Egypt’s Subsidy Blues

If people are hungry, provide food at prices they can afford. If they need fuel to cook it, or perhaps to bring their crops to market, give them a break at the pump. What could be fairer or more straightforward?

What, indeed. Governments all over the developing world have been seduced by the populist logic of subsidizing consumer necessities. The approach was especially alluring in centrally planned economies (including hybrids such as China and India), where prices didn’t reflect costs to begin with. And, of course, subsidies for petroleum proved to be as Arab as hummus for the oil exporters of the Middle East, where citizens have come to think of fuel at circa 1979 prices as a birthright.

If subsidies are good for the poor, why not let everybody else in on the deal? That’s a formula for multiplying the waste — subsidies reduce prices below cost, after all, artificially increasing demand and, where the subsidies are borne by the producers, undermining supply incentives. Nonetheless, extending eligibility to include both middle-class and business users has, more often than not, proved irresistible.

The catch, of course, is that few developing countries can really afford the drag on efficiency or budgetary cost. Case in point: Egypt, which devotes an astounding 10 percent of GDP to subsidies for food and fuel — both of which it must import. Whoever wins the presidential election runoff this weekend will thus face the unenviable task of prying both the middle-class and powerful business interests from their accustomed perquisites.

It needn’t (and probably shouldn’t) be done overnight; among other problems, that would spike inflation, which Egypt can’t afford, either. The big question is whether the new government will have the will and the way to manage it at all. Much, alas, is at stake here: Egypt’s failure to confront the subsidy issue would put at risk the gains of two decades of growth in which GDP per capita, measured in terms of purchasing power, almost tripled.

As you might have already guessed, subsidy withdrawal can be harmful to health. Back in 1977, when Egypt was effectively bankrupt, Anwar Sadat decided to let food prices rise and Egyptians took to the streets. Days of rioting and some 160 deaths later, Sadat changed his mind.

Apparently, the passage of time hasn’t made the process any safer. Yemen’s initiative to reduce fuel subsidies in 2005 led to riots that left dozens dead; the decision was quickly reversed. Today, Yemen’s transition government must finance fuel subsidies equal to nine percent of GDP — the highest fuel subsidy burden in the world.

It was much the same story in Nigeria, where the cash-starved government lifted fuel subsidies this past January and then quickly compromised after the announcement was countered with a general strike. The issue is far from settled, though: There are press reports that the government is so hard up for cash that it hasn’t paid gasoline marketers for subsidized deliveries since the beginning of 2012.

None of this bodes well for Egypt’s next president, who will be caught between conflicting economic priorities from the get-go. One the one hand, he must make headway in meeting the expectations of middle- and lower-income Egyptians who resent the fact that a disproportionate share of the (very substantial) fruits of growth under Mubarak ended up in the hands of cronies. Raising the price of bread and gasoline is hardly a way to win them over. On the other hand, the failure to cut the budget deficit over the next few years might well leave the economy broke and stagnant.

Egypt made it through the global recession in good shape, but stumbled badly in the wake of the revolution as tourism collapsed and investors (domestic and foreign) put their plans on hold. To bring back growth, the new government will need to woo the people who can vote with their checkbooks. And a critical step in that direction would be to spell out a credible plan for containing spending — a virtually impossible task without reducing subsidies, which have ballooned over the years to absorb more than a quarter of the government budget.

Actually, the most realistic path to investor confidence runs through Washington: There’s no way Cairo will be able to lure back private investors unless it can win a vote of confidence (and a multibillion dollar line of credit) from the IMF and other multilateral lenders. While the IMF won’t hold all the cards in the coming negotiations — the rich countries it represents have a strong interest in stabilizing Egypt — the Fund will surely insist on a believable plan to slow the hemorrhage of foreign currency from the Egyptian Central Bank before it throws good money after bad. And I can’t imagine any plan passing the laugh test that doesn’t include cuts in subsidies.

How, then, might the government thread the needle, making nice to Washington without alienating the home crowd?  The model for subsidy reform, ironically, comes from a country (Iran!) not known for either political subtlety or effective economic management. But I get ahead of myself.

Any realistic plan to reform subsidies must start with natural gas and petroleum products. Yes, food subsidies are also wasteful: Heavily subsidized bread is available in any quantity to everybody, and close to 70 percent of all Egyptians have ration cards that allow them to buy other staples at a fraction of cost. But lower-income Egyptians are far more sensitive to the price of food than to the price of gasoline. Equally important, food subsidies cost less than half as much as fuel subsidies.

By the same token, it also makes sense to delay the day of reckoning on subsidies for liquid petroleum gas (butane/propane), which most middle- and lower-income Egyptians use for cooking. Price hikes would hit the wrong people hard, yet only modest sums would be saved since only 14 percent of the fuel subsidy goes for LPG.

The big money — but relatively little of the benefit trickling down to the poor — is in the subsidies for gasoline, diesel fuel, heavy boiler fuel and natural gas. Much of it goes to industry, whose owners will no doubt raise a formidable fuss if it is taken away. But one has to hope that the folks who gained the most from economic growth under Mubarak (and have the most to lose if growth does not resume or the revolution turns anti-capitalist) will be in a mood to compromise, perhaps settling for tax incentives to install more fuel-efficient equipment. The large numbers of middle-class Egyptians who’ve become very attached to private cars are another story.

That’s where the Iran model fits in. Like Nigeria, Iran ran out of money to pacify ordinary citizens with subsidized fuel. And, as in Nigeria, the inefficiencies created by the subsidies were a formidable drag on growth. But unlike Nigeria, Iran played reform smart, offering cash compensation to roughly 80 percent of consumers before it sharply raised the prices of liquid fuels in March 2010. That outlay reduces the net budget savings by half. But, combined with a heavy PR effort (and a show of force against protestors), the money made it possible to set the economy on a path toward efficient energy use without creating a political blowback.

Egypt can’t afford to recycle such a high percentage of the savings from reform. But it could give all households ration coupons for very limited amounts of fuel at pre-reform prices, and allow those who don’t need them to sell the coupons to others who do. This would, presumably, go a long way toward making the reform palatable without undermining incentives to conserve fuel. And with time (and the restoration of economic growth), the coupons could be phased out.

No Egyptian government since Sadat’s has taken subsidy reform seriously. But, then, no Egyptian government before this one had the political legitimacy to take on so onerous a task. Moreover, no government has been confronted with so stark a choice between change and stagnation.

There are, in fact, signs that some Egyptian politicians are ready to bite the bullet. Last week the interim government quietly presented parliament (now dissolved) with a proposed budget that would cut fuel subsidies by 27 percent and end all subsidies to industry in 2013. The new government isn’t bound, of course, by the wishes of the old. But it’s an opening — cross your fingers.