Mediterranean Policy ProgramSeries on the Region and the Economic Crisis Prepared in Partnership with Paralleli Euromediterranean Institute

(Turin)

Policy Brief
June 2012

Summary: January 2011 was a watershed in Egypts history. More than a year on, the promise of change still exists, but apprehension has grown. The choice now is between two strategic approaches: a muddling through, which would provide fixes to existing flaws and pursue progress within what would remain essentially a legacy autocratic governance framework, and a bold adoption of a modern democracy that governs an equitable society on a path of sustainable development. A competition between these approaches is unfolding.

Egypts Transition Towards a New Governance for Sustainable Development

by Wafik Grais*

Introduction: The Promise of a Revolution January 2011 was a watershed in Egypts history. More than a year on, the promise of change still exists, but apprehension has grown. The success of the transition will depend on the countrys ability to define a shared vision of its political and economic governance, develop and implement a credible strategy to achieve the vision, and be a responsible member of the international community. However, this challenge of a shared vision will elude Egypt if any single political force attempts to impose its will and excludes those with different views. The vision requires a credible promise of individual freedoms and equitable growth, which provides employment opportunities to a growing labor force and comforts a population thirsty for decent life, respect, and dignity. The choice now is between two strategic approaches: a muddling through, which would provide fixes to existing flaws and pursue progress within what would remain essentially a legacy autocratic governance frame-

work, and a bold adoption of a modern democracy that governs an equitable society on a path of sustainable development. A competition between these approaches is unfolding. At the beginning, 2011 seemed to put Egypt on the second path, but the road followed since then has been chaotic. The dismissed parliament, which was dominated by the Islamic-inspired Freedom and Justice and El-Nour parties, inspired apprehension on the part of other political forces and the civil society.1 Furthermore, the process of designing a new constitution has been held up by power grabs. The perceived ineffectiveness of parliament and excesses on the part of certain Islamic-oriented parties creates doubt in their ability to lead the country. This uncertainty breeds both fears and strong hopes for the framework and prospects of the countrys economic development.

1 The Constitutional Court ruled on June 13, 2012, that the rules followed to elect the lower house of parliament were unconstitutional.

1744 R Street NW Washington, DC 20009 T 1 202 683 2650 F 1 202 265 1662 E info@gmfus.org

*Wafik Grais has written on public economic policy, financial development, and Islamic finance from Cairo, Geneva, and Washington areas since the early 1980s. He worked at the World Bank and in private equity management in Cairo and Marseille. He is now a freelance consultant on economics and finance. The views expressed in this article are his own, except where attributed to other sources.

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
Toward Transparent, Effective, and Inclusive Governance Actors claiming a political role in shaping the countrys future have not yet managed to offer Egyptians a clear vision for the countrys governance. Unfortunately, the game has been mostly the power play found in normal politics when the country actually needs statesmanship with a vision and ability to achieve it. At this stage, authorities should manage the transition and foster responsible, mutually respectful debate, ensuring a transparent governance process. At this moment, one can detect four broad sets of views vying for power to shape the countrys future: Non-secular Muslim Brotherhood and Salafists Secular Military establishment Silent majority Religious versus Secular Governance On one side, the Salafists and Muslim Brotherhood (represented by Al-Nour and the Freedom and Justice parties, respectively) would prefer theocratic religion-based governance with variations among them and other groups with similar inspirations.2 The Seculars, on another side, range from proponents of leftist policies to Westerninspired liberals of various shades and espouse separation between state and faith. The issue of theocracy versus secularism is central to Egypts future. For the silent majority, the theocratic versus temporal debate remains remote, even if these people voted overwhelmingly for Islamic parties in the recent parliamentary elections. The success of proponents of either side of the debate will depend on their ability to deliver welfare to the silent majority. Civilian and Military Authorities Roles The role assigned to the military establishment in Egypts governance is another core issue. A clear definition of the respective mandates of civil government and the military establishment will give Egypt the opportunity to conform with the worlds predominant model of civil governance.
2 Umaima Abdul Latif (2012), Salafists and Politics in Egypt, Arab Center for Research and Policy Studies, Doha Institute, www.dohainstitute.org, Doha, January, and Esra Bulut Aymat (2011) Egyptian Democracy and the Muslim Brotherhood, Institute for Securities Studies, November, report No 10. Other groups include other members of the Democratic Alliance and the Islamist Alliance.

