The shakiness of the economy could undermine progress towards democracy
Jun 23rd 2011 | CAIRO
FOR almost a month after the fall of Hosni Mubarak, the police vanished from the streets of Cairo. Integral parts of the reviled regime, they did not want to show their faces. Thanks to the self-discipline of Cairenes, there was little public disorder. But one thing did change: the traffic got even worse. With most of the traffic lights out and no cops, cars slowed to a crawl at every intersection.
Inadvertently, Egypt was trying out an idea from Dani Rodrik, a Turkish economist. Mr Rodrik compares a crossroads in Hanoi (but it could be Cairo) with one in Russia. In Hanoi, there are no traffic lights; cars and carts crowd into an impenetrable tangle, yet everyone gets through somehow. By contrast, in Moscow the lights work; columns of cars stop and advance in turn—right up to the moment some idiot in a truck runs a red light and smashes into the waiting queue. This happens again and again and again.
Egypt is now testing the merits of informality. The old corrupt rules are discredited. The government is running the economy from hand to mouth. It has no real mandate and lacks the confidence to tackle Egypt’s deep-seated problems. It is getting by, more or less. But nobody knows if muddling through will work.
Much is at stake in Egypt economically, as well as politically. Like other Arab economies, the country has what might be called a patriarchal economy, with a weak private sector dependent on a dominant state one. Such an economy is the counterpart to autocracy, and in the economic sphere, just as much as in the political one, Egypt is a test for the Arab world. If it can prosper, others can too.
The economy also matters to democracy. Most people poured into Tahrir Square in January because of economic discontent, as well as for political reasons (at any rate, that is what they told pollsters from the International Republican Institute). Many Egyptians, argues Ahmed Heikal, Egypt’s biggest private investor, underestimate the impact the economy is likely to have on the political system. If the economy improves, that should help consolidate democracy; if it falters, so will political reform.
It therefore seems all the more worrying that the first thing the economy did after the revolution was behave like a Russian truck. On January 25th, the day of the first big anti-Mubarak demonstration, an IMF mission had left Cairo saying the economy was motoring along. GDP was growing at 5% a year. The banking system was strong; so was the balance of payments (official reserves covered about eight months’-worth of imports).
After the uprising, GDP crashed, falling by 4% in the year to the first quarter. Manufacturing declined by 12%. Revenues from tourism collapsed, putting pressure on the balance of payments and starting a slide in foreign reserves (see chart 1). Official reserves have fallen by $9 billion this year, and the real figure may be higher (Egypt is thought to keep some reserves hidden). The government has estimated that it faces an external-financing gap of about $11 billion in the second half of this year and the first half of next.
How bad is this slump? A nine-percentage-point fall in GDP growth, from plus five to minus four, is less than some of the East Asian countries suffered after the recent financial crisis. Considering there was no public security for weeks, that banks and the stockmarket were closed, that strikes proliferated and investment collapsed as large numbers of leading businessmen were carted off to jail, things could surely have been worse.
Still, they were bad enough. The government faced immediate financing problems and the threat of a full-blown foreign-exchange crisis. Public expectations went through the roof, just as the economy’s capacity to meet them collapsed. Ziad Bahaa el-Din, a former head of Egypt’s investment authority who is now running for parliament, says that in his village 400km (250 miles) south of Cairo the young men have lost their hotel jobs and now sit around in the coffee house, mobiles in hand, waiting vainly for odd jobs. A backlash is growing. “We went to Tahrir Square and now we don’t have any customers,” laments Hany abd-el-Fattah, a tent-maker from Bab Zuwayla in Cairo.
The task of managing the mess has fallen to an interim government of technocrats, former opposition politicians and a few Mubarak holdovers. The circumstances look inauspicious. Though the government says it is laying the foundations for reform over three to five years, in reality it is only a stopgap administration, in office until elections planned for later this year. Though needing to make changes, it is cramped by hostility to the market reforms launched in the last years of the Mubarak regime. And though supported by demonstrators from Tahrir Square, it has no real mandate. It does not even seem to have the full backing of the military council that has the ultimate say over things in Egypt. The secretive generals—so far as one can tell—are mostly concerned with keeping the peace and deterring anyone who wants to stop them resuming their former position back-seat-driving the country. The result has been a government that is risk-averse to a fault.
