more profitable, entrepreneurs and firms will continue to orient inwardly, andthe strategy of export promotion will thus fail to succeed. Worse still, without reducing thetransaction costs, the Egyptian industries may go under in the face of the increased importcompetition being brought about by trade liberalization. Identifying the sources of the hightransaction costs is a first step toward understanding their role and importance. It goes a longway toward designing optimal policies to remove these obstacles, fulfilling Egypt's economicgrowth and potentials, stimulating entrepreneurs to stand up against internal and externalcompetition, and ultimately building Egypt a strong, vigorous economy.

5.13 The following consists of two major sections: import transaction costs and exporttransaction costs. The former contributes to the high domestic price, and the weak incentiveto export and the latter to the lack of export competitiveness. These two parts are inter-relatedin the sense that when imports are used as intermediate inputs into the production of exports,the added import costs will translate themselves into the extra costs of exports, furtherelevating their prices and downgrading its competitiveness. The section of import transactioncosts is further divided into four parts: high tariffs and taxes, expensive port handlingservices, cumbersome import clearances, and a stringent quality control system. All thesecosts are not meant to be inclusive and exhaustive. They are only part of many existing formsof transaction costs, such as marketing, information, management skills, finances, etc. Thereare also immense production costs on top of transaction costs. Nevertheless, these transactioncosts are more regulatory and bureaucratic, and thus more tangible for immediate policyactions.

Import Transaction Costs

High Tariffs, Import Bans and Sales Tax

5.14 Considerable effort has been taken by the Egyptian government to reduce themagnitude of its high levels of import restrictions, by reducing tariff rates, reforming tariffstructures and enhancing the transparency of import policies through the adoption of theHarmonized Commodity Classification and Coding System (HS). However, the average tariffrate still remains at a high level of 16%, with import-weighted tariff at 31% andmanufacturing-wide effective protection rate at 70%. In addition, tariff differential betweendifferent product groups and within each group is quite large (with standard deviation at xx%)creating large distortions in the relative prices. The high tariffs are further compounded by anumber of fees and surcharges which make the import tax regime less transparent anddiscretionary.


5.15 Also, there are stiff tariffs on fertilizer (30%), truck (70%) and agriculture machinery(50%), let alone import bans on seeds, poultry, textile and clothing. There is a sales tax rate of10% which is applied to all commodities, even to inputs for export goods. All these duties,tariffs, bans and taxes inevitably increase the cost of imports, contributing to the high cost ofproduction, consumption and exportation in Egypt.

Table 5.1: Tariffs and Taxes

S , Bai _edrs/ id te,ts Results

Merall trif simpe a tariff rate is,e 16% the:

~~~~~~~~~~~AV 10~ -W bonimt a te'PUlYtXli%'andedlNnSo ft.

averge mpored-eighted ta iff a 1 n h

rate at 70%:bans on imports see~~~ds, pulty tetile andAclthing:

2Hghsales tax 10 ae a sapie,ee nipt oexported goodsi

Cumbersome Drawback and Rebate Schemes

5.16 In order to promote export, schemes such as temporary admissions, duty drawbackand tax rebate have been developed by the Egyptian government to ensure that exporterscircumvent these trade barriers and have access to imported inputs at world market prices.Temporary admission allows exporters to import banned commodities whereas dutydrawback and tax rebate reimburse tariffs and taxes to exporters should they use importedgoods as inputs into the production of exports. However, these schemes involve cumbersomeprocedures and excessive paperwork. An exporter has to go through all the following 8 stepsto obtain a refund or a permit: (1) Customs Form 22, (2) Letter of Guarantee or InsuranceLetter, (3) Release Permit, (4) a Form to Industrial Surveillance Authority, (5) productionreviewing process by Industrial Control Authority, (6) Customs Form 13, (7) Export Form,and (8) determination of refund by a committee, etc.34 These procedures are inevitablycostly on time, money, efforts and attention. Besides, step-by-step documentation of eachtransaction for refund is difficult, non-sale indirect tax cannot be rebated, and eligibility issubject to local content requirement-only if the local content of final products reached 20%or more shall the imported components be eligible for a tariff reduction. In any event, theseexport-promoting schemes have become another form of transaction cost. They only partiallyalleviate the high import duties and remain to be insurmountable for small enterprises.

Expensive Port and Air Cargo Services

5.17 The four maritime transport services, Damietta, Port Said, Dekheila and Alexandria,and other smaller ports are essentially state-owned monopolies. A multitude of problems atthe ports, such as high service charges, low service quality, delays, and deterioration of portinstallations and equipment, has grown to the point where the ports could well become amajor impediment to the growth of export.

