Egypt fiscal cutback broadly on track

Higher growth and lower commodity prices are helping Egypt to reduce its budget deficit.

Egypt is rotating its economic policy towards a new model based on two arrows: lower government spending and higher investment. The move is prompted by Egypt’s backers in the Gulf—who seem unwilling to continue writing blank cheques—and the unsustainability of the old model—which saw the Egyptian government spending beyond its means. The Egyptian authorities and the International Monetary Fund are optimistic that the new model will lead to higher economic growth. And the latest numbers show that at least one of the arrows is on track to hit somewhere close to its mark.

According to the Ministry of Finance data, the budget deficit (the difference between the government’s spending and revenue) for the period July 2014 to April 2015 was 9.9% of GDP. The Ministry expects the deficit for the whole fiscal year, which ends on June 30, to reach 10.8% of GDP. This is quite a bit lower than the 2013/14 deficit, which was 12.8% of GDP, although still higher than the original deficit target (10% of GDP).

The expected deficit reduction will be achieved despite reduced support from the Gulf and the postponement in the implementation of capital gains tax. The former, which fell by $5.7bn compared to a year earlier, would have reduced the budget deficit by 1.9% of GDP if maintained at last year’s levels. The impact of the capital gains tax is less significant: it would have only reduced the deficit by less than 0.1% of GDP if it had been implemented.

So how was the deficit reduction achieved? First, higher growth has resulted in higher tax revenue for the government. Real GDP growth accelerated to 5.6% in the first half of the current fiscal year compared to 1.2% in the same period a year earlier. As a result, Egypt’s tax revenue increased by 22.6% over a year ago. Second, lower food and energy prices have helped the government to control its expenses.

Going forward, Egypt plans to continue tightening fiscal policy. The government has recently announced the deficit target for 2015/16 (9.9% of GDP), and Egypt’s five-year macroeconomic strategy expects the deficit to continue declining to 8.1% of GDP in 2018/19. There are risks to this outlook. Not least because commodity prices are expected to recover and may increase expenditure. In addition, too rapid a fiscal consolidation can sometimes be self-defeating: it can be detrimental to growth and hence to revenue and the deficit itself. But Egypt and its regional and international backers are intent on continuing firing the fiscal arrow.

Who is right about the currency auctions in Iraq?

Ahmed Chalabi’s campaign against the currency auctions is based on weak economics.

The currency auctions continue to divide opinions in Iraq. The Central Bank of Iraq (CBI) is appealing before the Supreme Court against the imposition of Article 50 in the budget law. The article, imposed by parliament, prevents the CBI from selling more than $75m a day in the auctions. Meanwhile, Ahmed Chalabi, the chairman of the parliamentary finance committee who is now spear-heading the attack against the auctions, has claimed that they have been a source of corruption, which led to the depletion of the country’s reserves. Undeterred by critics, the CBI has restarted the auctions on 6 April, after a few weeks’ suspension. Its daily sales averaged $133m in the first nine sessions, well above the limit set by parliament. Who is right and who is wrong in this debate?

1. On form alone, it was wrong to include Article 50 in the budget law. The budget law should be about fiscal policy: the government’s expenditure, sources of revenue, new taxes etc. Article 50, however, was about the conduct of monetary policy. It can be debated whether it intrudes into on the CBI’s independence, but the article was certainly out of place in a budget law.

2. Chalabi’s argument that the auctions were a source of corruption and have wasted the country’s reserves might be right. Around a quarter of the dollars sold in the currency auctions in 2013 were not used for their intended purposes, which is funding the private sector imports. But imposing a limit on dollar sales is not the right response.

If Iraq wants to maintain its peg to the dollar and eliminate the black currency market, it has no choice but inject enough dollars to meet demand. Failing that, market prices would decouple from the official price, making the peg redundant.

This is something that was confirmed time and again by Iraq’s recent experience, and is happening now too. Although the CBI no longer publishes data on the market rate, press reports suggest that the price of the dollar has reached 1340 as a result of the suspension of the auctions. This is 15% above the official exchange rate and represents the highest deviation probably since the data became available in 2004.

