Egypt's Next Crisis

Stratfor

Summary

Until just a few years ago, Egypt’s ruling military elite was able to “borrow” money from Egyptian banks with no intention of paying it back. President Hosni Mubarak’s son Gamal changed all that, reforming and privatizing the system in order to build an empire for himself. For the first time in centuries, Egypt’s financial position was not entirely dependent upon outside forces. Now, Mubarak and his reform-minded son are out of the picture and Egypt has a budget deficit and a government debt load that are teetering on the edge of sustainability. Analysis

Foreign Minister Ahmed Abul Gheit called on the international community Feb. 15 to help speed Egypt’s economic recovery. Such foreign assistance will certainly be essential, but only in part because of the economic disruptions caused by the recent protests. Even more important, the political machinations that led to the protests indicate Egypt’s economic structure is about to revert to a dependence upon outside assistance.

Egypt is one of the most undynamic economies of the world. The Nile River Delta is not navigable at all, and it is crisscrossed by omnipresent irrigation canals in order to make the desert bloom. This imposes massive infrastructure costs upon Egyptian society at the same time it robs it of the ability to float goods cheaply from place to place. This mix of high capital demands and low capital generation has made Egypt one of the poorest places in the world in per capita terms. There just hasn’t been money available to fund development.

As a result, Egypt lacks a meaningful industrial base and is a major importer of consumer goods, machinery, vehicles, wood products (there are no trees in the desert) and foodstuffs (Egypt imports roughly half of its grain needs). Egypt’s only exports are a moderate amount of natural gas and fertilizer, a bit of oil, cotton products and some basic metals.

The bottom line is that even in the best of times Egypt faces severe financial constraints — its budget deficit is normally in the range of 7 percent to 9 percent of gross domestic product (GDP) — and with the recent political instability, these financial pressures are rising.

The protests have presented Egypt with a cash-crunch problem. At $13 billion in annual revenues, tourism is the country’s most important income stream. The recent protests shut down tourism completely — at the height of the tourist season, no less. The Egyptian government estimates the losses to date at about $1.5 billion. Military rule — tentatively expected to last for the next six months — is going to crimp tourism income for the foreseeable future. Simultaneously, the government wants to put together a stimulus package to get things moving again. Details are almost nonexistent at present, but a good rule of thumb for stimulus is that it must be at least 1 percent of GDP — a bill of about $2 billion. So assuming that everything goes back to normal immediately — which is unlikely — the government would have to come up with $3.5 billion from somewhere.

Which brings us to financing the deficit, and here we get into some of the political intrigue that toppled former Egyptian President Hosni Mubarak.

One cannot simply walk out of Egypt, so since the time of the pharaohs the Egyptian leadership has commanded a captive labor pool. This phenomenon meant more than simply having access to very cheap labor (free in ancient times); it also meant having access to captive money. Just as the pharaohs exploited the population to build the pyramids, the modern-day elite — the military leadership — exploited the population’s deposits in the banking system. This military elite — or, more accurately, the firms it controlled — took out loans from the country’s banks without any intention of paying them back. This practice enervated the banks in particular and the broader economy in general and contributed to Egypt’s chronic capital shortage. It also forced the government to turn to external sources of financing to operate, in particular the U.S. government, which was happy to play the role of funds provider during the final decade of the Cold War. There were many results, with high inflation, volatile living standards and overall exposure to international financial whims and moods being among the more disruptive.

Over the past 20 years, three things have changed this environment. First, as a reward for Egypt’s participation in the first Gulf War, the United States arranged for the forgiveness of much of Egypt’s outstanding foreign debt. Second, with the Cold War over, the United States steadily dialed back its economic assistance to Egypt. Since its height in 1980, U.S. economic assistance has dwindled by over 80 percent in real terms to under a half-billion dollars annually, forcing Cairo to find other ways to cover the difference (although Egypt is still the second-largest recipient of American military aid). But the final — and most decisive factor — was internal.

Mubarak’s son, Gamal, sought to change the way that Egypt did business in order to build his own corporate empire. One of the many changes he made was empowering the Central Bank to actually enforce underwriting standards at the banks. The effort began in 2004, and early estimates indicated that as many as one in four outstanding loans had no chance of repayment. By 2010 the system was largely reformed and privatized, and the military elite’s ability to tap the banks for “loans” had largely disappeared. The government was then able to step into that gap and tap the banks’ available capital to fund its budget deficit. In fact, it is this arrangement that allowed Egypt to weather the recent global financial crisis as well as it did. For the first time in centuries, Egypt’s financial position was not entirely dependent upon outside forces. The government’s total debt load remains uncomfortably high at 72 percent of GDP, but its foreign debt load is only 11 percent of GDP. The economy was hardly thriving, but economically, Egypt was certainly a more settled place. For example, Egypt now has a mortgage market, which did not exist a decade ago.

From Gamal Mubarak’s point of view, four problems had been solved. The government had more stable financing capacity, the old military guard had been weakened, the banks were in better shape, and he was able to build his own corporate empire on the redirected financial flows in the process. But these changes and others like them earned the Mubarak family the military’s ire. Mubarak and his reform-minded son are out of the picture now, and the reform effort with them. With the constitution suspended, the parliament dissolved and military rule the order of the day, it stretches the mind to think that the Central Bank will be the singular institution that will retain any meaningful policy autonomy. If the generals take the banks back for themselves, Egypt will have no choice but to seek international funds to cover its budget shortfalls. Incidentally, we do not find it surprising that now — five days after the protests ended — the banks are still closed by order of the military government.

Yet Egypt cannot simply tap international debt markets like a normal country. While its foreign debt load is small, its total debt levels are very similar to states that have faced default and/or bailout problems in the past. An 8-percent-of-GDP budget deficit and a 72-percent-of-GDP government debt load are teetering on the edge of what is sustainable. As a point of comparison, Argentina defaulted in 2001 with a 60-percent-of-GDP debt load and it had far more robust income streams. Even if Egypt can find some interested foreign investors, the cost of borrowing will be prohibitively high, and the amounts needed are daunting. Plainly stated, Cairo needed to come up with $16 billion annually just to break even before the crisis and the likely banking changes that will come along with it.