As inflation hits another high, a growth-focused government finds itself walking a fine line between public discontent and economic progress
Inflation is something of an unruly beast. The bane of economists and central banks for the greater part of this century, it has been nipping at the heels of Egyptian policy makers since the economic reform program was kicked into action four years ago.
Previously a domestic phenomenon attributed mainly to economic growth, supply-side 'shocks' and the aftereffects of the Egyptian pound's floatation (and 30% depreciation) back in 2003, Egypt is now caught up in what analysts and talking heads are likening to a perfect storm: a whirlwind of agriculture-, commodity- and energy-driven inflation that is tearing into emerging markets, and the poor, in even the wealthiest of countries worldwide.
At the same time that Egypt is being buffeted by these winds, the factors that have underpinned previous inflation above 7% growth, low productivity, stretched capacity and struggling distribution systems have not gone away.
In fact, the government now finds itself standing on the edge of a slippery slope with inflationary pressures converging around it, and an outdated subsidy system, lopsided income distribution and large budget deficit weighing heavily around its neck.
Appearing to recede during the second half of last year after peaking at an annualized 12.8% in March 2007, inflation has recently sprung back with a vengeance: 16.4% at last count in April 2008. The United Nations World Food Program estimated that average household expenditure on basic foodstuffs and services in Egypt increased by 50% in the first three months of this year. And while the government may have been able to continue reciting its mantra of "growth, growth and more growth," pushing aside inflation in its earlier incarnations, this time the beast is different, and one which cannot be ignored.
Importing Inflation
The rapid increase in the global price of food and fuel has been behind the recent surge in inflation. Unlike wealthier countries, where food makes up a smaller portion of household spending, in Egypt it counts for 40% of the Consumer Price Index (CPI) basket (see box "The Value of Money"). As a result, the escalation in prices of basic products such as wheat, rice and cooking oil on the international market was the leading contributor to the current inflation rate of 16.4%; the CPI's food component jumped from 8.6% in December 2007 to its current high of 22%.
The United Nations' Food and Agriculture Organization (FAO) reported that its food index, which tracks the international price of agricultural commodities, was up 40% year-on-year (y-o-y) in December 2007, compared to a 9% rise from 2005 to 2006. The first quarter of 2008 continued the trend, with the index 53% higher than 1Q2007. Most critically for Egypt, which imports around 50% of its wheat and 60% of its total food supply, the FAO cereal index was up 92% y-o-y this April, reflected in the rapid rise of local bread and grain prices, which blew out by 27% in February alone.
While the international price of agricultural commodities has remained stable since February 2008, prices in the long run are expected to at best plateau, if not increase further. While some of the factors contributing to these expectations are short-term such as drought in Australia and disease in Vietnam, both major grain exporters the majority are more permanent.
Behind the rapid rise in agricultural prices has been the ongoing reduction in international grain stocks as population growth and demand has outpaced grain supply. Global wheat and rice stocks have reached their lowest levels since 1979 and 1983, respectively. The constraints on supply are being exacerbated by the effect of agricultural subsidies in the United States, Japan and Europe, which discourage food production in lower cost locations, contributing to a lower global supply of grain.
Record oil prices, which have hit $130 (LE 695.5) per barrel, are fueling increasing costs in agricultural production and transportation, as well as stimulating the biofuel industry. This year, 30% of the US grain harvest is earmarked for biofuels, while large swathes of agricultural land across South America are being dedicated to biofuel crops, placing further strain on prices. Add to this the growing demand for meat in countries such as China and India and the long-term trends propping up prices are evident.
Agricultural exporters such as Egypt which was the world's seventh largest rice exporter in 2007 exporting around 1 million tons of rice along with major grain producers Thailand, Vietnam, India and China, have attempted to provide short-term insulation for their domestic markets by banning or imposing duties and quotas on grain exports. These policies have cut into international supplies and driven prices up even further.
Convergence
Despite high agricultural prices internationally, the effect on domestic inflation should be transitory. "By definition inflation is a continuous increase," says Dr. Hanaa Kheir El Din, executive director of the Egyptian Center for Economic Studies (ECES), a leading Cairo-based economic research institute. "But when there is just a jump, you face the inflationary pressure and that's it. It tapers off." Food products do not have a significant flow-on effect to other sectors, meaning that prices should flatten out, albeit at higher levels.