3. It may be argued that the official exchange rate itself should be revised. Iraq may need to either devalue its currency by choosing a higher price for the dollar or even let its currency float freely. Chalabi has hinted at that in his interview, saying that “the price set by the central bank is its choice and is not based on a particular rule”. This is a debate that could be had, especially against the background of of lower oil prices. But as long as Iraq wants to maintain its current peg and as long as it wants to eliminate the need for an unofficial currency market, the CBI should to be allowed to supply enough dollars without restrictions. 

Economic consequences of the peace with Iran

A final deal with Iran could depress oil prices by around $9.

On 2 April, the world’s major powers (the so-called P5+1) and Iran announced a framework for a final agreement on Iran’s nuclear programme. The P5+1 are demanding limits on Iran’s nuclear programme in exchange for lifting the sanctions which have crippled the country and its economy. The impact that this announcement will have on the oil market depends on three related questions: Will the announcement lead to a lifting of the sanctions on Iran? How much will Iran produce once the sanctions are lifted? And how will the extra Iranian production affect oil prices?

Will the announcement lead to a lifting of the sanctions on Iran?

The announcement was far from being a final deal. It merely represented a set of parameters which will form the foundation of the final agreement. Long and hard negotiations are expected before the 30 June deadline, and “nothing is agreed until everything is agreed”.  But, a deal looks now more likely than it before the announcement, if only because the framework was more detailed than expected.

Sanctions, in particular, remain a thorny issue. The framework suggests that sanctions will be lifted only after “after the IAEA has verified that Iran has taken all of its key nuclear-related steps”. This could take six months to a year after reaching a final agreement, according to John Kerry, the US secretary of state. So sanctions are unlikely to be lifted until the first half of 2016, which runs contrary to the Iranians’ desire for their removal on the day of the agreement.

How much will Iran produce once the sanctions are lifted?

According to the latest estimates by the International Energy Agency, Iran has a spare oil capacity of 0.76m barrels per day (b/d) which can be reached within 30 days. It is fair to assume that Iran will try to produce and export the bulk of this spare capacity once the sanctions are lifted.

How will the extra Iranian production affect oil prices?

Useful lessons can be drawn from the Libyan supply shock in 2011. In that episode, Libya’s production declined from around 1.7m b/d to only 0.5m b/d resulting in a 25% increase in oil price from mid-February to end-April 2011. Assuming that Iran will impact the market proportionally but in the opposite direction, the additional expected Iranian production will probably lower oil prices by 16% (=25%*0.76/1.2). This means that the lifting of sanctions on Iran could depress oil prices by around $9. This assessment is similar to that of the US Energy Information Administration, which expects that additional Iranian production would lower oil prices by $5-$15.

Conclusion. While there is still a long way before a final deal with Iran is reached, the recent agreement on a framework is an important step in that direction. Once a final deal is reached, it could result in a lifting of the sanctions in the first half of 2016. This would add 0.76m b/d of extra Iranian oil into the market, which could depress oil prices by around $9.

Will the conflict in Yemen impact oil prices?

The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders.

Oil prices jumped by almost 5% when the Saudis launched air strikes against Yemen on 26 March. The strikes have raised questions on whether this could cause a significant supply disruption in the oil market. The answer depends on how the conflict unfolds and how widespread it becomes. For this, it is useful to consider three scenarios.

Scenario 1: The conflict stays within the Yemeni borders. This is the most likely scenario. The regional foes have tended to fight their wars through domestic proxies, as in the case of Syria. The scenario promises Yemen years of chaos and misery, but is likely to have little impact on oil prices. With a production of just 150 thousand barrels a day (b/d), Yemen is a small producer accounting for less than 0.2% of global oil supply. Any losses from the Yemeni oil production can be easily replaced with the Saudi excess capacity. And in any case, the oil market is ridiculously over-supplied, so a small loss will hardly be noticed. 

Scenario 2: The conflict spills over in a limited way. This could take the form of the closure of the Bab el-Mandeb Strait. The strait is an important trade route, where 3.8m b/d of crude oil and refined products passed through in 2013, mostly going from the Gulf to the Mediterranean. But the closure of the Bab el-Mandeb Strait does not take this supply out of the market; it just means that the oil tankers have to use an alternative route around Africa. This would add time and transit cost, but the impact on the oil market should still be contained.

In this regard, the strait of Bab el-Mandeb is far less important than that of Hormuz both in terms of oil flow (17m b/d in Hormuz versus 3.8m b/d in Bab el-Mandeb) but also in terms of the availability of alternative routes to bypass each strait (there is not enough pipeline capacity to bypass the strait of Hormuz, while alternative routes exist to bypass Bab el-Mandeb).

