The risks of food subsidies
While food subsidies aim to forestall social instability, they do not address the real causes of poverty, writes Nader Noureldeen
Governments use subsidies to decrease the prices of goods to lower than those determined by the free market. While subsidies can play a positive role in ensuring social stability, they can also be controversial.
There are several types of subsidy. The government may directly give cash, which is then called direct transfer. The government may also provide tax deductions, referred to as a tax subsidy, or trade protection subsidies, which involve the use of taxes or quotas to limit imports. The sectors that most receive governmental subsidies are education, agriculture, healthcare, public transportation, housing loans, fuel and food. The advantage of a subsidy comes in the lowered prices of certain goods, which usually leads to an increase in consumption.
Non-oil-exporting countries are facing increasing fiscal pressures due to the recent shock of high food prices. In addition to causing inflation, food-price shocks directly affect trade and fiscal balances. Egypt has increased the wages of public-sector employees and has tried to support the poor by increasing bread subsidies, implementing direct cash transfers, and lifting tariffs on basic food commodities. However, these measures are not sustainable without concurrent increases in revenues. In order to finance the additional expenditures, oil-poor countries may be forced to reduce other essential expenditure or increase borrowing, which has a negative long-term effect on their economies.
Non-oil-exporting countries that rely significantly on cereal imports, such as Egypt, Jordan, Lebanon, Morocco, and Djibouti, all have fiscal and trade deficits, contributing to their economic hardships. However, rising revenues from other commodity exports have eased some of the burden in oil-poor countries that are rich in other natural resources. For example, Morocco's phosphate exports tripled in value in 2008 and covered the country's oil deficit, while Jordan's export of potash helped cushion its food import bills.
Across the board, food-subsidy programmes can create a substantial fiscal burden. Food-price shocks drive up the cost of government food subsidies. At the same time, a common government response to shocks is to increase the coverage and size of these subsidies, driving up costs even further.
In countries such as Syria and Egypt, which have across-the-board subsidies, the subsidies exceeded one per cent of GDP in 2007 (the subsidies represented 1.3 per cent of GDP in Egypt, according to a 2010 World Bank report), but became 10 per cent of GDP in 2012 and could become a major fiscal problem if commodity prices stay high or in the event of future price shocks. Meanwhile, social and political considerations may make rationalising food subsidies unpopular.
Rural poverty is at the core of the Arab countries' food-security problems. About one quarter of the population of Arab countries is poor, and 76 per cent of these poor people live in rural areas. Poverty rates in rural areas are also dropping more slowly than in urban areas, according to a 2007 report by the Food and Agriculture Organisation. With so many of the poor residing in rural areas, it is imperative that social safety nets are designed to reach these people, which programmes based on proxy means testing are not currently well equipped to do.
Higher food prices contribute to increases in the incidence, depth and severity of poverty. The poor in the region are hit hardest by food-price shocks, since they spend anywhere from 35 to 65 per cent of their incomes on food. Rough calculations suggest that, barring economic growth, a 30 per cent increase in food prices in Egypt would result in a 12 per cent increase in poverty (World Bank, Increasing Food Security in Arab Countries, 2010). What impact will the recent food-price shock have on inflation?
The answer is that it will have a major impact. The rise in food prices threatens macroeconomic stability primarily through inflation. Until recently, rising commodity prices were contributing to inflation throughout the world, and by some five percentage points in developing countries, according to the World Bank.
A recent study by the World Bank published in September 2010 had the following to say about the food-subsidy system in Egypt.
"Egypt's food subsidies, important for ensuring political stability, do not target specific groups. The subsidies were introduced during World War II and have never been targeted. Egyptians seem to perceive food subsidies as the most concrete benefit they receive from government spending. Seen as an entitlement, food subsidies are politically sensitive. In 1977, a cut was attempted but it sparked violent riots."
"The system is costly. Egypt's food subsidies consist of two programmes: baladi bread, which is available for purchase by all, and ration cards which provide fixed monthly quotas of cooking oil, sugar, rice and tea to households holding these cards. The fiscal cost of food subsidies reached about two per cent of gross domestic product in 2008/09 (LE21.1 billion, or $3.8 billion) after stabilising at around 0.9 per cent of GDP between fiscal year 1996/97 and 2000/01."
"If leakages are eliminated and coverage is narrowed, the government of Egypt could save up to 73 per cent of the cost of food subsidies. A large part of the food subsidies are diverted away from the intended uses. Waste throughout the supply chain of subsidised foods, using subsidised baladi bread as animal or fish feed, and selling subsidised foods in black markets are examples of system leakages. Furthermore, a large part of these subsidies, which are not targeted, go to the richest groups, while many poor do not receive any of these benefits. In 2008/09, LE5.5 billion (28 per cent) of food subsidies did not reach intended consumers, with baladi bread accounting for 68 per cent of the leakage and cooking oil for 20 per cent."