Inflation in Egypt, however, is not showing any signs of doing so.
The government's decision to increase public-sector wages by 30% and finance the increase (as well as to adjust to rampant global energy prices) by removing part of the subsidy on petrol and diesel, is playing a role in prolonging the high levels of inflation.
Wage increases are generally inflationary. "Yes," agrees Kheir El Din, "if it is not accompanied by higher productivity it is likely to raise prices, and this has been experienced all through the last period. Every time the government announces a salary increase or adjustment in May or the beginning of July, immediately there is a jump in prices."
And that is just the public sector; the private sector is yet to react.
"The private sector will go in and strongly raise some salaries," says Tarek Moursi, a consultant to the Cabinet Information Decision Support Center from the University of Cairo's Department of Economics. "I don't think they will go as far as 30% [] But if they do, then this is going to raise the inflation rate significantly beyond that. We're looking at inflation not in the 20s but beyond the 20s -- 22, 23 even 30% inflation," he warns.
The effects of the fuel increase are more immediately obvious: Public transportation costs went up the same day the decision was announced. The diesel hike (up 46% to LE 1.10) had a faster-than-anticipated effect, pushing up transportation charges, which resulted in the price of flour jumping from LE 3,500 per ton to LE 3,700. The fuel hikes will also have a longer-term impact on inflation, as fuel costs are passed on by business.
Now factor in the recently brought forward removal of natural gas subsidies from industry -- the price of natural gas is to move from $1.25 per cubic meter (LE 6.69) to $2.65 (LE 14.18) by 2010. Add to that a 100% increase in the price of fuel oil to LE 1,000 per ton at the beginning of the year., and there are many reasons to expect inflation to continue.
"It shouldn't raise the prices at the same percentage as the increase in energy products," qualifies Kheir El Din, "because energy products do not represent 100% of the cost. So the prices should not rise at the same rate as the energy price increases, unless there are monopolistic practices that the government should try to address."
Regardless of what percentage of costs are passed on, removing the energy subsidies will put further pressure on the already spiraling prices of building materials: The price of steel and cement grew around 40% and 55% respectively from November 2007 to February 2008, while the price of bricks leapt 55% from December 2007 to January 2008. This does not directly affect the CPI, being absorbed instead in growing property prices, but the price increases will have some impact on business costs -- particularly for companies establishing new production facilities and rental prices down the line, as well as adding to a general public perception of inflation.
Forgotten amidst the angry reaction to fuel prices, fertilizer is another problem quietly lurking in the background. The Ministry of Trade and Industry (MTI) increased the price of nitrogen-based fertilizer by 90% in March 2008, to LE 1,500 per ton, resulting in the price of a 50 kilogram bag of fertilizer almost doubling from LE 35-38 to LE 70-75. Because of its timing, the price rise did not affect the last growing season, but it will the next, meaning a delayed impact on inflation. Add to this the removal of subsidies on natural gas, which accounts for around 55% of fertilizer production costs, and there is likely to be a further spur to agricultural prices.
All of these factors are converging in a climate of strong economic growth and the resulting consumer demand. Egypt is entering its third successive year of plus 7% growth (7.5% in 1Q2008), foreign investment continues flowing in ($7.5 billion (LE 40.13 billion) in 1H2007-08 alone, up from $407 million (LE 2.18 billion) in FY2003-04) and liquidity is growing at its highest rate in more than four years; M2 (see box "The Value of Money") increased 21.5% y-o-y in January, contributing strongly to inflationary pressure.
Why is High Inflation Bad?
It may seem a somewhat redundant question, but it is an important one to ask.
If the purpose of economic growth is to increase people's wealth and hence their standard of living, then high inflation is not good. This is due to the fact that unless an individual's wage goes up faster than the inflation rate (the case for almost no-one in Egypt at current inflation levels), then they are becoming poorer. Inflation is particularly destructive in the context of high unemployment and widespread poverty both characteristics of Egyptian society. It pushes people even further into poverty, increasing dependence on subsidies and fueling social discontent, especially when it is the price of food that is on the rise.
