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Reforming Egypt’s Untenable Subsidies

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Last week, Egypt's interim government renewed negotiations with the IMF to secure a $3.2 billion loan to alleviate its liquidity crisis. The loan will come with conditions, and will only partially address the projected $11 billion in financing that Egypt will need over the next two years. Subsidies will be front and center in negotiations.


Egypt's subsidy problems are particularly urgent. Egypt spends close to 10 percent of its GDP on subsidies, and almost everyone agrees that the subsidies are not effective at reaching the poorest of the poor. More than two-thirds of subsidy expenditures go to fuel, mainly benefiting transportation and industry, with the rest directed largely toward food subsidies. Overall, the government projects that it will pay almost $16 billion to subsidize energy this year, a 40 percent increase from the last fiscal year, due to the rising cost of energy globally.

Based on my recent conversations with policymakers in Cairo, there seems to be broad recognition across the political spectrum that the country's subsidy programs are untenable and must be reformed, but there is little consensus on how to do it. As the country faces mounting economic problems, including declining tourism, growing unemployment, rising consumer prices, and falling currency reserves, subsidy reform will be a tough challenge for the new government. Egypt's economy shrank by 0.8 percent in 2011, and faces a balance of payments deficit of $18.3 billion.

Although it is unlikely that subsidy reform can be agreed upon before the upcoming presidential elections, in the aftermath of that historic election, as a new constitution is drafted and the overall social contract between citizens and government in Egypt is restructured, the time will be ripe to implement a well-structured and well-communicated subsidy reform program. Egypt's new government should seize the opportunity to explain to its citizens the need for the painful adjustments and the benefits that will accrue from the changes. Critically, it must match subsidy reform with other structural adjustments--such as support for small and medium enterprises (SMEs) and formalizing the country's vast informal sector--that can generate new economic activity and expand the tax base.

Egypt's Subsidy Issues

Government subsidies tend to start out as well-intentioned assistance to a disadvantaged constituency, or with the goal of bolstering an important sector of the economy, but their market-distorting effects soon become apparent, and they too often end up helping the "wrong" people anyway. But once in place, subsidies are politically difficult to eliminate, even as they become unsustainably expensive and inefficient.

Egypt's food and fuel subsidies originated under former president Gamal Abdel Nasser, but became a fixture in 1973 when the price of commodities rose globally. Although previous structural adjustment agreements with the IMF targeted subsidies for reduction, Egypt's subsidies have stubbornly persisted. Egypt's leaders remember well that when former president Anwar Sadat tried to eliminate flour, rice, and cooking oil subsidies in 1977, the resulting riots shook the state. Hundreds of thousands of protesters flooded the capital, and the subsidy reduction was reversed. Today, illegal selling of subsidized flour and bread on the black market for higher prices is a problem, but represents a much smaller cost than the formal and informal subsidy of fuel.

Overall, subsidies of fuel make up 71 percent of spending on subsidies. Of this, only 14 percent is spent on liquid petroleum gas (LPG), which is used for cooking and fueling some of Egypt's many taxi cabs. The majority of households in Egypt rely on these butane containers for their cooking needs because they do not have gas connections in their homes. The government sells canisters for 2.75 LE, a tiny fraction of the actual cost of 80 LE, but a brisk black market siphons off supplies and drives up prices. Poorer Egyptians currently wait up to a week to collect a subsidized canister from government depots. Already, shortages and rising prices make the subsidy for cooking fuel an incendiary issue, with strikes and sit-ins taking place all over the country this past month.

The majority of fuel subsidies in terms of absolute cost go to diesel and energy-intensive industries like steel, cement, fertilizer, ceramics, and glass. These industries have been benefiting twice over because they receive their electricity and their fuel at subsidized prices. Many then export their products, keeping the profits. Not only has this led to inefficiency, but also corruption. Businesses rightly warn that increases in electricity and fuel costs will curtail growth so policymakers must be wary of squeezing businesses too hard, but neither can Egypt afford to subsidize inefficient industries in perpetuity. Subsidy reform entails winners and losers. Fiscally and socially, this moment of transition requires that Egypt reallocate its spending in more productive ways.