34 Refer to SRI International, 1995, "Achieving Egyptian Export Growth", p.V-9.


5.18 In general, Egypt's seaport service charges for imports triple that of competitors,3 5

which raise CIF cost for imports to Egypt by over 10% -- a significant number. Freight plusport costs are as much as 40% of the CIF price for some perishable goods requiringrefrigerated containers. Port costs for containerized cargo represent 9-14% of the CIF price.36

5.19 Container freight rates to Alexandria are generally 15-20% higher than to otherMediterranean destinations. The freight charge on a 20 foot dry container from NorthernEurope to Alexandria is between $280-$500 higher than to Piraeus, and $650-$1000 higherfor a 40 foot container. In Alexandria container handling costs are about $225 per 20-footcontainer, but in nearby foreign only $120-$180. Terminal handling charges (stevedoring,transport to the first point of rest and delivery to consignee's transport) for containers on linerterms range from approximately $183 - $225 for a 20 foot dry containers and $367-$441 for a40 foot unit, doubling that in Antwerp at $109 and $117 and in Zeebrugge at $100 (20 or 40).House keeping and maintenance are practically non-existent. Physical condition of theinfrastructure is mostly fair to poor, and particularly bad in Alexandria. Vessel time lost inport appears excessive. As an example, a 43,500 DWT bulk carrier was charged wheat atAlexandria. Due to long delay in testing the ship and cargo for radiation and waiting in timebetween finishing unloading the cargo and departing of the vessel, total chargeable time was196.70 hours, out of which nearly 10% was dead-time. Assuming $12,000 per daydemurrage ($500 per hour), the vessel lost nearly $10,000.

5.20 Air-freight rate is considerably higher than other middle-east countries. The averagecost of air freight from/to Egypt on Egyptian Airlines to/from northern European cities ranges$1.00-1.40/kg, doubling that of, say, Israel at only $0.45-0.50/kg. This high cost is largelydue to a one-way trip of Egyptian Airlines so that the opposite way flight is empty andwasted.

Table 5.2: Expensive Port ServicesBarriers/Impediments Results

1, Seaport services overall, charges tbiple that of competitorscontainer freight rate 15-20Q% higher than other Mediterranean portscontainer handling cost 2-3 times that of nearby portsterminal handling ebarges (stevedoring, transport to rest double that of nearby portspoint, delivery to consignee's transport)housekeeping and maintenance non-existent, resulting poor physical condition of the port and

poor quality of servicevessel time lost nearly 10% of total chargeable time, due to delay in testing for

radiation and in time between finishing unloading the cargoand departing of the vessel

2. Airport services air-freight rate is twice as much ($1.0-i .4/kg) as other middle-east countries (Israel, e.g. $45-.50/kg)

General Re naris:. It was estimated that tese seaport chatges.taise CIF cost for inwprt$ to Egypt by over 10% -a relatively high cost.

35 Refer to Hoekman, Bernard, 1996, "Trade and Investment Liberalization: Issues and Options for Egypt",pi1 1.

Refer to Nathan Associates Inc., 1996, "Egypt: Options for Increasing Market Competition in Maritime Portservices", p.6.


Cumbersome Import Clearances

5.21 Even though the import/export paperwork process has been greatly simplifiedcompared to the past, excessive bureaucracy still remains one of the main impediments totrade. The administrative process for complying with Customs regulations and the resulting"red tape" is still considered to be a major stumbling block. In particular, foreigners still finddoing business in Egypt extremely difficult due to non-transparent procedures and regulationsas well as inefficient bureaucratic practices. Egyptian Customs procedures are particularlycomplicated and rigid, as shown in Table 3.

5.22 Clearance of imported foodstuffs is particularly a problem with five agencies involvedin authorizing entry-the Atomic Energy Agency, the Food Control Agency of the Ministryof Health, the Agricultural Quarantine Body, the Animal Quarantine Body and the GOEIC.Imports of the same product in consecutive time periods are subject to repeated sampling.There are multiple steps, licenses, inspections and charges. The cumbersome importprocedures add another 15% to the costs of imports. For Egypt as a whole, if importedintermediate goods account for 60% of production cost, then a 5% increase would contributeto a 3% increase to the cost of export production, and a 15% increase would add to a 9%increase in the cost of export production.

Table 5.3: Cumbersome Import ClearancesBarriers/lmpediments:] t Results:

1. Multile clearance agencies clearacee of imorted foodstuffs is particularly a problem witb fiveagencies involved in auth rizing entry-theAtomkrit Energy Agency, the:Food Contrl Ae ncy ofthe Ministry of Healtho the Agsrul tuamlQuarantineBody, the Animal Quarante Body'and the GOEIC

2. Mualtlrourear+:ase cand licenses permit of delive permi of: dlirety,Form No. 11 if imports are financed through a bank, a procedure form,etc.

3.23 MuTipe GOEICinspectionsandhr s as inspections from the Matmi Energy Authority,aControl Departfent for determination of preliminary Custom duties ands-ales tax,specific Customs Controld tfo inspection,tariff manager for pricing, calculation of Customs duties, sales tax,service charges, Custoa m gate for another inspection

4. Delgys, extra storage charges, and the lost time and total delay amounts to three days and there is' a storage harge bonme byefforts importers

Gcnferai bemarks:These costs amount toantaraiff eqivalent (afconseaivefigure)dof5%..Ifthseintemediategoodsrsnt

Restrictive Quality Control System

5.23 The GOEIC inspects a sample of every consigp nent of goods entering Egypt that ison a list of products subject to quality control. Some 1,550 tariff lines or 25 percent of thetariff schedule is subject to 'quality control', of which about half are foodstuffs. Onceapplicable duties have been paid on goods subjected to inspection requirements, at least 1percent of each consigniment must be sampled and inspected for compliance with the relevantEgyptian standards. The pervasive application of quality control reflects a fundamentalconfusion between quality standard and safety standard.

