The COVID-19 inflation episode: Lessons from emerging markets


The COVID-19 inflation episode: Lessons from emerging markets



Unrest in Egypt: Political Challenges to Economic Stabilization

On November 20, the International Monetary Fund announced that its mission to Egypt has reached a staff level agreement with the Egyptian government on a macro-stabilization program. That was important news for President Morsi’s administration. Approval of this agreement by the IMF’s board would give Egypt access to about $14.5 billion of much needed foreign financing, including $4.8 billion from the IMF. However, the current political turmoil—following the November 22nd constitutional decree that gave the president powers over the judiciary—will probably make implementation of the agreed program more challenging.

Restoring economic stability is an urgent priority. The Egyptian economy has been in the doldrums since the revolution of January 25, 2011. Ad hoc financial support from Saudi Arabia, Qatar, Turkey, and other regional partners and financial institutions has so far helped avert a serious financial crisis. That is why a strong macro-stabilization program, with the IMF’s stamp of approval to enhance credibility, is needed as an important first step toward restoring confidence in the Egyptian economy and putting in place policies to restore growth and improve social equity.

According to a press statement by the IMF’s mission chief to Egypt, fiscal reforms (that include reforming fuel subsidies) are a key pillar under the program agreed with the Egyptian government. The objective is to reduce the government deficit from about 11 to 8.5 percent of GDP. He also stressed the importance of monetary and exchange rate policies to enhance competitiveness, to stimulate trade and to attract capital inflows. This means that the Egyptian authorities are expected to take politically difficult decisions on fuel subsidies, and probably on the exchange rate as well.

The Egyptian government spends about 6-7 percent of GDP on fuel subsidies. Therefore, any deficit reduction program will have to include actions to cut and eventually eliminate them. Further arguments for cutting fuel subsidies include the fact that a large portion of those subsidies go to the better off (according to the World Bank, 57 percent of the subsidy goes to the two top percentiles of the income distribution), as well as the fact that they encourage over-consumption of energy (it is estimated that the energy intensity of the Egyptian economy is 2.5-3.0 times higher than that of OECD countries).

On the other hand, Egypt’s poor and middle class also benefit from fuel subsidies, and cutting them will have social and political repercussions. For example, Jordan has recently tried reducing subsidies and the result has been widespread unrest. When President Sadat tried reducing subsidies in Egypt in 1977 mass protests forced him to reverse the decision.

Experience from other developing countries that have succeeded in lowering fuel subsidies (e.g. Ghana and Indonesia) indicate that there are two keys components to success: compensatory policies to help the vulnerable and public information campaigns to try and build consensus on the reforms. The recent bout of political unrest complicates Egyptian government efforts to launch an effective national dialogue on fuel subsidies.

The IMF’s 2010 Article IV consultation report with Egypt states that the local currency “appears somewhat overvalued.” Since then the nominal exchange rate has depreciated by about 7 percent, which is not enough to cover the inflation differential between Egypt and its trading partners. That is, the real exchange rate has continued to appreciate. If the real exchange rate was “somewhat overvalued” in 2010 when the economy was growing fast and had large external reserves, it is probably significantly overvalued in 2012 when growth has stalled and foreign reserves have dwindled to cover less than three months of imports.

A depreciation of the Egyptian pound may very well be required to enhance competitiveness, attract foreign investment, and reduce the current account deficit. But such depreciation would also increase the domestic prices of imports and reduce the purchasing power of the poor and the middle class. This is particularly true because Egyptians are highly dependent on imported food. Hence, implementing exchange rate realignment in the current political climate may be quite challenging.

In his press statement on November 20, the IMF mission chief stated that “broad based domestic and international support will be crucial for the successful implementation of the planned policies.” The international community has repeatedly expressed its desire to support Egypt’s economic program, and the IMF has acted quickly to mobilize this support. Therefore, it seems that the real challenge today is to build broad-based domestic support and a national consensus on the necessary economic reforms, a task made more difficult by the recent unrest.