Inflation-driven and in particular, food-driven social unrest has been rolling across the world over the last few months, with protests or violence witnessed in the Ivory Coast, Cameroon, Mozambique, Uzbekistan, Yemen, Indonesia, Somalia, Burkina Faso, Senegal, South Africa, Haiti, Argentina, Peru, Bangladesh, Vietnam, Afghanistan and Russia.
Closer to home, public protests, including the Mahalla riots, reflect discontent at the failure of wages to keep up with the cost of living, while the chaos surrounding subsidized bread distribution can be directly linked to food inflation.
All of this shows inflation for what it truly is: a very human issue. Not just in its impact on the poor, but also in its self-fulfilling nature. Once inflationary expectations are rooted in an economy, prices tend to escalate as businesses raise their prices in anticipation of cost increases or to take advantage of the inflationary environment to make more profit.
"It's always the case that inflation expectations are self-propagating. This is not new," says Moursi, "I think the general talk of the town is that people are betting that prices are going to increase."
In the worst case scenario, people (and foreign investors, see box "Foreign Investment and the Pound") lose faith in the value of money, creating major distortions and even economic collapse. Just consider Zimbabwe, which recently printed a Z$ 500 million bank note (worth around LE 10.70) to cater to inflation running at 165,000% per annum.
While this scenario may seem far away from Egypt's reality, there are a number of factors that are limiting the government's ability to respond to the problem.
Growth, Growth and More Growth
"The only viable scenario is growth, growth and more growth. Dealing with problems such as inflation and the budget deficit cannot distract us from the basic goal of boosting growth rates." That was Minister of Investment Mohamed Mohieldin speaking to local daily Al-Ahram in May, expressing a sentiment echoed by Finance Minister Youssef Boutros-Ghali in his comments to MEED, a business intelligence organization, at the recent World Economic Forum: "I need, at any cost, to maintain growth rates of 7% plus."
Despite acknowledging the effects of price increases, it may be fair to say that the government is more concerned with maintaining growth levels and ensuring social stability, than reigning in inflation, although not all analysts are in agreement: "Is there a consensus within the government that inflation ought to be curbed? Yes," says Moursi, "I think that there is a consensus that inflation is too high."
This overwhelming focus on growth sees the government juggling policies aimed at defusing public discontent with the less consumer-friendly decisions needed to fund them, all at the same time as maintaining its dedication to growth.
Rachid Mohamed Rachid, minister of trade and industry, acknowledges the fine line the government has to walk. "As a government, we now have to balance between our reform and development objectives and the protection of the low-income segments of the population. We need to achieve some sort of equilibrium," he said, speaking to Business Today Egypt in April.
On the monetary side, the Central Bank of Egypt (CBE) has been quick to act, initiating the third successive increase in overnight deposit and lending rates the short-term interest rates set by the CBE for its lending to, and deposits from, other banks to 10% and 12%, respectively.
In theory, interest rate increases put contractionary pressure on a growing economy. The Egyptian economy, however, has proven very resilient to the effects of interest rate change. "Our studies show that [] there is no significant effect of changes in interest rate on growth," says Moursi. His studies are outlined in more detail in a chapter he jointly wrote for The Egyptian Economy: Current Challenges and Future Prospects, a book recently published by the ECES: "The sharpest fall in inflation occurs one month following the shock [] After three months following the shock [] inflation begins to rebound [] The effects of the shock on interest rate and on inflation dissipate completely after twelve and four months respectively, following the initial impulse."
This resilience is partly a result of high levels of liquidity in the banking system. The CBE's efforts to drain off this liquidity the Bank siphoned off LE 69 billion in January and February 2008, compared to LE 18 billion in December 2007 have produced little result.
The government's decision to remove import tariffs on goods such as rice, oil, cement and steel in April was a step in the right direction, but only affects imported inflation. The decision to initiate export bans on rice and cement to increase domestic supply and counter price increases, on the other hand, while having a very short-term impact on prices, was quickly absorbed by strong demand. Bans in general are not a very effective policy tool, encouraging producers to switch to alternative production, reducing supply of the banned good, putting further pressure on its price and also resulting in the loss of export markets.