5.24 In theory, quality controls are mandatory for a number of imported products, primarilyfor health and safety reasons, and sometimes to protect Egyptian consumers from low qualityproduce. In practice, however, it has become a means to protect local industry. Certainimported products removed from the list of banned imports were put on the quality control


list, effectively retaining the import restrictions through long delays in approval. In fact, it iseven questionable that all the mandatory quality control regulations are based on health,safety, and quality grounds. It is surprising, for example, that spare parts for cars are subjectto quality control, while imported cars are not, and that imported playing cards are includedin quality control list while toys and hand tools, which can be dangerous items too, are not(see Table 4 for details).

5.25 The current quality control system has two main deficiencies. First is the multiplicityof agencies involved in issuing and enforcing the regulations. This in turn leads to anincrease in cost due to multiple inspection fees, delays, product loss in the clearing process,and higher facilitation and overhead costs. Testing of industrial products sometimes takes along time, especially if the required equipment is not available. Importers that regularly buythe same goods from the same foreign suppliers remain subject to inspection on a shipmentby shipment basis. Fees charged for inspection activities are based on either the weight of orunits in a consignment, and range from 0.5 piasters per kilogram to a maximum of LE 10,000per consignment. As is the case for tariff rates, fees for goods that are intended for retail saleare generally at least twice as large as those that are applied if the good is not prepared forretail sale.37 Final release of imports requires the approval of the GOEIC, as well as of one ormore of the other bodies mentioned earlier for certain goods. Clearance of foodstuffs isparticularly time consuming, as all the bodies involved (GOEIC, Health, Agriculture, AtomicEnergy Agency) sample consignments. According to one recent study, for some productssuch as meat it takes at least two weeks before releases are issued and another ten days tocomplete the paperwork. In manufacturing, GOEIC has been responsible, but many timesothers have to be involved as well; for pharmaceuticals and medical devices, the Ministry ofHealth is also involved.

5.26 The second deficiency is the lack of transparency and due process in the system.Transparency is the ability to know clearly what regulations apply to a product and to knowin advance the Cargo in regulations that will be made and the rationale for the change. Dueprocess is the process by which laws, decrees, standards, technical specifications or any otherofficial designation are implemented so that all affected parties can have advance knowledgeof proposed changes to them, can provide input into the decision making process. TheGOEIC reportedly ignores internationally recommended methods of testing and certification,and does not recognize internationally known and accepted quality and certification marks(such as that of the European Union or the International Standards Organization). The lack oftransparency and due process in Egypt increases uncertainty in decision making and has anegative impact on imports and investment.

5.27 The policies briefly described above directly affect imports, and thus exports. Theyimpose large welfare losses in the aggregate, and have made it more difficult and costly forfirms to obtain inputs that are required for export production. For example, farmersproducing for export must have ready and reliable access to seeds and plant cuttings so as tobe able to develop and grow varieties that are demanded on export markets. Manufacturedcomponents and intermediate inputs are often key elements of export-oriented production inthe industrial sector. Exporters need to have timely access to the imported inputs that are

To give one of the more extreme examples of fee escalation', animal lard, fats and margarine face a fee of LE 2 per ton ifunprepared for retail sale; as opposed to LE 500 per ton if packaged for retail sale.


required to satisfy export orders. Delays in clearing customs or passing inspection can beextremely costly. Producers may find themselves having to rent substitute machinery at highcost, or halt production temporarily. Executives may be required to spend valuable timedealing with administrative 'red tape' problems, time that could much more productively beused managing their business.

5.28 It is estimated38 that due to the current system of quality control, direct and indirectadditional costs to affected producers and traders range from 5% to 90% according toindustry, with the highest costs for food products and imported final consumer goods. Exportsdecrease by at least an estimated 9% to 12%. GDP loses by more than 1%. There is alsoreduced accessibility to the regionally important Euro-Med market, decreased foreign anddomestic investment, reduced product variety and availability and government resourceswasted on duplicative and unnecessary activities.

Table 5.4: Restrictive Quality Control System

1. Standard ctr Mn f Heath set standards for fod andii alth ela ted good. Egyptian:Orgaiation fo Standrs hch is patof te Minishryof

Inutry, doe so forindustrial prous and ervcs.ntereoenforement man othse: quaity control ministris ar Il invole

content standard r rsctive standardson si ze,s , color and textute, adt and sugar,~content tfo food. lpo e Ime maufacturine amoun4t of ink in a ballpoit pen and the lenth: of atChes are, among h mandatory items

shelf-lif standard . extensiv but many are i onistend _ Ir eal gs raulaed W st Ahas ashelfliife of2 oths whiteewerdsugar is 12: months~.

