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Economic Growth in Egypt: Constraints and Determinants

Economic Growth in Egypt: Constraints and Determinants. Anton Dobronogov (based on a paper co-authored with Farrukh Iqbal). Summary.

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Economic Growth in Egypt: Constraints and Determinants

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  1. Economic Growth in Egypt: Constraints and Determinants Anton Dobronogov (based on a paper co-authored with Farrukh Iqbal)

  2. Summary • Econometric analysis: trends in government consumption, credit to the private sector and the average growth rate of OECD countries have been significant determinants of growth in 1986-2003 • Growth diagnostic technique: in the early 2000s inefficient financial intermediation was a significant constraint on growth

  3. Plan of the presentation • Egypt’s growth performance in 1960-2003: phases and trends • Econometric analysis of growth performance in 1986-2003 • Growth diagnostic for the early 2000s • Experience with growth diagnostic approach: some lessons and questions

  4. Divergence, convergence, divergence, convergence…

  5. Increased correlation with OECD growth after 1985…

  6. … but there has been also convergence in volatility levels

  7. Phases of growth Phase 1: 1961 – 1973 • Low growth and divergence from OECD • The state dominated the economy • Import substitution policies • Low share of private sector in the GDP • Large military expenditures, two wars

  8. Phases of growth Phase 2: 1974 – 1985 • High growth and convergence with OECD • The government launched the “Open Door Policy” • Dramatic increase in windfall revenues from the Suez Canal and from petroleum exports • Deterioration of fiscal institutions: government’s current expenditures rose even faster than revenues

  9. Phases of growth Phase 3: 1986 – 1991 • Low growth and divergence from OECD • Collapse in windfall revenues following the 1985-86 oil price crash • Fiscal deficits averaged about 15% of GDP throughout this phase, accommodated through expansionary fiscal policy • Current account deficits up to 8% of GDP • Lower oil prices – lower implicit energy subsidies – lower effective protection

  10. Phases of growth Phase 4: 1992 – 1998 • High growth and convergence with OECD • Successful macroeconomic stabilization, the fiscal deficit fell from 15% to 1.3% of GDP in four years; • About one third of all state-owned enterprise assets privatized between 1991 and 1998; • Establishment of a free foreign exchange market for current account transactions and some easing of capital account restrictions.

  11. Gross Fixed Domestic Investment In Egypt and the Best Performing Lower-Middle Income Countries

  12. Current Expenditure, Capital Expenditure, and Budget Surplusin Egypt, 1991-2003

  13. Working Age Population As Share of Total Population in Egypt, 1960-2040

  14. Phases of growth Phase 5: 1999 – 2003 • Lower growth and slowdown in convergence • Several shocks including the Luxor terrorist attack in 1997, the global financial crisis of 1997-99, and a domestic financial scandal in 1998-99, September 11 (2001), war in Iraq (2003);

  15. Current Expenditure, Capital Expenditure, and Budget Surplusin Egypt, 1991-2003

  16. Money supply in Egypt

  17. Growth of Domestic Credit in Egypt

  18. Banking Deposits and External Capital Account Balance in Egypt

  19. Major Stock Market Indicators In Egypt

  20. Econometric analysis: variables Dependent variable: GDP per capita growth Independent variables (correlations with GDP per capita growth are in parentheses): growth of • OECD GDP (0.36); • Government consumption (share in GDP; -0.40); • Credit to the private sector (share in M2, 0.62); • Credit to the government (share in M2, -0.08); • Share of working-age population in the total population (0.37).

  21. Results of the Econometric Analysis

  22. Robustly statistically significant variables • trends in government consumption (-) • credit to the private sector (+) • the average growth rate of OECD countries (+)

  23. Growth diagnostic approach

  24. Growth problem High cost of finance Low social returns Low appropriability Bad international finance Bad local finance Poor geography, bad infra-structure Poor tax system Expropriation risks Low domestic saving Poor inter-mediation Coordination and information failures Macro risks Growth diagnostic decision tree

  25. Searching for a binding constraint in Egypt • Macro instability appears to have been binding on growth in the beginning of 1990s • After stabilization growth resumed, but hit another constraint in about 1997

  26. Is it social returns? Physical capital 1986-91 1994-99 GDP pc growth 1.3 3.0 GDP growth 3.7 5.0 Private I/GDP 12.3 8.6 Public I/GDP 18.1 14.6

  27. Investment Rates in Egypt

  28. 1995/96 1999/2000 Read and Write 13.2 * Basic vs. Read and Write -3.4 -0.1 Basic vs Illiterate 4.2 5.7 Secondary -0.7 2 University 7.1 8 Is it social returns? Human capital

  29. Is it insufficient private appropriation? Rule of law

  30. Is it insufficient private appropriation?

  31. Is it insufficient private appropriation? Taxes • ICA: “high taxes” and “tax administration” as important problems from business perspective • High degree of informality: about 84% of SME’s (not including micro) found to be (partly) informal in1998 BUT …

  32. Is it insufficient private appropriation? Taxes • The average tax to GDP ratio for top 10 LMIC for the latest available year is 15.8%. In Egypt it was 13.9% in 2003, down from 16.5% in 1997. • We also have data for 6 out of top 10 LMIC for 1998 on the marginal tax rates (corporate and individual). The average corporate one is 35.8%; the average individual one is 41.2%. In Egypt they were 40% and 32% respectively in 2003.