Similar to implementing price ceilings another idea that is often thrown around in inflationary periods bans and fixed prices lead to active black markets (think fertilizers and subsidized bread) and discourage increases in production, exacerbating supply problems. More than that, price freezes simply delay the inevitable in a globalized world, no country can remain insulated from the international market for long.
The areas that the government can tackle, and is already in the process of addressing, are the supply-side issues that underpin inflation. The release of 14 new cement and four new steel licenses, as well as increased investment to expand current production facilities, will help ease supply pressure over the next few years. The move to establish farms in Sudan and improve distribution systems through projects like the Italian funded Green Corridor project will also help, as will the large inflow of investment into the ports and shipping sector and the expansion of agricultural land and continued focus on improving productivity in the sector.
Supply-side initiatives, however, take time to implement, doing nothing to address inflation in the short to medium term. And while the government may look to appreciate the exchange rate as a short-term counter to imported inflation, this has problems of its own (see box "Foreign Investment and the Pound").
Budget Blow-Out
With its monetary policy seemingly toothless, supply-side initiatives still in the pipeline, and the exchange rate subject to market forces beyond its control, the primary tool available for the government to reign in economic growth and inflation is a contractionary budget.
Egypt's budget, on the other hand, has been running a deficit averaging 8.4% of GDP since FY2003-04. And while the government had been aiming to reduce this deficit by 1-1.5% annually, with a goal of a 3% deficit by FY2010-11, the effects of increased subsidies, international energy prices and the public sector wage increase, mean that this goal will be missed.
"We had a target of decreasing the deficit by 1% annually, but we will not be able to do that because of recent economic developments," Boutros-Ghali said at a press event earlier this year. The FY2008-09 deficit, he said, will be 6.9%, or about LE 70 billion arising from an increase of 24.7% in expenditures to LE 331 billion and revenues by 24.5% to LE 258 billion.
Tackling the budget deficit, however, means dealing with the issue of subsidies, which make up a hefty chunk (between 24 -40%) of the FY2008-09 budget.
At a time of social unrest, however, the government is steering well clear of any major reductions to subsidies, with the shadow of the 1977 bread riots which resulted in at least 70 deaths as the government tried to remove bread subsidies peering over its shoulder.
Despite the reticence to tackle such a sensitive area, there is no doubt the subsidy system needs to be updated. At heart this means targeting subsidies at those who truly need them, in the way that income support is managed in wealthier countries. And this needs to be done hand-in-hand with the continued implementation of the new tax system, which helps not only in paying for the subsidy system, but also in ensuring that the poorer segments of society feel that the burden of price increases is being borne by those who can afford it.
Kheir El Din, on the other hand, has a different view about the main problem behind the deficit. "We are all the time hammering on this issue of subsidies. The subsidy cannot be separated from the fact that incomes in Egypt are extremely low, wages in Egypt are extremely low," she says. "And there are other factors in the government budget which could cause inflation and no-one talks about them. For instance the servicing of the internal debt. One quarter of spending goes to servicing internal debt. Why is it that no one talks about this issue?" Unfortunately, the ability of the government to reduce its debt is dependent on running a budget surplus to release funds for paying the debt principle.
"The wage bill is enormous," she continues, moving back to the wage issue, "and the government is sustaining six million employees, which are not really necessary to run the government machinery. Why aren't we talking more seriously about bureaucratic reform?" she asks. "I think at present the food subsidy should be better targeted, but talking about removing it, given the level of inflation, given the level of salaries; I think is extremely unreasonable, politically that is," she concludes.
"In the course of liberalization some people will be harmed. Income disparities grow and the gap widens between rich and poor," said Mohieldin.
The resilient Egyptian public may have tolerated this situation in the past, but when the cost of food is skyrocketing, the shine on the economy dulls somewhat, and the failure of economic growth to 'trickle down' to the vast bulk of the population becomes a little less tolerable.
In many ways the government is now feeling the delayed effect of keeping wages low for so long. Now, as pressure for higher wages builds, the government is finding itself weighed down by a large budget deficit, a growing subsidy burden and a limited array of policy tools to respond.