2. QualitYcontrol ii i; i l authority to issue d ene quality controleregulations isdsareang:: ::: :s::::::::r:E ::::::::::::E:::E:::::: : i: : qVi :f iSministrics::the Ministries ofAgriculture. Health, Eoniomi;y, lodustry,ES:and Supplye.u iy tb9i

::::: extensive! mandatoy itnspection items X :t: y!g jyisomne I ,55lytariff lines or r25%0 of Wthe tariff schedule or: 1/6 of imprtEs: ::s:subject to qaity cotrol of which fi abo thal ar dbdtf~ Iaoeonly e1206 iMpre comdte n9, l n9,1 inti unde

qualitycontrol

eovxlapingv and. duplicative centers f authority;,;w : i tt Tfhele in dinati be*en ttheset miistries,doeir half or more5f1multiple test requirements Egyp~~*4 t'rglto riy aonarlyicafcapacity ishlfaevoted to ualt tsingPu

lack of transparency9fpi and due process ;00000000itA000 i nduces transactiounerdl dtain,reduc imnpots a0nd 0inve s tie dt ,h 0figh complianec costs 0 0;0) l |0 j:excessive; sampblng and testing, exte;ndeXdport charges due to 4elays, t0)

unncesarily cnrjctdpocsfees(iqaddpictv 6itr fu wachiiagency tatiunbertake ispet iiition chrsa based on w ight o

unt- s0vv a per il to maximum Lh 1O; -k iper consgment0time and effort coq nsumed clearanc t iei takes 2.3 htimesismuch is i*othe Meter ranean pot)s.

lowjt eficiency Cut: Ioms clearane ;inles$00,000 of- prdc pe of4f ; ic000 0ial per0 y 0i00i0wieAi:ar,lii. 00

whl ti inaor itis$66,000000

: Geuetrd iRemarks:. It is::estimtatedE thatthe Equality control: systeminleads to D.0 S9Kof additional costsE to affected priiducers tand tfr:i:ders,ttiw0ith thsvd:ie highest costs for food products and gimpredf final consumner goods. fExports fdecrease by fan testimated 9% to t12%, GDP1 loses

Export Transaction Costs

5.29 In general, export transaction costs are not as prohibitive as that of imports, thanks togovernment's intervention in regulating seaport charges to be internationally competitive forexports and eliminating almost all of the quality restrictions on exports. But still, firms areburdened with cumbersome administrative procedures which again involve multipleinspections, certificates and charges. One estimate shows that to complete all the requiredsteps for a typical export costs LE 1 ,052 per consignment, which entails forms of agriculturequarantine, purchase Customs form 13, certificate of origin, Custom's certificate, bank export

Refer to Nathan Associates Inc., 1996, "Research Studies of the Quality Control System in Egypt".


form and statement of accounts; inspections from Customs, export and import controlauthority; fees for inspection, sealing, storage; and the lost time of three days.39

5.30 Although seaport services are not significantly expensive for exports, air-freight rateremains to be lofty. The same distance costs double the price in Egypt ($1.0-1.4/kg) than in,say, Israel ($.45-.50/kg), because of the empty back hauls of Egyptian Airlines. As a result,this outrageous air-freight rate adds 40% to the cost of grape export, to just name an example.

Table 5.5 Export Transaction CostsBarnerts/Impeditments Results

1. Cumbersome admninistative procedures involve multiple clearaices, certiDicates, inspections and feesoriginating from agriculture quarantine, export and import controlauthority, Customs committee, bank statement of accounts, and. manymore. The time lost is 3 days. Total estimated cost is LE 1052 perconsignment.

2. Lofty airfreight charges air-freight rate ($l.0-1 .4/kg) doubles that of competitors (Israel, e.g.,(seaport charges are regulated by the Egyptian govemment to $.45-.50/kg) due tobe intenationally competitive for exports) empty back hauls.

3. Finance and Insurance generally not reported by exporters as a problem, althougb Insurance..__...__.__._.____________________________________ premium is higher ft an neaTby countries,Genermal Reawrks; even though export transaction costs are not as ptonounced as thitt of iiporis, they ame still estimated to accoint for

IolS%v of the exponprice, largely a tsultofcumbersonr administrative Procedures Many problers in exporting lie in the- poduction prces", such high defeutand spoilAge rates, high inventory costs, lack of Ifonmation on f6eign makets, all of which are

:results of the inwar-looking strategy of the firns.

5.31 Overall, exporters report that the serious constrains on increasing sales abroadinclude: high and uneven import tariffs; low-quality domestic inputs; cumbersome duty-drawback and temporary admission regimes; excessive paperwork, fees and delays forCustoms and various inspections during import and export; workers that are poorly preparedfor the jobs available; insufficient incentives to export; and the lack of access to informationon foreign markets and product standards.