  33. Then it is finance • But not international one: Egypt has comfortable access to lending from the IFIs as well as to foreign capital markets • Domestic savings rate remained low (more on this later) but constant throughout 1990s and is likely to be increasing in the course of demographic transition • So we have to look into quality of domestic financial intermediation

  34. Upward trend in real interest rates and lending margins

  35. Finance: access Low access and “insider problem”, hence higher shadow price of finance. Share of debt in the working capital of the firms which have an outstanding loan is 46%, whereas for firms which do not have an outstanding loan, this share is 0.

  36. Finance: supply-side problems Financial system strongly pro-cyclical, low resilience to shocks (especially capital markets, but also banks) Public banks dominate banking system Large domestic public debt (60% of GDP), short-term instruments -> crowding out private credit, no incentives for the banks to search for new clients, amplified risk-aversion during bad times From 16% to 30% of all loans are non-performing, in part because of politicized lending practices

  37. Finance: problems (continued) • Collateral-based lending is dominant (92% of transactions) • Credit registry is underdeveloped • Property rights are poorly defined, notably for land • Collateral is scarce • Some 40% of firms not having outstanding loan reported to have applied but were rejected

  38. Why growth in Egyptaccelerated in the first half of 1990s, but slowed down in the end of the decade • Macroeconomic stabilization cut off unsustainable expansion of banking credit to the government • This suddenly left the banking system with extra resources to lend to the private sector. • Private credit went up and so did the economic growth rate, but because of insufficient assessment capacity of the banking system and politicization of the credit allocation process, the quality of lending stayed poor. • When hit by the financial scandal of 1998-99, the system became even more dysfunctional. The harsh reaction of the government increased the risk-aversion of the banks, a tendency reinforced by rising levels of non-performing loans, scarcity of collateral and external shocks.

  39. Why growth in Egypt… (continued) • After the CBE eased monetary policy, banking deposits started to grow as a percentage of GDP (though falling as a percentage of M2), but so did the lending-deposit interest spread (from 360 basis points in 1998 to 530 in 2003). • Increased financial intermediation margin slowed down lending to the private sector. • Furthermore, during the growth slowdown, the government carried out expansionary fiscal policies which led to higher budget deficits and higher borrowing by the public sector. • This increased the probability of “forced” roll-over of government securities, hence further reducing the banks’ willingness to lend. • A combination of these factors resulted in excess liquidity of the banking system instead of higher private investment. • It is in this sense that the financial system posed a constraint to economic growth after 1999.

  40. Some lessons from experience with application of growth diagnostic approach

  41. Why distinction is made between social and private returns to investment, but not between social and private costs of finance? If the financial system seriously misallocates resources, this would affect social costs of finance through high opportunity costs and possibly high fiscal costs (e.g. if the government uses the taxpayers' money to bail out poorly performing public banks), yet private costs for those who have access to finance may remain low

  42. Why only insufficient private appropriation may adversely affect growth, but not unequal private appropriation? • Think of an economy with pervasive rent-seeking and "insider-outsider" problem; e.g. with high barriers to entry and/or large badly targeted subsidies • In this economy private returns for insiders are likely to exceed social returns (e.g. appropriation will be excessive) and could be quite high, whereas for outsiders appropriation will be very low • There is no guarantee whatsoever that the insiders are talented entrepreneurs • If they are not, this will push private investment and growth down; • This situation may surely could and does persist in some countries for quite prolonged time periods • Similarly, private costs of finance for some economic agents could be lower than social costs, e.g. because of subsidies, and higher for others, e.g. because of bribes needed to get access to credit.

  43. Some criticisms are not justified • - "GD approach looks for silver bullets" - not if you view it as a tool for prioritization of policies and reforms; • - "GD approach does not take into account policy complementarities" - not really: if the constraint binds on growth, it will not be a "stand-alone" thing, rather it will be connected to a number of policy areas • - "binding constraints bind because they are politically difficult or impossible to remove, so it is less useful to identify them" - even if the first part of this statement is true, it is still possible to think about politically feasible ways to shift the constraint out somewhat if not removing it completely; • Furthermore, the most relevant costs could be financial rather than political; if the constraint binds on growth, ex-post financial costs of its removal are likely to be low (welfare gains produced by growth acceleration will almost certainly outweigh them), but these costs may loom large ex-ante - and that's exactly when the Bank can help a country the most.

  44. Economic Growth in Egypt: Constraints and Determinants Anton Dobronogov (based on a paper co-authored with Farrukh Iqbal)

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