Tackling Subsidy Reform

In the past year, the government has indicated that it intends to reform subsidies, but none of these proposed reforms have been implemented. This is not necessarily a bad thing, as international experiences reforming subsidies reveal that sudden and uncoordinated changes to subsidies are wildly unpopular and largely unsuccessful. However, half-hearted attempts and lack of follow-through will be confusing and undermine public support.

In November 2011, the cabinet issued a decree to end subsidies on natural gas to energy-intensive industries in January 2012, but this did not occur. Similarly, the minister of supply and internal trade announced a new coupon system for distributing butane canisters in September 2011. The plan would distribute 14 million ration cards to the neediest Egyptians. It was supposed to be initially implemented in two sparsely populated governorates, but was not. Finally, the government is hoping to "cut" subsidies by switching to less expensive natural gas. Importing natural gas instead of fuel oil would reduce by half the government's expenditure, but it would also require upfront investment in infrastructure to make the switch possible. Rather than piecemeal pronouncements, a coordinated and comprehensive subsidy reform plan should be developed.

Iran's successful reform of its petroleum subsidies in 2010 points the way for Egypt. A wide-reaching public awareness campaign announced the increase in fuel prices months in advance, and the reforms were paired with direct cash transfers to more than 80 percent of the population. Families had to apply to receive a cash transfer, but the IMF noted (PDF) that the application process was well run and more than 98 percent of applicants were approved. Cash transfers were delivered in advance to the bank accounts of participating families, where the money was frozen but visible until energy prices increased.

Nigeria's subsidy cuts, on the other hand, illuminate mistakes that governments in similar situations should seek to avoid. On January 1 of this year, the Nigerian government attempted to end its approximately $8 billion of yearly petroleum subsidies in order to curtail abuse of the subsidy and to channel the savings into infrastructure. When the cuts came into effect, widespread protests and strikes erupted, ending only after President Goodluck Jonathan agreed to restore a partial subsidy. The causes of the unrest are clear. Citizens had only about two months to prepare for a future of higher prices, and only some of the poorest Nigerians were to receive any form of assistance. Moreover, Nigerian citizens, long accustomed to severe governmental corruption, had little confidence that the savings resulting from the cuts would actually be channeled into infrastructure and improve their quality of life in any way.

Egypt's current economic woes and political transition makes the prospects of a comprehensive and effective subsidy reform particularly challenging. In recent months, the government has been buying Egyptian pounds in part to stabilize the currency, since a weaker pound would make imported food and fuel more expensive (boosting the cost of subsidies even more). This spending has led Egypt's foreign currency reserves to plummet by more than half in the last year. At current spending levels, reserves are expected to last only for another three months, and the government is already buying energy on credit wherever it can. Currency devaluation looks more likely, but if devaluation occurs, it will become more expensive for Egypt to import food and fuel, a potentially grave situation for poor citizens.

But Egypt's brewing crisis also presents an opportunity to tackle a subsidy problem that has been decades in the making. An effective subsidy reform program should be phased in, focusing first on the most costly and inefficient fuel subsidies and only later addressing food and cooking subsidies, perhaps when certain economic metrics (say, a resumption of GDP growth in excess of 5 percent annually, or declining unemployment) are met. It should couple subsidy cuts with carefully explained direct cash transfers to households and other reforms to stimulate economic activity, such as an expansion of credit to SMEs, reductions in bureaucracy for starting new businesses, and formalization of the informal economy. Any subsidy reform program should also be matched with a public awareness campaign to explain the myriad benefits, including reductions in corruption, wasteful energy consumption and pollution, and improvements in efficiency.

Egypt's leaders should use this time of transition to push through much-needed subsidy reform that will put the country on a more viable economic path, and free up resources to be directed more efficiently to economic growth and poverty reduction.



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WALL STREET JOURNAL

U.S. Bureau of Economic Analysis