In this position, if the twin handholds of foreign investment and a stable currency are yanked from its hands, the government may find itself treading air on the edge of a very slippery slope.
The Value of Money
Inflation itself is a somewhat confusing concept. Measured by the Consumer Price Index (CPI) a 'basket' of goods and services believed to represent the consumption of an average households inflation is an increase in the level of the prices represented by the CPI over time. Price changes are caused by changes in demand and supply across the economy. Changes in the demand or supply affecting one good, for example the price of wheat, do not usually lead to inflation, as the CPI measures the movement of a broad range of items. Price changes in goods such as fuel, which affect costs immediately and also have a flow-on effect to other prices, on the other hand, can be inflationary.
Inflation is also popularly thought of (in economic circles at least) as too much money chasing too few goods. The key to understanding inflation as it relates to money, is to think of money just like any other good on the market; if there are too many DVD players on the market their price will go down, too few and it will go up. Money works the same way: If you have LE 1000 in your pocket, that pair of shoes costing LE 90 is not as valuable to you as when you only have an LE 100 note; in fact, you might even buy two pairs. More money leads to a decrease in its value relative to other goods and services, reflected in an increase in their price this is inflation. An increase in the supply of money also (generally) increases demand for goods and services, leading to inflationary pressure, particularly if the supply of those goods and services is restricted. The amount of money in an economy the money supply, referred to as M2 is made up of currency in circulation and short-term demand or savings deposits.
Foreign Investment and the Pound
Foreign investment is a prime target of the inflationary beast. At the moment, the CASE is steaming along, buoyed by foreign interest in the profitable Egyptian market and seemingly oblivious to the business environment around it. This is typical of an inflationary environment, where business costs lag behind price increases, and companies milk the boosted profit margin over the short-term.
On May 15, however, the CASE fell 5.8%, its biggest single-day drop in two years, part of a 14% decline in the CASE since the fuel hikes were announced on May 5.
If fear of social instability, or simply the desire to cash in before the cost crunch, creates an outflow of foreign investment, it could hit the Egyptian pound, and the economy, hard. Signs of risk-wary investors abound in the international market place; Turkey and South Africa have both seen their currencies plummet due to investors' concerns over domestic inflation outweighing the perceived gains from higher interest rates. In the context of imported inflation, a depreciating currency would have a major impact on domestic inflation rates.
Putting a further dampener on capital inflow is concern amongst foreign investors that central banks in emerging markets are more concerned with growth and interest rate stability than controlling inflation, a concern which may be valid for the CBE, in the past at least.
Moursi, however, thinks that fears of an outflow of foreign investment may be overstated. "It depends on what the international businesses are coming to do," he says. "If they are coming to sell in the domestic market and the domestic market alone, then [currency depreciation] will not have a dramatic effect. If you are mainly targeting the international market, and those are few businesses to my knowledge that have been doing that, then there might be a problem."
Egypt has been protected to some extent by running a current account surplus over recent years. In 4Q2006-07, however, it slipped into the red and has remained in negative territory since, currently sitting at -0.1% of GDP. This is not a major concern at the moment, but if foreign capital begins to hemorrhage, the current trend of an increasing trade deficit from demand for imported goods escalates, or the government starts spending foreign currency reserves (a healthy $33.8 billion (LE 180.8 billion) in April) to prop up the Egyptian pound, the country may suffer. This is particularly so in the context of burgeoning public debt, which increased to $32.8 billion in 2007, and the associated servicing payments.
Kheir El Din says that regardless of foreign investment flows, the pound should depreciate. "Well if it's left free it should," she says, "not because investors are being scared off, but because our inflation rate, domestic, is much higher than that of our trading partners." Some sectors may consider a lower pound is not all bad news. "If there is depreciation we may be able to attract more resources from the outside world. Maybe tourism would improve. Services would probably improve. So we should be able to attract more external resources," she adds. But in a context where imported inflation is the primary concern, these benefits are outweighed significantly by the likely costs.
By Andrew Schurgott
© Business Today Egypt 2008