Facing widespread demands for “social justice”—one of the few aims everyone can agree on—the government raised the top rate of income tax slightly and introduced a minimum wage of £E700 ($118) a month. Egypt can probably afford this; £E700 is equal to the poverty line and is low enough not to destroy jobs (though the amount is planned to increase). The government is also proposing a cheap-housing programme and a number of job-training stipends. Total social spending (including education and health) is to rise about 20% in the next 12 months.
Given the size of the slump, a temporary increase in the budget deficit is justifiable. And this one (a boost of two percentage points of GDP) is relatively modest—relative, that is, to the fiscal deterioration in rich industrialised countries after the 2007-08 slump. The IMF, at any rate, praised the budget.
And to give it its due, the government succeeded in forestalling the worst. There has been no bank collapse and no run on the pound. The stock exchange reopened without alarms. The foreign-exchange crisis is moderating: reserves fell $800m in May, compared with $3 billion in March. The government was also successful in raising $11 billion from foreign governments and international financial institutions. In fact, if you include all the various promises from Gulf states, the grand total could be over $20 billion—a remarkable vote of confidence in Egypt.
Despite its limitations, the first post-Mubarak government had one precious—even unique—advantage. It came to power at a heady moment of change, when Egyptians were ready to accept painful measures as well as handouts. Its freedom of manoeuvre was greater than it seemed. It did not have to please a constituency of supporters, nor did it have to look for votes in a future election. At the very least, it had a chance to come clean about some of the hard choices facing the country.
That chance was lost. The government’s first act was to approve a 15% public-sector wage rise proposed in Mr Mubarak’s dying days. It boosted state pensions and gave 450,000 contract workers permanent jobs. The total wage bill could rise 25%. It is not clear the government could afford this. The problem is not just the cost of the bill but the message it sends: the government “comes across as trying to please as many people as possible”, complains Ahmed Galal, the head of the Economic Research Forum, a think-tank.
It has also been inconsistent. It said it would implement a property tax proposed by Mr Mubarak and widely regarded as desirable. It then scrapped the idea under pressure from landowners. It proposed a capital-gains tax on dividend payments and scrapped that, too.
But its worst failure is over what Mr Heikal calls the elephant in the room: fuel subsidies. For years the government has sold every kind of fuel at below—often well below—world market prices, and paid the difference. It also subsidises bread and other staples. The direct costs are soaring (see chart 1): food subsidies now account for 2% of GDP; fuel consumes 8%. In all, subsidies cost almost three times the size of the education budget.
This is a grotesque distortion of national priorities. Fuel subsidies help the rich more than the poor. One driver of a gas-guzzler reckons the government gives him £E150 every time he drives from Cairo to Alexandria. They keep alive uneconomic energy-intensive firms. They help businesses that need no help. Tourism takes a fifth of diesel subsidies, which are therefore fuelling air-conditioning in luxury hotels. In contrast, some of the poorest people in the country do not get the cheap food they are nominally entitled to because they live beyond the reach of the system that administers it. That system is made staggeringly inefficient by theft and leakages. A former finance minister said he could administer the subsidised bread programme only if he had one security guard for each sack of flour.
Cutting subsidies is hard. Some do help the poor, who need to be shielded from the cost of removing them. Immediate removal would also send prices spiking (though the deficit-financing cost is inflationary, too). But everyone knows the existing system is corrupt and that the country needs a targeted programme to ensure subsidies go to those who need them. Hania Sholkamy of the American University in Cairo got as far as setting up two pilot conditional-cash transfer programmes, one for 400 families in a Cairo slum, the other for 24,000 families in a poor region of Upper Egypt. Inexcusably, the new government shut them down, apparently because they had been started under the old regime. The government says it is planning a subsidy reform. But in the budget for 2011-12—its main economic programme—it did nothing. Indeed, it expanded the system to keep pace with rising world food and fuel prices. Subsidies will cost 9% more this year.
The government could and should have done better than this. It avoided the worst, and bought democracy some time. But it postponed decisions that need to be taken if Egypt’s economic problems are not to worsen. Moreover, inflation and unemployment are bound to rise in the short term, partly because of the slowdown and especially because Egypt is vulnerable to rising commodity and fuel prices. So the next government is likely to be even more scared of change than today’s. That government will be Egypt’s first elected regime for decades. The last thing it will want to do is court unpopularity right away, and possibly imperil the fledgling democratic system.
