By Mahinaz El Baz

Egypt’s government has committed to periodically increasing the pre-tax cost-recovery ratio on most fuel products in order to achieve 100% in fiscal year (FY) 2018/2019 and to eliminate electricity subsidies by FY 2020/2021, according to the International Monetary Fund (IMF). In FY 2014/2015, the government launched an energy subsidies reform program by reducing subsidies and increasing fuel prices in the budget—although they still remained well below international prices. In order to continue with the budget deficit reduction plan, the government announced a reduction in energy subsidies one day after floating the Egyptian Pound (EGP) in November 2016. A second reduction occurred in July 2017. The reduction in energy subsidies was a major factor of consumer inflation. Fuel prices rose to more than 100% higher than they were in 2014, while increases in electricity prices ranged from 29-124% higher, depending on the consumption tier, according to BNP Paribas’s report.

Prior to the budget approval for the FY 2017/2018, the Egyptian state had earlier cut fuel subsidies in a move that will save around EGP 35 billion compared to FY 2016/2017, according to the State Information Service. The government has followed through on its plan for a fourth round of electricity subsidy reform, lowering its expenditures on electricity subsidies to EGP 30 billion.

It worth noting that energy subsidy cuts are part of plans made when the government acquired a $12 billion extended fund facility (EFF) loan from the IMF in November 2016. Egypt’s fuel-subsidies bill has decreased from a peak of 5.9% of growth domestic product (GDP) in FY 2013/2014 to 3.3 % in FY 2016-2017, the IMF declared. It is expected to decline further to 2.4 % of GDP by the end of the current FY 2017/2018.

Narrowing the Budget Deficit

With spending estimated at EGP 1.4 trillion and revenue targets of around EGP 989 billion, Egypt’s government submitted the new state budget for FY 2018/2019 to the House of Representatives in April, according to the pre-budget report issued by the Ministry of Finance. The new budget is targeting a growth rate of 5.8% of GDP. It further aims to reduce the budget deficit to 8.4% of GDP in FY 2018/2019, achieve a primary surplus of 2% of GDP, and reduce public debt to 91-92 % of GDP. Additionally, it seeks to achieve a 10% inflation rate. In order to achieve these goals, the government will be working on increasing revenues while restructuring public spending to create the fiscal space for spending on social services, the pre-budget report stated.

On the spending side, the government is moving on with its plan to reduce energy subsidies. Subsidies on fuel will be cut by around 21%, leaving total spending at around EGP 89 billion in the new budget. Electricity subsidies will witness a tougher cut of around 45%. “The main impacts of the subsidy cuts are an improvement in the government budgetary results, and hence a better control over domestic public debt towards fiscal sustainability, as well as a short-term increase in the rate of inflation because of upward price adjustments in energy-dependent goods and services,” Dr. Alaa El-Shazly, professor of economics at the Faculty of Economics and Political Science (FEPS) at Cairo University, told Egypt Oil & Gas.

Highlighting both economic and social impacts of subsidies cuts, Mahmoud M. Barbary, Assistant lecturer in Economics Department at Helwan University, explained to Egypt Oil & Gas that from an economic perspective, the energy subsidies program in Egypt has failed to achieve its goals, which included fostering the industrial development, avoiding the inflation problems, and protecting the national advantage.

From a social perspective, the main goal of energy subsidies is to help lower classes to get energy products in low prices. However, official data indicates that higher classes benefit from subsidies the most. Statistics show that the poorest 20% of the population, who consume the least, receive around 10% of the subsidies value. Meanwhile, the middle 60% of the population consume 45% of the subsidies. The richest 20%, who consume the most, receive 45% of the subsidies, according to a 2014 report by Sherif Zoheir, a senior tariff specialist at the Ministry of Finance.

As of 2017, Egypt was the sixth cheapest country all over the world to fuel a car, according to Global Petrol Prices website. Petroleum and natural gas represent approximately 96% of Egypt’s energy consumption.

“I think that gradually phasing out the energy subsidies will not affect the industrial development plan, because the government can find other investment or industrial motives, such as taxes or duties motives; also the government had a mitigation plan to compensate the poor, such as cash subsidies or necessary goods subsidies,” Barbary added.

International Oil Prices: Increasing Challenges

International oil price fluctuations are among the top challenges that might stop the Egyptian government from achieving its macroeconomic goals for FY 2018/2019. This comes along with other international challenges, such as interest rates and international trade growth.

The Ministry of Finance has drafted the budget on the assumption that oil prices will settle at around $67 per barrel. The Ministry further explained in its pre-budget report that an increase of one dollar in oil prices will cost the government EGP 4 billion in expenditures and will thus be translated into a wider budget deficit. Moreover, this increase in expenses would limit the money available to the government to finance capital and social expenses in the light of the increases in international prices, eating up the health and education allocations.

“The assumed international price of oil in preparing the government budget is typically an average price around which prices may fluctuate under changing market conditions. So, on average, there need not be a significant deterioration in fiscal deficit calling for further cuts in energy subsidy under normal fluctuations in international oil prices during the fiscal year,” Dr. El Shazly said.