C. CoRE AREAS FOR ACTION

5.32 The Government is aware of problems outlined above and the concerns expressed bythe exporting community in Egypt that the high transaction costs reduce theircompetitiveness on global markets. A large number of initiatives have been taken by theGovernment to address these concerns including: (i) the number of forms to be used toregister compliance with export regulations has been reduced to one; (ii) exporters have beenexempted from fees for safety/security procedures; (iii) many of the port service fees chargedto exporters have been reduced; (iv) the shipment cost of containers carried by the EgyptianNavigation Company were reduced by 50 percent; (v) transport of containers within the portis now to be free; piloting fees and dock storage charges were lowered by 20 to 75 percent;(vi) handling and security charges for export goods and the electricity cost of refrigeratedcontainers were reduced by 50 percent; (vii) regulations relating to overtime incurred inapplying export-related administrative requirements were eliminated for exports; and (viii) a1989 decree imposing a fee of LE S on refrigerated goods that were not held in public sectorstorage facilities was abolished.

39 Refer to SRI International, 1995, "Achieving Egyptian Export Growth", p.V-18.


5.33 While recent Government actions have been substantial, many of these efforts can beperhaps best characterized as alleviating symptoms. More fundamental reforms are necessaryfor export-led growth to take place. What is needed is to enable Egyptian industries tocompete more successfully in the world markets by reducing the costs of doing business inEgypt. Only through competition will Egyptian industries become stronger, and will servicesuppliers be given the incentives to expand the diversity of services offered, upgrade theirquality, and price services competitively. This section focuses on actions that can be taken inreducing the transactions costs of imports as described above, and in creating strong buyer-seller links, and export mentality. Implementing these actions could help get at the root ofsome of the bottlenecks to the growth of exports.

Infrastructure

Seaports

5.34 Changes and quality of port handling services should be internationally competitive.This can be achieved by permitting private national and foreign companies to freely engage inport service operations in competition on equal terms against each other and against existingstate-owned companies.

5.35 An important factor raising the costs of exporting are the level of port service fees forhandling and storage of goods, and the quality of the services provided. Port services,transportation, handling, etc. are not natural monopolies. Experience in other countries hasdemonstrated that great efficiency gains can be achieved through greater competition in thisarea. Deregulation and privatization of port services had a major impact in Mexico. Entryinto the relevant service activities was made free, service market segmentation waseliminated, and firms were allowed to subcontract freely and set prices according to marketforces. The results were immediate. In one year the cost of services in the port of Veracruzdeclined by some 30 percent, while container turnover went up by almost 50 percent. Similarelimination of barriers to competition in the provision of port services in Chile led tosubstantial reductions in operating costs (by about 50 percent over two years). As noted by aWorld Bank report, "the deregulation of transport services in Chile and Mexico has had animportant effect on those countries' ability to compete internationally. By reducing the costsof shipping by almost 50 percent, small and medium sized firms that would otherwise bemarginal, have been able to expand their export activities."40 Thus, the Government of Egyptmay wish to consider the following reform actions.

5.36 Actions:

* Start legislative process to terminate the legal and regulatory status of statemonopolies in port services. Law 12-1964 and other regulations pertaining to suchstate monopolies should be abrogated or changed to permit the participation ofprivate national and foreign companies.

40 World Bank, Latin America and the Caribbean: A Decade After the Debt Crisis, 1993, p. 90.

Main Report: Promoting Outward Orientation Through Exports 7 1

* Eliminate interlocking directorships and shareholdings between port Authoritiesand operating companies or among port operating companies since they inhibitcompetition and impede effective supervision by the Port Authority of companieswith port policies.

Airports

5.37 Since Egypt's comparative advantage may lie in export of high-value added, lightweight products such as software, electronics, or highly perishable horticulture items,developing adequate capacity in cost-effective air shipping services is vital to exportdevelopment. Currently, the average cost of air freight from Egypt on carries such as EgyptAir to northern European cities ranges 2 to 3 times higher than its main competitors. TheGovernment of Egypt may wish to consider the following actions.

5.38 Actions:

* Relinquish monopoly control of air transport and ease regulations restrictingcompetition from non-Egyptian airlines and charters.

* Egypt is one of the few countries in the region where exporters usually must pay airfreight costs both ways-i.e. exporters must pay for the fully loaded 'head-haul'and of the empty back haul when the aircraft returns. Costs could be reduced bypermitting tourist charter flights to accept air freight on the backhaul.

Customs Refoms

5.39 In today's increasingly competitive global marketplace, the ability to import quicklyand at the lowest costs is crucial for maintaining a competitive advantage in exports-particularly in countries such as Egypt where dependence on imported raw material andinputs in relatively high. The ability to deliver competitively-priced products fast and on timeis considered a pre-requisite of effective linkages with key markets. It is imperative thatEgypt improve customs administration to reduce transaction costs of imports so as to similarexports and modernize industry.

Temporary Admission and Duty Drawback Schemes

5.40 Actions can be taken to further improve the temporary admission and drawbacksystems. Procedures for obtaining duty drawback or using the temporary admissionmechanism can be simplified and made more transparent and efficient. Establishing a set ofstandard input-output coefficients for broad categories of goods could help in expanding theuse of these mechanisms. Extending access to agricultural producers should also be pursued.Customs clearance procedures should be greatly simplified, become more automated andmove towards a paperless environment.