Nonetheless, it will have to bite the bullet. To call Egypt’s economy a failure would be too much, but it has not done nearly as well as it could. A fifth of the population lives on $2 a day or less, and another fifth lives just above that level. Almost everyone thinks the number of poor is growing. Neither they, nor the entrepreneurial middle classes, have benefited from what growth has taken place. Moreover, the cost of failing to produce new jobs is rising, as the babies born a generation ago (when fertility rates were higher) are entering the job market. The cohort of 15-20-year-olds is the largest among the population (see chart 2). If this demographic dividend is to be cashed, and if democracy is to take root, then living standards will have to improve.
As a measure of what is needed, compare Egypt with Turkey, a country of similar size (75m people) and, in the 1990s, similar economic performance. At that time, Turkey was roughly as wealthy as Egypt is now (its GDP per head at purchasing-power parities was $5,500; Egypt’s is $6,300 at PPP). Like Egypt, it had persistent inflation (indeed, its record was worse). And for years its army lorded it over a series of weak civilian governments. Now Turkey’s average income is $13,000, which puts it into the World Bank’s category of rich economies. Last year 28m tourists visited the country. Egypt, with its pyramids and pharaonic treasure, got just 11m. If Egypt is to catch up, it will have to do what Turkey did: reduce the overweening power of the state and provide an environment in which private firms, especially long-suffering small and medium ones, can thrive.
The state’s role is too large. Despite fitful periods of reform, the public sector still accounts for over 40% of value-added outside agriculture—higher than in most former communist economies. The state controls some prices directly and influences others through subsidies. The army controls an estimated 10-20% of the economy (no one really knows), including things like olive-oil and pest-control factories which serve no military purpose. And the government is hooked on deficit spending. Though the deficit has not risen much, it has long been too large, and is now 11% of GDP. Turkey’s is 3%. Egypt needs to cut its deficit to near that level—which requires subsidy cuts.
Yet where a strong government is needed—as regulator, enforcer of contracts and guarantor of competition—it is weak. Its welfare provision is a shambles, with an incomprehensible tangle of entitlements which still leaves gaping holes in the safety net. The quality of state provision is an even bigger problem than its quantity. Only in the external sector (reducing barriers to trade and foreign direct investment) and, partially, in banking have reforms been successful.
One result is that private firms are knotted in red tape. Egypt comes 94th in the World Bank’s “Doing Business” measure of regulations. Small and medium-sized companies cannot get credit from state banks. Many small firms do not even have bank accounts. The new government is planning to create a financial instrument for small firms. It is a start, but the next government will have to do a lot more.
It will also have to reverse the long-term failure of Egypt’s education system, something beyond the remit of an interim administration. Once a centre of Arab learning and an exporter of teachers to the Arab world, Egypt has seen its education standards decline alarmingly. This is partly for lack of money—the country spends a smaller proportion of GDP on education than most Arab states—but is also a result of bad organisation. The quality of everything, from schools and equipment to teachers, is appalling. The ministry of education employs as many bureaucrats as teachers, and there is no national teaching accreditation system. Educational failures cast a shadow over the quality of the workforce.
What are the chances that Egypt can rise to these challenges? In the long run, reasonable. The country has real advantages. It is the most populous Arab country and, because it is not dependent solely on oil, offers a bigger menu to investors. As a location—on the Suez Canal linking Europe, the Middle East and Africa—it is hard to beat. In common with other Arab countries, it has favourable demographic trends, with a growing labour force and a declining dependency rate (children and pensioners as a share of the working-age population). On the rare occasions the government started to liberalise—in 1974-79, 1991-98 and 2004-08—the economy boomed. “This is an economy that can bounce back,” says Ratna Sahay, the head of the IMF’s delegation to Egypt.
The big uncertainty is politics. Many Egyptians are optimistic, arguing that the removal of Mr Mubarak and plans for elections and a new constitution remove the biggest source of political doubt: what happens after the pharaoh. They also argue that there is a broad consensus supporting private-sector-led growth. A group called the Coalition of Revolutionary Youth, formed by Tahrir Square demonstrators, has a market-oriented economic policy to which all the main parties—including the youth wing of the Muslim Brotherhood—has signed up.
Yet this seems over-optimistic. Political uncertainty is everywhere. It is unclear whether post-Mubarak Egypt will have a presidential or a parliamentary system. It is not certain whether the elections will take place before the constitution is agreed (as the army says) or after (as liberals want). No one knows how much support the Muslim Brotherhood and the old-fashioned left have. No one knows how strong the temptations of populism could be.
On balance, if the politics stays stable, the economy should do well enough to consolidate democracy eventually. But that is a big if. As Mr Heikal says: “If we get things right, we could be Turkey in ten years. If we get them wrong, we could be Pakistan in 18 months.”