The success of proponents of either side of the debate will depend on their ability to deliver welfare to the silent majority.
Over the last 50 years, the army had a central role in the society, and the dominance of security issues and military concerns created bonds between citizenry and the army. Those bonds seemed to strengthen with the armys public position to support the revolution. However, the reality of vested interests, a traditional armys sense of bearing superior responsibility, and all parties limited familiarity with the role of political signaling have eroded the mutual trust between the first and the civil groups. These difficulties were compounded by the fact that the military establishment had taken the responsibility of leading the country through the uncharted territory of transition. At this stage, a grand bargain between the military establishment and civil government may be the most practical course of action. The gap between the army and the parliament could be bridged by consensual solutions such as moving towards a semi-presidential system, overseeing the military budget by a limited parliamentary committee (comparable to congressional committees in the United States), establishing the national security council led by the president, and maintaining the armys special privileges, especially in its economic affairs.3 Core features of the bargain will be the respect of the armys role together with the moving of the country to civilian rule. The Silent Majority: Ultimate Decision-Maker The silent majoritys voice will ultimately determine the outcome of all debates. One would not err in assuming that most Egyptians long first and foremost for an opportunity to live a dignified life that provides for a decent standard of living with respect for tradition and faith without dogmatism.4
3 Bank of America & Merrill Lynch (2012), Egypt Macro Viewpoint- Coming out of the Cold, February 4 See also Al Jazeera (2011) Voice of Egypts Silent Majority, November, http://www. aljazeera.com/news/middleeast/2011/11/20111125184827710523.html

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
Towards a New Constitution The debate on the composition of the constitutional assembly has been intense. Fifty percent of the assemblys members of parliament were from the dominant F&J and Nour parties. The rest were drawn from a broader constituency of professional groups and sector representatives and had ties with the same parties. That assembly was dismissed by a court judgment and a new one has yet to be formed. The conflict of interests in being a constitutional assembly member and parliamentarian at the same time bears risks that could be mitigated if parliament were dissolved and a new one elected once a constitution is adopted. Building a Healthy Economy Serving the People While the political transition has reached the critical step of presidential elections, the country faces tremendous financial, economic, and social challenges. Uncertainty in the countrys governance and fundamental policy orientation is dampening entrepreneurial initiative and damaging economic activity. The country is in a bind between the need to remove uncertainty quickly to create a businessfriendly environment and the need to allow for sufficient time for deliberation to achieve broad consensus on the countrys governance and policy direction. Once again, this is a struggle between a muddling-through approach and a bold move to a clear development strategy. The new administration that will be ushered in by the presidential elections will need to work rapidly to reestablish macroeconomic viability, ensure social development and satisfactory social protection, and drive the economy onto a path of innovation, competitiveness, and sustainability. Public Policy Design and Implementation The first priority is to establish a management capability to design and implement a socioeconomic development strategy. Today the state acts as a guardian of rules and as a development coach. It needs to provide broad access to economic opportunities and to guarantee fair, transparent, and competitive processes, while maintaining a strong legal framework and an independent and efficient judicial system. Meanwhile, the countrys socioeconomic management will need to clearly convey that it will build on the foundations of freedoms, responsibility, and accountability. This is essential to overcome the mistrust between citizens and public authorities that has grown over the years. It is also essential to foster entrepreneurship and encourage investment by removing corruption and poor accountability. A third priority is the rapid settlement of the choice between muddling through and bold transformation of the countrys business and social environment. Other countries experiences can provide insights and guidance on options, though carrying experience from one country to another must be done carefully. Central and Eastern European (CEE) and Commonwealth of Independent States (CIS) countries experiences are particularly revealing. At the risk of oversimplification, one may consider that the former pursued a vision with determination and reformed their economies accordingly. In contrast, CIS countries mostly followed a more tentative approach, had less forceful economic champions, and felt a less urgent need to focus on the development of economic institutions. A 2004 assessment of transition in CEE and CIS countries points out that in the CEE, the transition recession was relatively shallow and short-lived; GDP fell on average by less than 15 percent, and per capita incomes recovered in many countries before the end of the 1990s. On the other hand, the decline was far more severe than expected in CIS countries: GDP fell on average by over 40 percent and, although growth picked up strongly later, no CIS country had regained its pre-transition per capita GDP by 2004.