Import Inspection and Valuation

5.41 Under the WTO, all members, including developing countries, must abide by therequirements of the agreement on customs valuation. This requires that in principle the basisfor valuation is the invoice presented by the importer. In Egypt the introduction of thesemultilateral rules may require a change in current procedures. Customs valuation is generallyconsidered an uncertain process by importers, except if Egyptian minimum or referenceprices are used rather than invoice values. Often these reference prices are imposed byCustoms, and may be higher than what was actually paid for the goods. However,developing countries that were not party to the 1979 (Tokyo round) Agreement on Valuation-which includes Egypt- may delay implementation of the Agreement for five years after thedate of entry into the WTO. Developing countries which currently value goods on the basis ofofficially established minimum values may request a reservation to enable them to retain suchvalues on a limited and transitional basis, subject to the terms and conditions required by theother WTO members. While there is fair amount of slack built into the Agreement in termsof the transition, in the medium term Egypt will have to alter customs valuation procedures.This will require training, as well as upgrading of the information base available to customsofficials regarding the prices of products.

5.42 To be competitive on world markets, producers must have access to raw materials andinputs that allow them to produce goods of the quality required by consumers in any givenmarket at a price that is the lowest available. In many instances the required inputs will beproduced abroad. Egyptian enterprises producing for export must then be able to import suchinputs free of taxes and duties if they are not to operate at a cost disadvantage. Althoughtemporary admission and duty drawback systems exist, they are generally seen as onlypartially alleviating the high import duties that are applicable to many imports of intermediateinputs. The 'transactions costs' associated with the temporary admission and drawbackschemes are often prohibitive for small enterprises.41 Customs officials that in other countrieshandle cases, claims and disputes appear to be unwilling or unable to take responsibility fornon-routine decisions in Egypt. Such cases are generally passed on to higher levels ofauthority, greatly increasing the average time involved in obtaining decisions. TheGovernment of Egypt may wish to consider the following actions.

5.43 Actions:

* Establish a green channel for imports by allowing exporters to import raw materialsand capital goods through a "Green Channel." This would involve no inspection ofmerchandise and duty to be assessed on the basis of invoice submitted byaccredited exporters. A provision for random ex-port factory audit should exist,and any violation would be subject to penalties and for repeat violation, removalfrom the list of exporters that can use the channel.

41 For example, the department of Customs responsible for administering the temporary admission and drawback systems islocated in Cairo, not in the ports.


* To reduce transaction cost associated with imports and to promote exports andmodernization of the economy, adopt a principle of voluntary pre-shipmentinspection. Importers will be able to obtain document classifying and valuingconsignments from a small number of accredited international firms (such as SGS,Veritas, etc.) selected by the government. These firms will inspect and sealcontainers. The associated costs will be borne directly by the importers. Dutieswill be paid on the basis of value and classification determined by pre-shipmentinspection body. Customers will be obliged to allow sealed containers to passthrough customs without inspection and harassment upon payment of duties.

* Develop comprehensive action plan for customs reform that would minimize face-to-face contacts between importers and customs officials, reduce requiredsignatures, consolidate required inspections, and rely on an enforcementmechanism based on spot checks and stiff penalties for cheating rather than thecurrent system which requires inspection of most shipments.

Quality Controls

5.44 A number of difficulties have been identified in the current system of quality controlsin Egypt. First, quality standards are often confused with safety standards. Second,overlapping and duplicative centers of authority result in multiple testing requirements.Third, there is a perceived lack of transparency and due process. Streamlining the qualitycontrol process and focusing it on safety concerns would reduce the cost of doing businessand move Egypt towards a system that is consistent with its obligations under WTO andEMA membership.

5.45 The issue of the perceived lack of quality of Egyptian good was often raised ininterviews with Egyptian and foreign firms. This is a problem for small and medium-sizedenterprises in particular. If exports of manufactures are to expand significantly in the future,substantial efforts will need to be made to improve quality and thereby the internationalreputation of Egyptian products. Efforts could be made to stimulate the awareness of qualitycontrol and the importance of satisfying foreign standards (whether mandatory, health andsafety related, or the technical specifications required by foreign buyers), help firms inimproving quality control and management systems, and to aid them in obtaininginternationally recognized 'quality' certification. The relevant international standards in thisconnection are the ISO-9000 series of standards. One option that could be explored is toestablish a 'certification fund' that can provide matching funds for ISO 9000 certification andfor the services of consultants to audit companies. The rationale for such a fund is that smalland medium sized enterprises are unlikely to be able to borrow for purposes of certification.Alternatively they may be unwilling to do so because of a lack of knowledge of the potentialbenefits. It is important that a certification fund is limited to the provision of matching funds.Firms should be required to bear part of the costs involved to ensure their seriousness. Thescheme should also be limited to small and medium sized private sector enterprises, as theseare the ones likely to be either financially constrained and/or unaware of the existence of/needfor certification. The Government of Egypt may wish to consider the following actions.

74 Main Report. Promoting Outward Orientation Through Exports

5.46 Actions:

* Revamp the inspection process by establishing a single authority for inspection andtesting.

* Focus testing on safety concerns rather than quality standards. A review process-including international experts with extensive experience in this area-should beinitiated to determine whether existing standards are necessary, and, if so, whetherthey are compatible with international ones. If not, international norms should beadopted where possible. Such controls should be motivated only by health andsafety of consumers, plants and animals.

