Egypt’s Financial High Noon

With another meeting earlier this week in Cairo, the Egyptian government continues its tortuous negotiations with the IMF about a $4.8 billion loan. The loan discussions have been ongoing for nearly two years, since soon after the fall of President Mubarak in February 2011. During that time, Egypt’s foreign currency reserves have declined from roughly $36 billion to only $13 billion today, and the country faces an increasingly severe balance of payments crisis. It is literally running out of hard cash — a dire problem since it imports much of its food and fuel. Egypt currently has less than 90 days of supply in its strategic wheat stock, an unnervingly small safety net for the world’s largest wheat importer.

Despite a growing sense of urgency, the Egyptian government has not been able, or willing, to close a deal with the IMF. In fact, in the most recent round of talks, the government back-pedaled away from the set of economic reforms it put on the table last November, and now proposes more gradual steps to combat its fiscal deficit. Among the major sticking points with the IMF is Egypt’s costly and unsustainable regime of subsidies, which currently consumes close to a third of the government’s budget.

While it is widely recognized that food and fuel subsidies are expensive and inefficient, Egyptian leaders do not want to touch the political third rail of subsidy reform. Who can blame them? Seared into the memory of just about every Egyptian politician is the winter of 1977, when bread riots nearly toppled the government of Anwar Sadat. At the behest of the IMF, Sadat tried to roll back state subsidies on food staples and cooking fuel. It took the army — and the re-imposition of the subsidies — to restore order, but not before scores had died and hundreds of buildings had been sacked.

With an already tenuous situation on the streets of Cairo, Port Said, and other major cities, the Egyptian government is hardly looking to stir up more trouble for itself by rolling back the popular food and fuel subsidies that most Egyptians have taken for granted their whole lives. But Egyptian leaders also realize that without subsidy reform, the country’s fiscal situation is untenable. Sooner or later, serious subsidy reform is inevitable. However, the Morsy government, like the military-led government before it, continues to kick the can down the road. Word has it that it’s waiting until a new parliament is elected before tackling the subsidy behemoth.

Inconveniently, the date of the parliamentary election keeps getting postponed, and without some large cash infusion — which doesn’t appear forthcoming from either the IMF or Qatar, which has already given billions — Egypt’s coffers will run dry in just a few months.

Egypt is certainly not alone in its addiction to subsidies. Many rich and poor countries are likewise guilty of adopting subsidies that rarely meet their intended purpose but soon become politically entrenched. OECD countries spend more than $250 billion a year subsidizing agriculture, yet most of that goes to big agribusinesses rather than the revered family farmer. The International Energy Agency estimates that global energy subsidies amount to more than $500 billion. As in Egypt, the benefit of most energy subsidies is skewed not to the poor, but to businesses and middle class car owners, encouraging inefficiency and environmental issues. It is no surprise that Saudi Arabia, which spends some $43 billion per year to keep domestic fuel prices low, is the world’s largest per capita consumer of oil. The steep rise of domestic consumption in the Kingdom due to subsidies has some analysts predicting that Saudi Arabia could become a net importer of oil by 2030.

In practice, subsidies create more problems than they solve by distorting the market in myriad ways, from encouraging wasteful consumption and corruption to depressing local production. In Egypt, decades of subsidized bread and other foodstuffs have discouraged domestic investment in the agricultural sector, resulting in lower local production. Corruption in the system is also rampant, with a thriving domestic black market and widespread smuggling of subsidized gasoline out of the country for resale at higher prices.

None of this makes eliminating subsidies any easier. But while the path to reform is littered with failed attempts and riots, some governments have succeeded in weaning off subsidies, and there are lessons to be gleaned from their experiences.

First, it is critical to communicate the importance and purpose of reform. Governments must take time to explain to their major stakeholders — citizens, business groups, labor unions, and others — the need for the painful adjustments and the benefits that will accrue from the changes. As a way of buttering up public opinion, Ghana preceded its 2005 fuel subsidy reduction by commissioning an independent study that demonstrated how society’s richest benefited the most from subsidies. It also emphasized through billboards and radio spots how the poor would be compensated in other ways, such as raising the daily minimum wage and eliminating schools fees. Through these measures, it was able to avoid the large street protests that had undermined earlier reform efforts.

Iran, too, laid the groundwork for its 2010 subsidy reform through an extensive public relations campaign. The government explained its goal was not to eliminate subsidies for the poor, but to move from a grossly inefficient system based on products (cheap energy) to one based on households (through cash transfers). For months prior to the reform, the government printed electricity bills showing the true cost versus the subsidized rates households and businesses were paying as another way to educate the public.

In Egypt’s case, the government needs to launch a concerted public relations campaign that exposes the wastefulness and corruption in the current subsidy system, and that also explains the potential in reallocating funds to more productive investments and targeted assistance to the poor. Cleaner air and less clogged streets should also have some appeal for urban elites.

Second, governments must present a comprehensive reform program that matches concrete benefits with subsidy reductions. Iran, for example, deposited cash compensation into household bank accounts in the weeks leading up to its subsidy reductions. Although these deposits were frozen until the day of the price increases, people were reassured knowing the money was actually there. According to an IMF assessment of Iran’s subsidy reform program, in the first 12 months of the program the government replaced some $50-60 billion in energy subsidies with $30 billion in cash transfers to households and another $15 billion in support to industries to help them make investments in greater energy efficiency.

In contrast, Nigeria hiked fuel prices in January 2012, with only vague promises to channel the savings into
future infrastructure spending in return. Given the government’s sorry track record in meeting its commitments, the public was duly skeptical. Not surprisingly, widespread strikes and riots occurred, forcing the government to back down.

India, which spends north of $40 billion a year on food and energy subsidies, is heading down the path of transformational reform by replacing its bloated and corrupt subsidy system with direct cash transfers to the poor. Its challenge is one of execution. It first has to ramp up its rural banking network to make cash transfers on such a scale feasible — a gargantuan task in a country of 1.2 billion people. Regional tests are off to a bumpy start, with beneficiaries complaining that cash transfers have not been delivered as promised.

In undertaking any major subsidy reform, Egypt faces its own credibility gap with citizens. Subsidy reform has been talked about on and off for years, with various plans presented but never implemented. Just in the past two years, several half-hearted initiatives have been put forward only to be ignored. In the face of such uncertainty, hoarding has spread, contributing to fuel shortages across the country. This makes clear and honest communication all the more important.

The way forward for Egypt is not rocket science: An effective subsidy reform program should focus first on the most costly and inefficient fuel subsidies, and then phase in other reductions in a systematic way. It should couple subsidy cuts with targeted cash transfers to poor households and transitional support for energy-intensive industries like glass and cement that will be most affected. Reform certainly won’t be easy, but given that it’s inevitable, a well-planned process is preferable to the alternative.