Troubled economic times can stoke the fires of protectionism. But would preferential treatment for Egypt's industries pay off in the long run?
As post-revolution Egypt moves into its second year, most of the economic conditions that served as a catalyst for the uprising remain. Political gains have not translated into increases in foreign direct investment, lower prices for consumers or more jobs for the country's multitudes of unemployed youth.
Against that backdrop, Egypt's battered manufacturing base has asked the government to consider instituting measures to protect domestic industry from what many consider to be unfair competition from abroad. Such measures as higher tariffs on imports, restrictive quotas, subsidies, preferential tax treatment and other direct government intervention spark spirited discussion of the benefits and cost of protectionist policies.
In January, the leather, medical devices and textiles chambers in the Federation of Egyptian Industries, as well as several automotive manufacturers, submitted memos to Foreign Trade & Industry Minister Mahmoud Eissa asking for steps to be taken to protect their members from imported goods. The ministry has only responded to one request, though it will not likely be the only measure as Eissa has expressed a commitment to protect domestic industry in two separate meetings with federation members.
Domestic manufacturers' concerns are not unfounded. A report by the Egyptian Center for Economic Studies (ECES) shows that 1,260 factories in Egypt have closed during the last half of 2011 and 960 are in "financial distress." Almost 900 of the shuttered factories and 250 of those in trouble are in Egypt's three industrial cities: 10th Ramadan City, 6th of October City and Borg El Arab. According to Safwan Thabet, the head of the 6th October Investors Association, almost 40 percent of the city's 1,500 factories have gone out of business in the past year. "Of those remaining, almost 80 percent operate at 70 percent or less of their full capacity," he says.
According to the ECES report, the chemicals industry has been the hardest hit (70 closed factories), followed by engineering (50) and spinning and weaving (30).
According to Tarek Tawfik, former chairman of the Chamber of Food Industries, the fact that exports increased by 20 percent at a time when domestic as well as regional economies are in political and financial turmoil is a testament that the current customs and tariffs system works. "When you reduce tariffs, a byproduct is that you become an exporter," says Tawfik.
Increasing tariffs to give domestic industries an advantage can be tricky. In an attempt to provide a boost for the spinning and weaving industry - part of the textiles chamber that asked for protection - the Ministry of Foreign Trade & Industry imposed dumping fees of LE 3,300 per ton on imported yarn that took effect January 3. "The fee is based on the extra cost that domestic yarn producers incur per ton, so imported and domestic yarn are comparably priced," says Hamada Kalouby, of the Investor and Exporter Association in El Mahala, El Kobra governorate. He admits, however, that production costs for weaving and textile companies will likely increase as they rely mostly on imported yarn in their products "I believe some increase is acceptable," he says. "But the ministry has to carefully monitor the market to make sure that traders don't overprice their products."
In Egypt, suppliers typically pass on the dumping fee to their customers unabated. This fact prompted the Chamber for Textile Industries send another memo to the trade ministry asking for an increase in the existing 40 percent customs fee on imported finished clothes to offset the higher cost of imported yarn. "This [dumping] fee will increase our costs by 50 percent," says Hamdy Aboul Enien, a member of the ready-made garments division in the textile chamber. "The problem has always been marketing the [domestic] yarn. There must be another solution other than applying the dumping fee."
Meanwhile, several automotive industry players are asking the Ministry of Foreign Trade & Industry to postpone for 2012 and 2013 the 10 percent annual tariff reduction called for in the EU partnership agreement. The Egypt-EU partnership agreement applies on all imported goods.
Pros of protection
There are those who believe that a protectionist policy could work. Tarek Selim, a microeconomics professor at the American University in Cairo, cites the "Infant Industry Argument," which contends that nascent industries in developing countries often cannot match the economies of scale of older, established competitors in other countries, and therefore need protection. "Protectionist measures aim at creating a supply-demand gap in the market," says Amr Elalfy, co-head of research at CI Capital. Theoretically, that gap would be filled by domestic industries that increase production and thus employ more people, he says.