* Recognize international standards certification for non-food imports; foreign testresults of-and certification by-internationally recognized bodies should beaccepted.

* Reduce inspection levels to minimum spot checks; use compliance history as thebasis for the frequency of sampling and testing of imported products.

* Fees for inspection services should be cost-based rather than specific as is the casecurrently.

- Support standardization of lab quality through the certification by the NationalInstitute of Standards. Results from any certified lab should be acceptable, therebyeliminating multiple testing and increasing transparency by assuring quality of labresults. Private testing agencies and laboratories should be allowed to contest the'inspection market' once certified on the basis of objective criteria-as laid out byprocedures developed under auspices of international organizations such as theISO.

* Increase transparency and due process by: giving advance notice of any proposedrules, providing an opportunity for public comment establishing knowimplementation dates, and providing a clear appeal process.

* Establish a 'certification fund' that can provide matching funds for ISO 9000certification and for the services of consultants to audit companies.

Maximizing FDI and its Benefits

5.47 Trade and factor flows have become increasingly complementary over time as firmsspecialize and diversified the production process geographically. Attracting inward foreigndirect investment-both equity and nonequity-is particularly important in fostering exports.In addition to creating employment and contributing directly to export growth, FDI alsobrings with it great opportunities to nurture indigenous industry by helping the latter to enterexport markets via local and from these global supply arrangements; transferred technologyand management skills; enhance training (an increasingly critical area); and, vitally importantto Egypt, in assisting local companies in developing joint-venture and licensing deals fromwhich at the moment far too many are excluded. Given Egypt's comparative advantages in


terms of the size and cost of its labor pool, its internal market and its strategic location, itslevel of FDI is well below its potential. Increasing the level will require marketing as well ascontinued efforts to ensure not only the absence of overt discrimination against foreigncompanies, but also the availability of an adequately skilled and productive work force, aninfrastructure that meets minimum standards of quality, the protection of intellectualproperty, and the availability of efficient service suppliers.

425.48 Egypt needs a honed inward investment promotion agency with a highly targetedapproach based on current 'best-practice.' Options to achieve this include the following:

5.49 Create a small group of experienced sales professionals, perhaps reinforced for a shorttime by outside 'specialists' to deliver training and offer advice. This elite group might bedrawn from across different parts of the civil service and should be distinguished by a strongcommitment to making Egypt the premier FDI location in the Middle-East. The new agencywould not have a control function but rather would focus exclusively on sales/marketing,aftercare and sector development. The body could have a 'supervisory' board made up ofboth foreign investors, those already in Egypt, and local companies, as well as officials andministers. The purpose of this board would be to both assesses the performance of the agencyand to advise it on key aspects industrial trends and international investment.

5.50 Privatize the entire FDI business by giving it to a group which works to specific andagreed targets both by volume of investment flows and in other areas such as aftercaredevelopment. If this approach was adopted it would close monitoring to ensure performancetargets are achieved. It might also make sense to place within it Egyptians who wouldbecome the corps of a new investment body in due course. Issues such as assisting localcompanies in quality and delivery programs would have to become the responsibility ofanother body to allow the private company to fulfill its targets and to focus exclusively onwinning investments. One advantage of this model lies in the fact that it would create a groupcompletely dedicated to 'kick-starting' the country's FDI efforts.

5.51 A combination of both of the above is also possible.

5.52 Focus on After-Care. Someone should be charged with the responsibility of regularlycontacting existing businesses, finding out if they use domestic sources, if not why, ifsomething could be done to facilitate the backwards linkages, if they can be encouraged toinvest more in the country. While care must be taken not to appear to be a high pressuretactic, companies should be made to feel that there investments are welcomed whilemaximizing on their potential.

5.53 Create an FDI friendly environment. In addition to the wide range of issues discussedin context of creating a private sector friendly environment, attention should also be given to"small items" that can often make a difference in terms of first impressions .g. visarequirements, airport customs, orderliness of taxi queues and pricing at airports.

42 As currently constituted, the General Authority for Investment (GAFI) is basically a control agency and doesnot act to market Egypt, support investors already in the country, and target new investors.

76 Main Report: Promoting Ourward Orientation Through Exports

5.54 Maximize the potential of export processing zones to attract investments by providing"one-stop shopping," ensuring no bureaucratic obstacles such as with customs and qualitycontrol.

Forging Buyer-Seller Links

5.55 Many of the 'tiger' economies have in some form or other created export supportagencies which are compatible with and facilitate the efforts of firms. These bodies areespecially important for those SMEs with limited, if any, export experience. And whilst thegovernment agencies cannot and should not do the work of these companies at their best,there are many outstanding examples, the agencies provide critical services to exporters.Unfortunately for Egypt, it has too many such bodies and they are insufficiently coordinatedand underfunded. The functions and activities performed by the state institutions areconstrained, inter alia, by limited resources, lack of staff training and motivation, public-sector pay scales, insufficient permanent dialogue and interaction with the beneficiaryenterprises, and absence of financial and other inputs from the latter. Egypt's public exportagencies are not sufficiently resourced or coordinated to offer the kind of support common inmany other parts of the world. Were this deficiency compensated for by a buoyant FDImarketplace-flow which causes exports to arise from experienced overseas companieswhich do not require assistance to export-then perhaps the situation would be less grave.But this is not the case.