From his side, Barbary explained that the oil prices now are unexpected due to the Iranian-American conflict. “We cannot fix the oil price at this rate right now, any increase in oil prices will lead to a higher energy subsidies, while the decrease in oil price will not lead to a decrease in energy subsides, because we import the energy products in its final shape as a final product and the refining process costs a major proportion in energy subsidies bill. The government must be ready for oil price fluctuation and should be flexible in dealing with any price increase putting plan B and plan C with flexible timeframe to fulfill its energy subsidies reform program,” he added.

Interest rates are another challenge facing the government. There is a direct relation between international oil prices, interest rates and energy subsidies. For instance, on a local scale, the Central Bank of Egypt (CBE) kept its benchmark interest rate unchanged in May, as the government prepares for a new round of fuel subsidy cuts against a backdrop of rising global oil prices, according to Bloomberg. In May, the bank’s Monetary Policy Committee (MPC) held the overnight deposit rate at 16.75% and the overnight lending rate was kept at 17.75%.

The increase in international oil prices “gained momentum in April and May 2018, leading to the materialization of an upside risk to the domestic inflation outlook,” the MPC said in a statement. Even so, it said that the outlook “remains consistent” with achieving the inflation target of 13% (+/-3 percentage points) in the fourth quarter of 2018. Brent crude has risen 19.3% since the beginning of 2018, to almost $80 per barrel, according to Bloomberg.

The rise in oil prices means that the CBE will proceed with caution as it unwinds high borrowing costs, said Bilal Khan, a senior economist at Standard Chartered Bank, according to Bloomberg. Additionally, “the recent rise in US yields could complicate the timing of cuts further.”

Controlling the Inflation Rate

Reducing fuel subsidies usually leads to an increase in the inflation rate. “The expected subsidy cuts, based on our estimates, should have a 4% incremental impact on headline Consumer Price Index,” Allen Sandeep, director of research at Naeem Holding, told Ahram Online.

The government estimates inflation to reach 10% at the end of the FY 2018/2019, while the average inflation rate for the year is set at 13.2% in the budget statement. “We expect one or two hikes in energy prices through the coming fiscal year. There is no way the government can rein in the resulting inflationary pressures to the neighborhood of 10%,” Omar El-Shenety, managing director of Multiples Group said, according to Ahram Online. In the same context, estimates made by local investment bank Pharos put inflation at 13.8% by the end of FY2018/2019, while the IMF expects 15.2%.

Egypt’s annual urban consumer price inflation -headline inflation- slowed to 13.1% in April from 13.3% in March, according to the CBE. Annual core inflation recorded 11.6% in April, compared to 11.59% in March, the CBE said. Economic experts believe that the inflation rate will increase, due to the changes in consumer behavior in Ramadan, in addition to the upcoming fuel subsidies cut. Thus, they argue that the expected spike in inflation could push the CBE to increase interest rates again.

El-Shenety points out that the highest inflationary wave is behind the country, and it is time to encourage investment by lowering interest rates again. He points to another factor that makes lowering rates inevitable, namely the cost of local debt. Each one per cent increase in interest rates costs the government millions of dollars in debt payments, he added.

The government has put the rate on treasury bills at 14% in the new budget, compared to 16 -18% in the current fiscal year. Foreign investments in Egyptian treasury since the devaluation in November 2016 until March 2018 have come in at $23 billion.

When asked about the best solutions to control the expected increase in inflation rate after reducing energy subsidies in general and fuel subsidies in specific, Barbary highlighted that the government must find a strong and secure plan to control the markets as the fuel prices affect almost everything citizens use on daily basis. “It is only few hours after fuel price increase and we will face a price increase in all necessary goods and services like foods, vegetables, dairy products, and transportation. The only way to control the inflation rate is controlling the markets and declaring the prices of the necessary goods and services through TV and newspapers,” he added.

Having a different point of view, Dr. El Shazly, believes that rationalizing energy consumption and market surveillance can help in controlling the expected increase in the rate of inflation.

the Subsidies Reform Program: Steps Forward

Egypt is planning to fully liberalize the energy market – fuel and electricity – by removing subsidies in the mid-term. Economic experts stress on the importance of raising the public awareness and explaining the implications of the subsidies reform program, in addition to the transparency in declaring the upcoming steps.

“Our major problem in Egypt is that we deal with the reform concept as a price increase process, while the reform must include a plan to provide the citizens with energy subsidies, market control regime, a flexible time frame to fulfill the reform program and mitigation procedures. Thus, we cannot limit the reform program in the price increase process, because we can continue to increase the energy products prices and the oil prices continue to increase as well, which makes us rotates in a vicious circle. The appropriate way to phase out the energy subsidies is to make a five-year timeframe including the mentioned above factors, not only the energy products price increase, although it is unlikely that the energy subsidies will be zero within the next 5fiveyears,” Barbary said.

Meanwhile, Dr. El Shazly believes that the removal of fuel subsidies is expected to take place during the current presidency term. “The average fiscal deficit as percent of GDP after liberalizing the fuel market is expected to be around 6%,” he added.

Experts believe that local and international challenges may harden the subsidies reform program and increase its negative effects on both short and mid-terms. Yet, the previous subsidies system failed to meet its goals. As a result, liberalizing the market became an inevitable matter.