The country is in a bind between the need to remove uncertainty quickly to create a businessfriendly environment and the need to allow for sufficient time for deliberation to achieve broad consensus on the countrys governance and policy direction.
3

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
Conveying Confidence in Macroeconomic Sustainability Today, macro financial sustainability remains problematic. While the Central Bank of Egypt (CBE) should be commended for maintaining orderly payments and confidence, the degradation in the countrys finances will require immediate attention with genuine macroeconomic policy coordination between monetary and fiscal authorities. The drastic deterioration in the balance of payments (BOP) has to be rapidly reversed: the overall BOP position swung by $19.6 billion, from a surplus of $1.3 billion to a deficit of $18.3 billion over 2011. It has eroded net foreign exchange reserves by $8 billion in 2011 and let them stand at $15.2 billion, or about three months of imports, at end of April 2012. This performance is traceable to the more than 30 percent drop in revenue from tourism and the swing in FDI and portfolio investments from inflows of $15.4 billion to outflows of $16.8 billion. While improvement in the world economy and robust oil prices can help capital inflows and tourism revenues, a prompt return of security and confidence in the business environment will be critical priorities. The budget deficit has hovered close to 10 percent of GDP over 2010/2011. It was planned at 8.6 percent for the current fiscal year 2011/2012 but may in effect be higher, putting pressure on public domestic debt and crowding out finance to the private sector. An overall rationalization of budget expenditures is of the utmost importance. It will need to address requirements of security and the overall deployment of subsidies. The latter could be redeployed while containing adverse social consequences, especially with regard to energy subsidies. Consumer price indexes inflation may be running at close to 10 percent on an annual rate. However, the reemergence of local supply bottlenecks and distortions in the distribution channels, as well as the probability of a rebound in international food prices, pose risks to the inflation outlook. To deal with these issues, Egypt considered recourse to the IMF and World Bank as well as bilateral assistance. However, the position of transitional authorities has not reflected their awareness of the critical situation of the countrys finances. In part because of the absence of a strategic stabilization and development view, opportunities to conclude a deal with these organizations were missed. Today, the uncertainty on the agendas of various groups claiming the countrys leadership is leading external partners to seek confirmation that there is broad consensus in engaging with them before concluding a deal. A $3.2 billion IMF deal is thus held hostage by internal political debate and soul searching, while the foreign exchange hemorrhage continues. The IMFs and WBs support plays a catalytic role in mobilizing additional support: other external partners are holding back while they are uncertain on Egypts policy direction. It is also likely that even financing from friendly GCC countries would be more forthcoming with the presence of a credible Egyptian macroeconomic program supported by IMF and WB. Thus, a foremost priority of a new administration is to rapidly put in place its program and seek the support of international finance institutions. Promoting Social Cohesion and Human Development Financial and economic performance is intrinsically linked to social equity and human development. Poverty and regional income disparities, jobs creation, social protection, education quality, and health services are core challenges to any forthcoming administration. Addressing poverty and its regional dimension is essential for social equity and stability. The extreme poor and the poor were estimated at 9.1 percent and 35.7 percent, respectively, in 2008. The poor tend to be concentrated in the rural areas and in Upper Egypt. Moreover, many families are vulnerable to small shocks, which would increase poverty dramatically: an assessment indicates that a 20

While improvement in the world economy and robust oil prices can help capital inflows and tourism revenues, a prompt return of security and confidence in the business environment will be critical priorities.
4

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
percent drop in consumption would increase poverty by 66 percent, affecting up to 23 million families. Economic performance, education and skills development, and demographic trends have resulted in a serious employment challenge. It has been brewing for a long time and was partly at the root of the January 25, 2011, movement. Overall unemployment is reported at more than 12 percent, while youth unemployment is widespread (90 percent of the unemployed are less than 30 years old). The informal economy represents the main source of employment for new labor market entrants, with a total number of workers in the informal sector reaching 7.9 million, according to the 2006 census. The social protection framework requires a significant reform. The social insurance system has developed into multiple programs with different coverage and benefits package for various segments of the population, resulting in a patchwork of coverage, including food and energy subsidies and social assistance programs. Overall, subsidies are close to 10 percent of GDP ($20 billion): consumer food subsidies could represent 2 percent, cash transfers 3 percent, and energy subsidies to producers and consumers are large at around 7 percent. A redeployment of the subsidies will entail better targeting to ensure effective support to vulnerable groups. The reduction and reordering of energy subsidies should provide fiscal space, contribute to enhancing industrial competitiveness, and provide incentives for clean growth, helping face the employment challenge. 5 Improving educational achievements, promoting better skills for market needs, and rationalizing public expenditures are likely to top the countrys education agenda. The Egyptian government provides free public education in line with constitutional requirements. Some 85 percent of students from primary to tertiary levels are enrolled in public institutions, and the university system is largely publicly financed. Public spending on education is somewhat high by international standards (5 percent of GDP compared to an average of 4 percent for similar countries).
5 As a hypothetical scenario, imagine slashing energy subsidies in half, and allocating half of the savings to food subsidies and half to work programs. The halving of energy subsidies would release $7 billion, or 3.5 percent of GDP. This amount could be used to revamp allocations to a restructured and targeted food subsidy program, say by 1.75 percent of GDP, that would allow an almost doubling of food subsidies, bringing them to 3.75 percent of GDP or around $7.5 billion. The budget would have left still an additional 1.75 percent of GDP or $3.5 billion for other needs. Assume this amount is used to create jobs at a cost of $10,000/job; this would entail creating 350,000 jobs a year.

