How sweet is it?

Is Egypt entering a new upturn cycle? Well yes, and no, writes Wael Gamal

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In July 2004, just days after the cabinet reshuffle, EFG-Hermes issued a report entitled Government Changes: Entering the Sweet Spot in the Reform Cycle. Six months on and the brokerage company and investment bank has issued a second report, In the Sweet Spot. It is one more example of the optimism that has come to pervade business circles. The question is, is it justified?

The report concludes that Egypt's economy is entering a cyclical upturn after the boom- bust cycle of 1993-2002, noting that "following the devaluation of the Egyptian pound on 28 January, 2003 real GDP growth began to accelerate after four consecutive years of deceleration."

"The restoration of external and internal balances in the first cycle was the outcome of one-off positive shocks including Paris Club external debt relief, the inflow of conditional financing via stand-by arrangements with the IMF, and the devaluation of the pound vis-à- vis the US dollar by around 65 per cent in 1990. One-off shocks," the report continues, "existed in both cycles, such as the surge in Suez Canal revenues due to military traffic associated with the first (1990) and second (2003) Gulf wars."

Similarities extend to macro-economic variables: "The pick-up in both cycles was preceded by fiscal excesses, inflationary pressures, an overvalued currency and negligible growth in credit to the private sector. In the first cycle, these imbalances were addressed via external assistance, privatisation of state- owned assets, liberalisation of product markets and a one-off devaluation. Similar measures have already been envisaged to address similar imbalances since 2003."

The report does, however, identify at least one major difference -- that "the first cycle was primarily driven by domestic demand whereas the second is driven mainly by external demand". More importantly, the improvement in external and internal balances in the first cycle was driven by "one-off exogenous factors whereas the fundamental improvement in external competitiveness has been driving the recent restoration of the external balance".

The report's conclusion appears to run counter to Egypt's falling competitiveness ranking in international indices -- Egypt was down again in 2004 from 58 position to 62. Yet the Egyptian economy, argues the report, is now less vulnerable to external shocks.

The report examines the Egyptian response to six major external shocks from 1997 until present. Only the first shock, the East Asian financial crisis in July 1997, was non-political in nature. The remaining five reflected domestic or regional tensions -- the Luxor attack, the second Intifada, 9/11, the war on Iraq and the Taba attacks. In analysing the effect on the stock exchange the report concludes that the Taba incident had a minimal impact on the market whereas the Luxor attack aggravated an already bearish investor base. On the other hand "the market penalised the attacks on the US and rewarded the US invasion of Iraq."

It is questionable, though, whether the stock exchange, which is still dominated by local big players, can serve as a proxy for economic health. Nor is the Taba incident easily compared to the attacks in Luxor: the former targeted Israeli tourists while the latter was an outgrowth of the political confrontation between the state and political Islamists. It is hardly surprising that the market should react differently.

In fiscal year 2003/04 real GDP growth rate grew to 4.3 per cent, lagging behind other emerging markets. It was driven almost exclusively by tourism, Suez Canal revenues and a surge in oil prices. The only local factor, then, was the first.

"The tourism sector," the report suggests, "is witnessing a structural improvement in competitiveness. Rising demand for tourism was evident in the 75 per cent growth in the number of tourist arrivals from 4.3 million tourists in the financial year 2001/02 (impacted by 11 September) to 7.5 million tourists in financial year 2003/04 and the growth in tourism revenues from around $3.2 billion in 2001/02 to over $5.3 billion in 2003/04."

Tourism and the Suez Canal accounted for approximately 85 per cent of the 27.5 per cent growth rate in aggregate services receipts in fiscal year 2003/04. As a result the balance of goods and services, excluding net factor income, recorded its first surplus in modern history.

These inflows, together with falling demand for imports as the recession deepened and low private investment rates, helped ease the pressure on the Egyptian pound.

Gauging possible exchange rate misalignments, the report argues, is essential: there are "negative trends that are not worrisome in the near term but that necessitate remedial measures once the overshoot from past devaluations has been recovered. Fiscal consolidation is the key to avoiding further deterioration in currency cover, stemming inflationary pressures and decelerating the pace of real appreciation".

The accumulation of a large stock of domestic public debt and an associated rise in debt servicing costs is another key feature of the current cycle. The report is confident in the new government's approach towards the problem.

"The new government seems to be aggressively targeting this objective via the rationalisation of current expenditures, particularly indirect subsidies and the maximisation of current revenues via tax policy and administration reform," it says. It also believes the government "should lever the export-driven recovery to push fiscal consolidation further and offset the loss in fiscal stimulus through strong private sector growth". This last, of course, has been made harder by the recent rise in the pound, which is likely to impact negatively on exports, and by the downward pressure of tax and custom tariffs on budget revenues.