Egypt: Reform continues to boost sentiment

We have reduced Egypt's GDP growth estimate for the current FY2005/06 following the multiple terrorist attacks on the Red Sea holiday resort of Dahab at end-April. The bombings caused the death of over 23 people, including a number of tourists. These were followed by two suicide attacks on security personnel and foreign peacekeepers in the Sinai Peninsula. Beyond the appalling cost in lives, the attacks are forecast to inflict damage on the country's important tourism industry; the sector is the main employer in Egypt and is a key source of FX earnings. We have reduced our real GDP growth forecast from 6.0% to 5.8% as a result. Although tourism recovered well following bombings in Taba in 2004 and Sharm al-Sheikh in 2005, this third attack could impact tourist sentiment by a greater degree. Given the location and links with the previous attacks, the Sinai segment of the industry is likely to suffer. The government has blamed these (and previous) terrorist attacks on the Tawhid wal Jihad group, which they say is made up of Sinai Bedouin with militant Islamist views. Holiday cancellations were seen following the attack, especially last minute bookings. However, the fact that the peak tourist season has already finished should limit the economic fallout.

Furthermore, the economic outlook continues to be supported by the government's reform program, with domestic and international sentiment remaining strong. The latest official data indicates the economy grew at an annual rate of 6.1% in Q4 2005. Both private consumption and investment continue to be supported by the government's reform measures, including lower taxes and tariff rates. Moreover, a new strategy for the industrial sector, which has been identified as a major growth driver, is producing results. Investment incentives in the qualified industrial zones (QIZs), and government support to local manufacturers aimed at raising quality standards and efficiency have already provided a boost to exports and created jobs. These factors will continue to support the economic outlook in FY 2006/07. In addition, private consumption and investments should be supported by the continuation of the government's expansionary stance (see next page) and interest rate cuts. In April, the central bank reduced overnight interest rates by 25bps to bring lending rates to 10% and deposit rates to 8%. This follows a 50bps cut in January and a 25bps cut in December 2005. These rate reductions are on the back of slowing inflation: CPI decelerated in March to 3.7%, from 4.0% in the previous month.

Foreign investment will continue to be driven by the government's privatisation program. In March, the government invited expressions of interest from strategic investors interested in buying 75-80% of the stateowned Bank of Alexandria; the sale of the bank is expected in H2 2006. In preparation for this divestment, Bank of Alexandria sold its 29.9% stake in Misr Iran Development Bank in April and plans to make further divestments of other banks and companies. The majority stake sale of the bank is the first stage and a key tenet of the government's banking reform program. The banking reform program includes the privatisation of the country's state- owned banks, the opening of the industry to foreign investments, the broadening of the capital base of mixed-ownership banks and reinforcing regulations and taking action against bad and doubtful debts. The privatisation program will also help fill government coffers and attract FDI. Around 46 public sector companies are being offered for full or partial sale in 2006 alone. Foreign direct investment has increased to USD 3.3bn during H1 2005/06 (July-December 2005) in comparison with USD 1.8bn during the first half of the previous FY. This augurs well and this year will witness the biggest foreign investments inflow. The higher inflows have help the balance of payments realise a surplus of USD 2.6bn in H1 2005/06, compared with a USD 714m deficit in the corresponding period of the previous fiscal year, which should protect the EGP and even allow for a further modest appreciation.

However, key to maintaining this strong investor sentiment over the medium term will be for the government to tackle its high fiscal deficit and growing debt level. Both the fiscal shortfall and debt levels have accelerated sharply on the back of higher spending and the government reform program. A fiscal deficit of around 9.5% of GDP is forecast in FY 2005/06 and government debt levels are currently around 95% of GDP. Importantly, a recent mission from the International Monetary Fund (IMF) concluded its visit to Egypt by announcing an agreement with the Egyptian government to reduce public spending to curb the value of public debt and its percentage of the country's GDP. The IMF noted that although recent tax reforms were an important development, they need to be complemented by an ambitious and credible medium-term fiscal consolidation strategy that puts public debt as a share of GDP on a firmly declining path.

However, despite this statement, the budget for FY2006/07 has in May, sees spending continuing to increase. Total operational expenditure is slated to increase by 16.2% to EGP 217.2bn, while the total budget outlay, including debt-servicing, will rise by 28.0% to EGP 274bn. The government will absorb a large part of the cost of increased fuel prices. The total subsidies budget is set to increase by almost 70% to EGP 59bn, of which the allocation for fuel subsidies is EGP 40bn (compared with EGP 22bn in FY 2005/06). Moreover, the public-sector wage bill is set to rise by 15.6% to EGP 52bn on the back of a 20% public sector wage increase in 2005 prior to elections. The expansionary budget reflects the government's priority of job creation and raising living standards. Despite the higher spending, the budget deficit is forecast to narrow in FY 2006/07 to 8.6% of GDP, on the back of higher revenues, especially given the privatisation income. Furthermore, the government has indicated tax revenues have increased, despite the reduction in rates due to the stronger economic growth and more people paying taxes. However, without reducing spending and reforming the subsidy system, the government will not reach its target of reducing the deficit to 2% to 3% of GDP by the end of the year. Although the budget deficit and public debt is manageable in the short-term, especially given the strong growth and privatisation program, they remain high. The deficit and debt level cannot be sustained at current levels without compromising Egypt's economic potential in the medium term.