The reduction and reordering of energy subsidies should provide fiscal space, contribute to enhancing industrial competitiveness, and provide incentives for clean growth, helping face the employment challenge.
Nevertheless, there is evidence of sizable private education spending (estimated at 3.6 percent of GDP), in part reflecting spending on extra tutoring, which would bring overall education spending above most developed and developing countries. The performance of the education sector, however, has not kept pace with expenditures. Egypt has made great strides towards universal basic education enrollment, but 27 percent of young people aged 18-29 have not completed basic education. Literacy rates are relatively low, at 85 percent of youths ages 15-24, compared to 93 percent in similar countries. The average scores in the Trends in International Mathematics and Science Study (TIMSS) tests reveals that Egypts education is below average. Efficiency assessments suggest that equivalent outcomes (in terms of literacy rate and test scores) could be achieved with about a quarter of the public spending on primary and secondary education, placing Egypt in the 50th percentile among countries in terms of the overall efficiency of education spending. Significant disparities in health outcomes persist across regions with rural faring less well than urban areas. Total spending in the sector is dominated by direct out-of-pocket payments by households, which account for more than half of all health expenditure in Egypt. Social health insurance coverage is extended to only half of the population,

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
including about one-third of the active labor force. The level of risk pooling and financial protection against an adverse health event available to the Egyptian citizen is limited. The aging and urbanization of the population is expected to lead to a substantial transformation in the epidemiological profile of the population, as a growing share of the disease burden will shift from communicable to non-communicable diseases and injuries. Treatment of these diseases will require investments in new technologies and procedures, and it will have an impact on per capita expenditures on health care. Public health care reform needs to strengthen the efficiency of spending by enhancing productivity rather than reducing the spending level. Inefficiencies in public health spending should lead to the reallocation of resources to higher priority areas within the health budget, including to the most cost-effective services and programs, and to better target government health subsidies to priority population groups (such as incidence of infant mortality in rural and urban areas). In addition, strong population growth, population aging, and the proposed healthcare reforms will add pressure on public resources over the medium term. In this context, the focus of reforms should be on enhancing system efficiency rather than reducing spending. Fostering Competitive Sustainable Development Egypts economic transition out of state management was initiated under President Anwar Sadat (1970s). Although other countries have engaged in such a transition later than Egypt and already came out of it, the country is still engaged in outdated debates on economic development. Moreover, its meandering transition path has been marred on the shoals of incompetence, mismanagement, graft, and greed. The countrys new leadership has the opportunity to rise to change it. Among the numerous challenges to foster competitive sustainable development, priority needs to be given to the implementation of the rule of law, promotion of small and medium enterprises (SMEs), the positioning of the financial sector as a stable and effective development tool, and adoption of an incentive framework for sustainable development. The 2012 World Bank Doing Business report ranks Egypt 110 out of 183 countries in terms of ease of doing business. These results confirm the urgency to ensure that laws and regulations are streamlined, and rule of law and enforceable contracts prevail. Mixed signals to the markets on policy orientations will only perpetuate poor economic performance and welfare erosion. Another priority is the authorities acknowledgement of SMEs importance as the mainstay of the economy and drivers of economic growth and employment. Their performance bears on public finance and the balance of payments and, importantly, on environmental sustainability. By 2014, SMEs can be expected to account for more than 40 percent of total employment, and they will produce more than 35 percent of GDP and at least 10 percent of total manufacturing exports. Today, they may account for 6.4 million businesses though only 6 percent only are formal.6 However, with 5 percent of total lending, SMEs have limited access to finance stunting their development and limiting their contribution to society. A determined policy to foster SMEs development and integration in the formal sector is essential. Egypts financial sector has undergone significant reforms that have allowed it to weather the impact of the global economic crisis and the ongoing changes in the countrys governance. The launched reforms need to be pursued and consolidated if the countrys financial system is to play an effective role in fostering sustainable development. The independence of a competent central bank has to be confirmed. Though regulatory arrangements have been introduced to expand non-bank financial intermediation, their impact on the real economy remains limited. Supervision practices will need to evolve to better support market development and rely less on the formality of rule compliance. Attention to the financial sector will be essential,
6 Mc Kinsey-IFC (2011) Micro, Small and Medium Enterprises (MSME) Data base

