Citing "civil unrest and sliding foreign exchange reserves" and "severe financial imbalances," recent headlines such as "Egypt in footsteps of bankrupt Greece" and "Egypt: The growing budget deficit threatens to bankrupt the state" have warned of impending economic doom. Addressing legislators on Dec. 30, as the pound began its most dramatic dip in a decade, President Mohamed Morsi dismissed the bleak predictions, declaring that "Egypt will never go bankrupt." In January, however, foreign reserves plummeted to a new low of $13.6 billion, not quite enough to cover three months worth of imports, or slightly below the level most analysts consider critical. The government has already blown through its allocated fiscal year funds for the purchase of diesel fuel, which powers the nation's busses, lorries and other forms of domestic transport. In an effort to stanch the bleed, the Central Bank has imposed capital controls, prohibiting people from carrying more than $10,000 in American currency out of Egypt. In late February, officials also approved a draft law to increase tariffs on luxury imports and banned the import of exotic birds. "That's the end," says Eduardo Borensztein, an economist with the Inter-American Development Bank who studies public bankruptcy and currency crises, explaining that such measures are never a good sign. They're a "signal for when you're getting to the end of the rope."
Morsi is not the first revolutionary leader of Egypt to grapple with a financial crisis. Ahmed Orabi, an army general, led a popular uprising in 1879 against Tawfiq Pasha, the ruling Khedive of Egypt and Sudan, deposing the military dictator in the name of the underclasses. Then as now, the country was burdened with so much state debt that over a fifth of the government's annual budget was devoted solely to servicing it. The previous Khedive, Ismail Pasha, had borrowed millions of pounds from the British in an attempt to jumpstart a capitalist economy. Worried that Orabi wouldn't repay the money, London invaded in 1882, bombarding Alexandria and marching British soldiers up the Nile. Some 1,400 Egyptians were killed, and the English army successfully re-imposed Khedive Tawfiq's rule, ushering in a 70-year era of British imperial control.
Present-day Egypt is very unlikely to go bankrupt, say experts (or to go to war over unpaid financial obligations). As in the 1870's, the nation is saddled with debt, but today the vast majority of it--some 85 percent--is domestically held by Egyptian financial institutions and private citizens. Many of the country's foreign loans were forgiven by rich nations in the 1990s in exchange for Egypt's assistance in the first Gulf War, and the government has since funded most of its deficit via auctions of treasury bills and treasury bonds. If Egypt announced tomorrow that it doesn't intend to pay back a penny of its $35 billion in foreign debt, it would still owe LE 1.33 trillion to its own people. Defaulting on its local debt, which comprises a third of Egyptian bank holdings, would hardly solve the country's current financial predicament. Rather, it would shutter Egypt's financial sector and halt the economy. "It's a bit of a self-inflicted wound if you default on your own banks," explains Borensztein. (Likewise, inflating away domestic debt by printing more money has its own dire economic consequences.)
The real problem, say economists, is Egypt's balance of payments, or currency, crisis: With tourism and foreign direct investment--among its main foreign currency earners--slowing to a trickle since the 2011 revolution, Egypt is struggling to pay for essential imports, and its foreign reserves are dwindling rapidly. "They don't have enough forex to keep spending the way they're spending," says Mohamed Abou Basha, an economist at EFG-Hermes. In this case, the source of the profligacy is the government, which has so far managed to cobble together funding to run a budget deficit (equal to around 11 percent of the GDP). But the global community, represented by the International Monetary Fund, is no longer willing to loan Egypt the money it needs to keep spending unless it comes up with a plan to rectify this chronic unbalance. The IMF is requiring that Egypt raise revenues and reduce spending before it signs off on a requested $4.8 billion loan. "There will have to be sharp spending cuts, probably subsidies being the biggest focus, and higher taxes," says Abou Basha.
The other economic prescription for solving a balance of payments shortfall, which is estimated at more than $11 billion in Egypt, is to devalue the currency. The value of the pound drops, making imports more expensive and Egyptian exports cheaper for the rest of the world to buy. The law of supply and demand kicks in, the theory goes, and Egyptians import less while other countries buy more Egyptian goods, eventually evening things out. In December and January, the government let the pound slide from around LE 6 to the dollar to around LE 6.7 before resuming reserve spending in order to peg the currency at that level.