"If the government redistributed these savings to the poorest quintiles, their per capita benefits would increase considerably. In 2008/09, reducing leakages to 10 per cent and excluding the richest 40 per cent could have saved LE9.5 billion, or 48.6 per cent of the cost. The savings could have increased to LE12.3 billion [62.8 per cent of subsidies] if the richest 60 per cent were excluded."
"The food subsidy also favours urban areas, especially Cairo. In 2008/09, the Cairo governorate received much more than the expected share according to its share of the population. In contrast, all governorates in Upper Egypt, with larger shares of poor people, received much less than expected. The number of beneficiaries increased significantly between 2004/05 and 2008/09. In 2008/09, 81 per cent of Egyptian households purchased baladi bread (up from 76 per cent in 2004/05), 87 per cent purchased baladi bread and baladi wheat flour, and 68 per cent were holding ration cards (up from 58.5 per cent in 2004/05)."
"Consumer benefits also increased. Per capita benefits from baladi bread increased between 2004/05 and 2008/09 by almost half to LE147 a year. When wheat flour is added, the per capita consumer benefits increase to LE171 a year. Similarly, per capita benefits from ration cards increased to LE125 a year (2.7 times). Urban consumers benefit most from baladi bread subsidies, while rural consumers benefit from ration cards."
"Food subsidies lifted nine per cent of Egyptians out of poverty in 2008/09. Although food subsidies provide only a small proportion of total per capita consumption in Egypt, the incidence of poverty in Egypt would have increased from 20 per cent to 30 per cent in the absence of food subsidies. Baladi bread, the most important subsidised food, accounts for most of the poverty impact. Leakages in the system cost the budget LE5.5 billion in 2008/09."
It can be seen that the food-subsidy system has advantages, but there is an urgent need to start the reform process. In spite of several positive aspects of the food-subsidy system in Egypt, mainly its significant poverty reduction impact, the World Bank study provides hard evidence of the large losses in the subsidy bill, whether in terms of leakages to non-intended beneficiaries or benefits received by non-needy groups. International experience shows that Egypt's system is no different from universal subsidies and ration programmes all over the world. They are all vulnerable to leakages, suffer from errors of inclusion and of exclusion, and are biased towards urban populations.
As a result, some concrete recommendations can be made.
First, move baladi bread subsidies to the end of the supply chain. There is evidence that the longer the distribution process and the larger the number of transactions, the more opportunities arise for leakage. Besides, incentives for agents to leak goods from one market to the other will persist as long as there is a substantial difference between the regulated price and the market price. Therefore, in addition to the separation of production and distribution, and attempts to introduce a flour-tendering system in some governorates, the government is now planning to purchase bread directly from bakeries at market prices and then sell it at subsidised prices in bread outlets.
Second, ensure that smart cards enable beneficiaries to get their full share of benefits. Smart cards now cover 19 governorates, but they should cover the entire country before the end of 2013. The use of smart cards has resulted in large savings in the procured quantities of subsidised foods.
Third, replace food subsidies with food coupons or stamps. Food stamps usually provide a way to phase out general food subsidies, as they have done in Jamaica, Sri Lanka and Jordan. These programmes may also be effective in terms of reducing leakages and increasing the effectiveness of subsidies.
Fourth, use geographic targeting in the distribution of food subsidies. To have an equitable food-subsidy system, the allocation of food subsidies should be made according to the shares of governorates in poverty. Thus, governorates that do not receive food subsides proportional to their shares in poverty should receive increased food subsidies. According to the budget constraints and political conditions, this could take place while keeping for a transient period the subsidies unchanged for other governorates that do receive shares of subsidies that are higher than their shares in poverty, or by gradually dropping quotas or items received by these governorates.
Fifth, improve the self-targeting of food subsidies. Self-targeted programmes are technically open to everyone, but they are designed in such a way that the level of benefits is expected to be higher among the poor. Accordingly, home-delivery services of baladi bread should be wound down in favour of using distribution outlets for better geographic targeting to neighbourhoods.
Government subsidies tend to start out as a form of 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. However, once in place, subsidies are politically difficult to eliminate, even as they become unsustainably expensive and inefficient.
Egypt's current economic woes and political transition make the prospects of comprehensive and effective subsidy reform particularly challenging. 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.
The issue of social stability and the increased percentage of poverty that has taken place within the last two years should be considered carefully, because most of the violence and riots that have occurred in developing countries have done so as a result of soaring food or fuel prices.
The writer is a professor in the Faculty of Agriculture at Cairo University and former consultant to the minister of food supply and interior trade.