Public Information Notice No. 10/49

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with the Arab Republic of Egypt

April 14, 2010

On March 24, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Egypt.¹

Background

Egypt made significant progress in wide-ranging structural reforms that accelerated after 2004. This spurred rapid output growth—averaging 7 percent a year during FY2005/06 FY2007/08—underpinned by foreign investment-driven productivity gains and the favorable external environment. Reforms also reduced fiscal, monetary and external vulnerabilities, leaving some room to maneuver on macroeconomic policies in the event of negative shocks.

Egypt weathered the global financial crisis relatively well and financial market pressures eased after the initial outflow. Equity prices plateaued in recent months, after having recovered over half of the losses since the April 2008 peak. Egypt’s sovereign spreads tightened during 2009 and, in early 2010, remain well below their pre-Lehman levels. The temporary financial outflow was met mostly with a drawdown in the central bank’s foreign currency deposits with commercial banks, reversing the buildup in 2006 07 and limiting the impact on the Egyptian pound and real economy. The authorities allowed some additional nominal exchange rate flexibility, with the pound depreciating by about 6 percent between September 2008 and March 2009, and subsequently appreciating (with resumed capital inflows) almost to its pre-crisis level.

The real economy held up relatively well in the face of weaker external demand. Although the current account moved into deficit (2.4 percent of GDP in FY2008/09) as service receipts and remittances declined, and investment and activity softened in exposed sectors, growth still reached 4.7 percent in FY2008/09. Resilient domestic consumption demand, and production in the construction, communications, and trade sectors, helped sustain growth and the pick-up to nearly 5 percent in the first half of FY2009/10.

The government reacted quickly to the crisis by providing a sizable fiscal stimulus in the second half of FY2008/09 based mainly on accelerating investment projects. Key fiscal reforms such as introducing the property tax, broadening the Value Added Tax (VAT), and phasing out energy subsidies were postponed. The FY2009/10 budget continues to support economic activity and targets a wider deficit of 8.4 percent of GDP largely reflecting a substantial projected cyclical fall in revenue (particularly from trade and Suez Canal traffic), as well as the impact of wage increases adopted before the crisis and higher post-crisis debt service costs.

Reducing the fiscal deficit and public debt are key medium term objectives. Egypt’s public debt remains high in comparison with many other emerging market countries. While much of the debt is denominated in local currency, the maturity structure is short, creating an annual rollover requirement of 20 percent of GDP. To address this vulnerability and help spur private sector-led growth, the government has announced its intention to reduce the deficit to about 3 percent of GDP by FY2014/15.

Supportive monetary policy helped resist crisis-related pressures. The Central Bank of Egypt (CBE) cut policy rates six times between February and September 2009 as both headline and core inflation declined rapidly to single digits by August 2009. The deceleration of inflation stalled since October 2009, with headline inflation rising above 13 percent, mainly due to supply shocks in several food categories. In the absence of demand pressures, the pick-up in headline inflation has not become more widespread, and core inflation remains in single digits and inside the CBE’s informal comfort zone. Accordingly, the CBE has kept rates unchanged in the past three Monetary Policy Committee meetings.

The CBE’s Phase I banking reforms (2004 08)—strengthened supervision, restructuring and consolidation, and a cleanup of NPLs—reduced financial vulnerabilities. Also, limited reliance on short term wholesale funding channels and relatively traditional portfolios, allowed Egyptian banks to sidestep many of the detrimental effects of the crisis. While the financial system remains stable, the CBE’s Phase II reforms (2009 11) seeks to implement Basel II standards and improve access to credit.

Executive Board Assessment

Executive Directors agreed with the thrust of staff’s assessment. They commended the authorities’ sound macroeconomic management and the reforms implemented since 2004, which had strengthened the resilience of the Egyptian economy in the face of the global financial crisis.

Directors praised the authorities’ policy responses to the crisis. The targeted fiscal stimulus and successive cuts in interest rates helped cushion the impact of the global slowdown. Directors observed that economic performance held up well, with growth falling less than in many other emerging markets during 2008/09, and picking up further in recent quarters. Financial market conditions have improved and some capital inflows have resumed since the initial downturn. However, inflation remains elevated despite falling substantially from the peaks experienced in 2008.

As the recovery gains strength, Directors underscored the importance of shifting policies back toward fiscal consolidation and other reforms. They supported the authorities’ objective of reducing the fiscal deficit to about 3 percent by 2014/15, in light of the still high public debt and large financing requirement. Directors encouraged the authorities to make a substantive step to reduce the fiscal deficit at an early stage—to lessen vulnerability, boost confidence in the fiscal adjustment strategy, and speed the response of private investment. Increasing the low tax revenue-to-GDP ratio with a full-fledged VAT, and improving the efficiency of public spending by reforming energy subsidies and pensions will be crucial to achieving the authorities’ fiscal objectives. Directors saw merit in strengthening public debt management through lengthening debt maturities and diversifying the debt structure.

Directors agreed with recent decisions to keep policy interest rates stable. However, if inflation does not abate as expected, they encouraged the CBE to consider tightening monetary conditions to prevent a buildup of inflationary momentum. They also saw further reductions in inflation toward partner country levels as a key objective for the coming years. Directors noted that continued short-term capital inflows could challenge monetary policy making, and encouraged continued increases in exchange rate flexibility.

Directors agreed that continued broad-based reforms are needed to foster inclusive, employment-generating growth. Priority reforms should focus on improving the investment climate and raising productivity. Developing public-private partnerships can help mobilize private sector financing and know-how, but associated contingent liabilities should be monitored closely. Fiscal adjustment and productivity-enhancing reforms also will reduce the risk of real exchange rate appreciation and help maintain competitiveness. Directors supported ongoing financial sector reforms to help contain risks and improve private sector access to credit. They encouraged forward-looking risk management and in this respect welcomed plans to introduce Basel II standards.

Directors also pointed to the need to enhance data quality and availability to help improve the policy debate and business environment.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.