In general, however, Egypt has resisted devaluation. The government spent around $22 billion in fiscal 2011/12 on food and fuel subsidies, much of which it paid for in foreign currency, running the state around LE 134 billion. Those same commodities would cost LE 150 billion at today's exchange rate, with the pound worth around 10 percent less. The medicine most economists say Egypt needs--higher taxes and more or less doing away with public subsidies--is difficult to swallow politically, as is currency devaluation, which spurs inflation. There is a "notion that the strength of the currency is associated with the strength of the economy," says Ahmed Kamaly, an economics professor at The American University in Cairo. Officials have announced some of these unpopular measures in recent months, only to back down in the face of mass protest. Observers say the current regime is unlikely now to force unpleasant reforms down the throats of Egyptians, who will soon go to the polls to elect a new parliament. Meanwhile, the country is running out of options and time.
Rather than fixing underlying issues, Egypt has pursued stopgap measures. A country can run balance of payment deficits as long as the international community is willing to lend it money. Economist Ugo Panizza of the Graduate Institute in Geneva, Switzerland points to Lebanon as a prime example of a nation that has been running such deficits for years. But at the end of the day, the state must make up the difference either by borrowing (as Lebanon and Egypt have done) or via the central bank using foreign reserves to inject money into the economy by buying local currency. The latter strategy of propping up the pound by artificially creating demand for it has run the CBE some $2 billion a month.
Indeed, none of this has come cheap. Since the January 25 uprising, the Central Bank has spent about $23 billion of its reserves defending the pound and compensating for the balance of payments deficit. Recently, the government has cobbled together a set of economically counterproductive measures to stop people from converting their money from pounds, including capital controls, high interest rates and import bans, all of which ultimately slow the growth the country desperately needs. The longer Egypt continues to extinguish fiscal fires rather than fixing its root problems, says Abou Basha, "the more painful it is."
As foreign reserves dwindle, the Central Bank has less money at its disposal to pad the pound's fall, making it increasingly likely that the state will be forced to pull the plug abruptly on public expenditures. Industry executives have said that their companies can absorb the cost of fuel price hikes but only if they are gradual and planned. Waiting until the last possible minute to devalue the pound and balance the budget when Egypt's foreign reserves run dry only increases the likelihood of a "disorganized devaluation" in which the pound plunges into a downward spiral that takes on speed from its own momentum, leading to dramatic, mass inflation, while workers' wages become increasingly worthless. "They should have done it before they wasted all their funds," Panizza says. "Now if they let the exchange rate go, it could go anywhere." Analyst William Jackson of Capital Economics says that historically, disorganized devaluations have led to dips as much as 50 percent below a currency's fair market value. Similar economic situations in Turkey and Venezuela in recent years dragged the local currencies downward at a pace that continued at a steady clip for years. Following the plunge of the Turkish lira in 2001, hundred of thousands of Turks lost their jobs. Incomes and nest eggs dwindled to half their value within weeks, while living expenses ballooned. In Venezuela, where just last month, the state was forced to devalue the bolivar more than 30 percent due to a balance of payments crisis, people struggled to find staples like wheat flour, cooking oil and toilet paper. A burger at McDonald's cost $12.
Panizza says Egypt has one way out: It must set a goal exchange rate, presumably somewhere around the pound's estimated true market value of LE 7.5 to the dollar, let the currency fall until it gets there and line up "someone with deep pockets that will help us defend" it. The IMF has played that role in the past, but analysts predict that the current government won't agree to the conditions of the IMF loan until after parliamentary elections are held, and without international intervention, Egypt will run through its foreign reserves before then. Qatar, which has stepped in as Egypt's regional benefactor since the revolution, loaning it $4 billion plus another $1 billion as an outright gift, could step in with another injection of cash to keep the country limping along for another few months. But Egypt can't depend on its wealthy neighbors to keep it afloat forever. "The moment you run out of reserves, when no one else is willing to lend you money, you have to adjust," says Panizza, who echoes the view that adopting the inevitable economic reforms sooner rather than later could spare the Egyptian people a lot of pain. "Adjustment will come at some point, but if you do it well it won't hurt as much," he says. Foreign troops are unlikely to reappear in the Alexandria seaport anytime soon. But things will probably get significantly worse before they get better. Says Jackson, "The next few years are going to be really tough."
© Business Monthly 2013