While protectionist measures could provide a much-needed life preserver in a sinking economy, there is wide agreement that any intervention in market dynamics should be temporary. Elalfy and Selim are strident in their belief that protectionism would be effective for no more that five years. "After that, inefficiencies will appear," says Selim, citing the threat of monopolies and inflation.
Another key component of any protectionist policy should be growth plans that would help protected industries to "upgrade" themselves to the point where they can be competitive and self-sustaining in a free market, according to Selim. "I need to know where my competitive edge lies, and not just protect for the sake of protecting," says Neveen El Tahri, co-chairperson and managing director of Delta Financial Investments, an SME financing firm.
Choosing the right sectors to protect is also important to the success of any protectionist policy. "Sectors that can be developed to survive and prosper once protectionism is removed, as well as those that are labor intensive, should be the priority given the need to create jobs," says Yaser Gamali, head of global banking and markets at HSBC Egypt. "Sectors that have a sustainable advantage in terms of geography and low cost base, and specific domestic advantages shouldn't be protected."
But for others, protectionist policies come with a significant downside. Ashraf Salman, chairman and CEO of Cairo Financial Holding, believes protectionism will never work. "No one will benefit because once you implement such a policy the quality of the goods produced will decline," he says. That means companies would be less competitive and employ fewer people. A case in point is the Egyptian automotive industry. For about 30 years, Egyptian carmakers Ramsis and Nasr enjoyed a huge advantage over imported automobiles, which where subject to tariffs of more than 200 percent. Still, the two companies managed to go out of business. In 2005, tariffs were reduced to 40 percent to 135 percent and Egypt has become a regional assembly hub for major car producers.
The effect of protectionism could also extend to trade relations with other countries. Gamali warns that sustained protectionist policies could be construed by other countries as "anti-competitive and against the General Agreement on Tariffs and Trade (GATT)." Violating trade agreements like the Aghadir Treaty could mean going to the International Arbitration Court, costing Egypt money and hurting its reputation.
Alternatives
Trying to reduce imports by making them more expensive will only hurt consumers, as quality and availability of particular products are major reasons why businesses - and consumers - choose imports instead of buying Egyptian. "Things like coffee machines, industrial refrigerators and cleaners, and light bulbs are available [from domestic producers] but are of poor quality," says Omar Fathy, owner and CEO of Divine Worx, a restaurant and catering business. "We try to import as little as possible, but not at the cost of quality. These things are critical for our business."
Tawfik, of the Chamber of Food Industries, believes that if the government wants to invigorate domestic industry and reduce imports, the way to do it is through infrastructure development. For instance, government data indicate that as much as 15 percent of imported wheat is lost due to poor storage and transportation, he says. "This is unacceptable when the global average is 2-3 percent."
Excessive waste is also apparent in the distribution chain, where the World Food Program reports that 28 percent of bread is lost. And Tawfik estimates that as much as half of perishable goods such as fruits and vegetables never make it to market, doubling the price of those items for consumers. This explains in part why domestic agricultural products can cost about the same as imports, says Fathy. "Imported goods need to be shipped farther and stored longer, yet they are of higher quality and the price difference is negligible," he says.
Some see blanket subsidies as one reason for Egypt's supply chain problems. "Because everyone is subsidized, no one bothers to make their business more efficient," says Tawfik. In effect, the government inadvertently ends up subsidizing waste and inefficiency.
High tariffs can also encourage smuggling. "This translates to lower-than-market prices," says Tawfik, adding that preventing smuggling is "the best way to protect the domestic industry."
Propping up the pound also plays an important role in making imports more attractive. "It is now over-valued," says Tawfik. "So the cost of importing goods is less than what the global market would dictate." And with the current slowdown, everyone is looking for cheaper alternatives, he says.
According to Eissa, small and medium enterprises (SMEs) comprise 90 percent of companies operating in Egypt and are a critical component of any economic recovery. Finding the best model to support them will be a tall order as these companies "never had any privileges," says El Tahri, of Delta Financial Investments. A major problem is the lack of awareness concerning financing instruments that are available to SMEs. Banks are the main source of credit for SMEs, which are usually required to meet the same standards as corporations, she says.