5.56 To export it is necessary to be able to produce a good or service that meets therequirements of foreign buyers (i.e., product specifications, deadlines, reliability of supply)and to identify potential clients and obtain a contract from them. This in turn requiresknowledge of available technologies that can be used to produce specific products;availability of know-how regarding needed retooling/upgrading of existing plant required tomeet foreign market specifications; access labor inputs, raw materials, components andcapital equipment; and mechanisms to ensure that quality standards are met. Many Egyptianfirms are weak in all these areas. The two factors mentioned most often as being particularlyimportant problems in this connection are weaknesses in marketing and establishing apresence in overseas markets by Egyptian firms, and the lack of attention given to meetingquality standards required by foreign buyers. Relatively little use is made of outside,independent certification bodies like Societe Generale de Surveillance (SGS) or BureauVeritas. Such firms are established in Egypt, but their services are usually mandated byforeign buyers and not demanded by local producers. Very few intermediaries exist that cansupply information services. Weaknesses in this regard reflect historical circumstances: arelatively closed economy, with much of its manufactured exports occurring in the context oftrade based on negotiated protocols with former centrally planned economies in Eastem andCentral Europe and the former Soviet Union. Marketing and associated skills were notrequired in such an environment. Large foreign retailers and other specialized buyers andtrading houses are not very prevalent as buyers of products and in eliminating distribution-related activities/investment in foreign markets.

5.57 Actions:

* Create a single, one-stop shop export promotion center. This would require thecentralization of Trade-Point, the EEPC, and the GOIE into one agency. Such an


approach would liberate economies of scale thereby releasing both financial andmanpower resources, enhance coordination, boost productivity and should lead tosimplified customer service and access. The exact nature of the new structurecould be the subject of at task-force to include representatives of the EBA, the FEI,possibly someone from a major foreign exporter, say a Japanese trading house, andboth Egyptian SME and large company representatives. Possible outcomes couldinclude:

* A publicly funded agency with a private sector dominated Board. The Board wouldgive direction to the executives and in so doing would instill confidence in the newbody by the private sector as a whole.

* Retention of the existing bodies ,but with much greater coordination, for exampleby the Ministry of Trade and Supplies. The disadvantage of this model is that it isunlikely to gain a vote of confidence from the private sector which is likely tocontinue to pursue its own interests. It also misses the opportunity to achieve aradical break with the past practices which have not worked.

* Pass the entire responsibility for exports to a private sector body. It could befunded on a 'performance-bounty' basis as measured quantitatively by non-traditional export growth in the designated export sectors and countries selected bythe body for targeting ,and 'qualitatively' by asking its 'client' companies whatthey think of the new body's performance.

* Enhance information management systems.

- Benefit from the huge amount of research/analysis by keeping a date base ofcontaining information from reports/studies such as area of reform, recommendedaction, status (why taken or not) and reference document.

* Make timely statistics widely available.

* Keep data base of contacts, buyers, markets.

Creating an Export Mentality

5.58 Current producers are content to service a large, protected domestic market. Theydon't think about exports. To create an "export mentality," govermnent needs to setambitious export goals, create environment in which goal can be met, and engage in publicrelation policy campaigns.

5.59 Actions:

* Set an ambitious export target and strive to meet it. For Egypt's non-traditionalexports to reach $10,000 million by the year 2000 (an often cited governmenttarget), exports would need to grow at an estimated annual rate of 35%. At this rateof growth, Egypt would capture 0.25% of world merchandise exports within 5


years (almost catching up to Egypt's share in 1970 -- 0.27% -- and approximatingthe share of Thailand in 1970). Sustained for 10 years, Egypt would capture 1% ofworld exports (the level of Brazil in 1972; Korea in 1978; and Thailand today).Setting such ambitious targets has the advantage of making clear that tinkering onthe margin will not be successful and that full scale change in the way business isdone is required.

* Follow up with specific actions to help stimulate an "export mentality" and toeducate the public. The following types of action have been used in somecountries:

* The Prime Minister could hold a monthly TV press-conference where exportstatistics are announced. This can create an excitement and awareness aboutexports. It also contributes to a private sector friendly environment by ensuringthe timely availability of information.

- Conduct annual national contests that rewards entrepreneurs that open up newmarkets or introduced new products. The President could present awards, and therecould be substantial press coverage of the winners activities.

- A media campaign could be used to explain the importance of exports.

* Overseas Egyptian industrialists could be encouraged to return to Egypt for 1-3months to work with sister companies. While UNDP's TOKTEN (Transfer ofKnow-How through Expatriate Nationals) program has been used for academic andcultural exchanges in Egypt, this program has been used successfully for industrialexchanges in countries such as Vietnam and China. It can help bring expertise andmarketing know-how back to Egypt.

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Arab Republic of Egypt Country Economic Memorandum Egypt...

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