Public health care reform needs to strengthen the efficiency of spending by enhancing productivity rather than reducing the spending level.
6

Mediterranean Policy ProgramSeries on the Region and the Economic Crisis

Policy Brief
given its critical role in intermediation of the economys resources and funding growth. Importantly, at this juncture, an effective regulatory framework for Islamic finance needs to be put in place. Public policy needs also to develop an incentive framework that prices natural resources at their true economic costs. For too long, Egypts businesses have disregarded their impact on water, air, noise, and land because these natural resources were considered cheap. The outcome has been over-exploitation and led to damages to the populations health and welfare. Conclusion: The Challenge of Statesmanship The 18 days that followed January 25, 2011, allowed Egyptian society to emerge out of the numbness it had experienced in the last 30 years, unleashing a freedom of expression and organization that gave an opportunity to various groups to present and defend their visions. Mature democratic systems organize debates that contribute to sharpen views and offer solid foundations to citizens to make educated choices. However, historys message is that change such as the one unfolding is unavoidably messy and disorderly. Stable organization and orientation take time to materialize, after several rounds of debates and elections. No one can be blamed for such developments. On February 11, 2011, Egypt begun traveling in uncharted territory; a destination will be reached with trials and errors. If they look ahead and decide firmly to leave to their children the legacy of a bright future, Egyptians will build a modern state, true to the countrys history and culture and enlightened by the strength and peace requirements of its future. It will require that all involved become fully aware of their own interest but show goodwill for compromise, accept differences and compete transparently for clear and well-disseminated agendas. Statesmanship will need to override petty power grabbing politics. This is Egypts leadership challenge.
About the Partners

The German Marshall Fund of the United States (GMF) is a non-partisan American public policy and grantmaking institution dedicated to promoting better understanding and cooperation between North America and Europe on transatlantic and global issues. GMF does this by supporting individuals and institutions working in the transatlantic sphere, by convening leaders and members of the policy and business communities, by contributing research and analysis on transatlantic topics, and by providing exchange opportunities to foster renewed commitment to the transatlantic relationship. In addition, GMF supports a number of initiatives to strengthen democracies. Founded in 1972 through a gift from Germany as a permanent memorial to Marshall Plan assistance, GMF maintains a strong presence on both sides of the Atlantic. In addition to its headquarters in Washington, DC, GMF has seven offices in Europe: Berlin, Paris, Brussels, Belgrade, Ankara, Bucharest, and Warsaw. GMF also has smaller representations in Bratislava, Turin, and Stockholm. www.gmfus.org

Paralleli Euromediterranean Institutes mandate is to contribute to the creation of a Euro-Mediterranean area of freedom and of economic and social development. The institute acts at the local, national, and international level with the aim of meeting the needs of the North-West region of Italy concerning its relations with the other sides of the Mediterranean Sea. The activities of the Institute fall within the process of Euro-Mediterranean partnership initiated by the European Union with the 1995 Barcelona Process and currently undergoing a major relaunch through the Union for the Mediterranean, since July 2008. Paralleli intends to contribute to the reinforcement of political relations, economic cooperation, cultural exchange, and human flows between the European and the South-East Mediterranean countries. Its main objective is to promote dialogue at cultural, social, and political level between the societies of the Mediterranean countries, with the aim of encouraging and improving economic relations between them, with a particular focus on the dimension of sustainability and co-development. For this reason, the institute has decided: to involve civil society in the development of Euro-Mediterranean relations; to create and to support networking in the Mediterranean area; and to increase the value of research in order to suggest truly effective policies to local, national, and international actors. www.paralleli.org