A protected market might mean that SMEs will be less interested in competing in foreign markets, which could hinder product quality and limit growth potential, says Khaled Ismail, Endeavor Egypt Chairman. "Entrepreneurs need to think globally as much as they can," he says. Some experts view protection measures as adding another layer of certainty that could change at any time and make it even more difficult for SMEs to get credit. "Banks will lend to protected industries, but they also will analyze the potential impact of any reduction in protection levels when determining the financial viability of the borrower," says Gamali.
What is vital for SMEs to succeed is an overall healthy economy from the top down. "The majority of SME business is done with large corporations," says El Tahri. To that end, the government should simplify and streamline its regulatory framework, as well as eliminate corruption, says Ismail. By moving more and more toward de-centralization, SMEs will find a more fertile ground to grow," he says.
Government leadership
In the past, the government has been at the forefront of attracting investments through its public-private partnership (PPP) program and emphasis on infrastructure projects. Experts see that as a crucial leadership role that must continue. "I believe that the positive role the government can play is to indulge in several mega projects" that benefit multiple sectors," says Ismail. Tawfik has a similar point of view. "If the government uses PPPs to build silos and gives the private sector the right to use for a limited time, then the government would have upgraded its infrastructure, helped the private sector, increased employment and moved the economy forward," he says. Even simple projects like packaging would help revitalize industry while creating value-added products and higher returns, adds Elalfy.
According to a report by McKinsey Quarterly titled "State Capitalism," government intervention creates its own set of winners and losers. "There are plenty of good reasons for political leaders to intervene these days in domestic economies," said the report. "If nothing else, we can hope for better-crafted rules for future flows of cash, goods and services. But this acknowledgment cannot obscure the fact that markets do these things more efficiently and effectively than politicians do."
Protectionist policies are intended to boost domestic businesses, but some say that limiting foreign access can have unintended consequences. "Politicians trying to help rescue their domestic economies aren't making choices with the global economy in mind," the report said. "They're primarily interested in bolstering their personal stores of political capital by serving and protecting their most powerful constituents." It is not difficult to see how that could lead to favoritism, where natural gas prices, for example, might increase for privately owned fertilizer companies, but not for those that rae state-run, says Salman, of Cairo Financial Holding.
Elalfy believes that maintaining a protected economic model could open opportunities for mergers and acquisitions. Foreign companies that see financial opportunity from operating in a protected environment could acquire companies that might come cheap given the downturn, he says. "If the government gives incentives to bigger entities based on capital or productivity or both, this can be a good way for SMEs to merge into bigger, more stable entities," Elalfy says.
An open future
The priority for the foreseeable future must be growth over containing inflation and maintaining currency exchange rates, according to Elalfy. And experts see exports as crucial to achieving economic growth. "We must support exports," says Tawfik. "No country is self-sufficient." For Elalfy, manufacturing to international standards for export can only improve the quality of products for the domestic market.
Under such a market structure, incentives to attract investment should also be removed, according to a McKinsey report titled "The Truth about FDI," which says foreign investors are more concerned about infrastructure, workforce, and size and growth of the domestic market than they are with financial incentives. The report also points out that financial incentives would be a burden for governments.
The report also argues that domestic component requirements and forcing foreign investors to partner with domestic businesses are ineffective. Salman says strategic investors need to determine their optimal business model without restraints. "China doesn't have local content requirements for consumer electronics, but its companies are rapidly moving from assembling final goods to producing the full value chain," said the FDI report. The case illustrates the importance of FDI in transferring technical knowledge and increasing access to international markets.
However, encouraging domestic investors will be a key to creating domestic jobs, both in SMEs and large companies, says Gamali. A protectionist policy will attract investors as long as there is an "integrated plan," he says. This will require a major shift in government strategy to focus on supervising and regulating the market rather than directly investing in it, according to Salman. Anti-dumping regulations and restructuring subsidies so that they are based on prevailing international prices, rather than full or partial exemptions, will be important to maintaining market efficiency, he says. Salman advocates restricting companies from exporting until domestic demand is met.
However, Salman does not expect policies to change dramatically, saying the major change will be a "no corruption policy." The fact that that the next government will have a limited tenure means "their decisions need to work for the majority to ensure they keep their jobs," he says.
© Business Monthly 2012