The closure of the Bab el-Mandeb Strait is unlikely. There is a heavy presence of international warships in nearby waters as well as an American military base in Djibouti. And if necessary, the Egyptian, Saudi or even the Israeli navy could be deployed to keep the strait open.

Source: Energy Information Administration

Scenario 3: A widespread regional war. This scenario is extremely unlikely. But if it did materialise, it would represent a major shock to the oil market. At risk would be a third of the world’s oil production. However, it is difficult to imagine how an outright war can come about. After all, the regional powers have shown a preference to fight their wars through local proxies and possibly by exporting fighters rather than engage in a direct conflict.

Conclusion. The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders. The prospect of a regional spillover currently looks unlikely. Perhaps realising this, oil prices declined sharply on the second day of the Saudi strikes, reversing all the gains made on the previous day. 

Are lower oil prices impacting the Iraqi dinar?

Lower oil prices and confusing policies are starting to cause a dollar crunch in Iraq.

1. Iraq gets almost all of its US dollars from the government’s sale of oil. To meet the private sector’s demand for dollars (to pay for imports, travel and medical expenses etc), the Central Bank of Iraq (CBI) holds daily auctions in which it sells dollars to the private sector at the official exchange rate (1,166 Iraqi dinar per 1 US dollar) as long as import receipts are provided.

2. The 2015 budget imposed a new restriction preventing the CBI from selling more than $75m a day in its currency auctions. The imposed limit reduces the volume of dollars available to the private sector by two thirds (daily volumes averaged $204m in 2014). The limit was not in the initial draft of the budget, but was later added by the parliament to prevent the depletion of international reserves as oil prices declined, reducing the availability of dollars in the economy.

3. The restriction on the currency auction brings back memories of the dollar crunch of 2013. Following the sacking of its governor, Sinan al-Shabibi, the CBI significantly reduced the volumes of dollars on offer at the auction. As a result, the market price of the dollar deviated from the official price. At its peak, the dollar was sold at 1,292 dinar in the market, almost 11% above the official price. But even during this episode, the volumes sold at the auction were about double the new $75m limit.

4. Following the approval of the budget, the CBI reduced the volume of the dollars sold in its daily auction to an average of $80m—above the ceiling imposed by the budget, but much lower than the $204m it sold daily in 2014. Unsurprisingly, the market price of the dollar began to deviate from the official price. It reached 1,237 dinar to the dollar on 19 February, 6.1% above the official price.

5. The CBI suspended the daily dollar auction after 19 February, leading to speculations that it would stop selling dollars altogether. The CBI denied these speculations, claiming that it has merely replaced the daily auction with a new mechanism based on direct bank transfers. Meanwhile, reports suggest that the government and the CBI are likely to appeal against the article restricting the CBI sales to $75m a day. Against this backdrop of policy uncertainty, the dinar has continued falling against the dollar. Anecdotes suggest the dollar was trading at 1,264 dinar a few days ago.

6. Why is the currency auction so controversial? Its controversy led to the sacking of a former CBI governor, the imposition of a limit on the auction’s daily sales and, ultimately, its outright suspension. Opponents claim that the CBI was lenient in selling dollars against fake import receipts. The dollars sold were then used for speculation and sometimes smuggled out of the country.

Are these claims right? Probably yes. My estimate of private sector imports of goods of services in 2013 is $41bn, which is below the $54bn sold in the CBI’s auctions in the same year. This suggests that some of the dollar purchases were indeed used for speculation and probably smuggled out of Iraq.

7. But is tightening the supply of dollars the correct response to this? Probably not. As in 2013, supply restrictions will only lead to a decoupling of the market price from the official price—a process that is ongoing now despite the CBI’s insistence that it is only temporary.

Egypt’s new growth strategy

Egypt’s new strategy of less government spending, more investment and higher growth is a little ambitious

The economy of Egypt has slowed down considerably since the 2011 revolution. Annual real GDP growth, the standard measure of economic activity, has averaged 2.1% in 2011-14 compared to 5.6% between 2004 and 2010.

Almost half of that growth differential was due to a slowdown in investment. It is hardly surprising that investors have been spooked by the political and legal uncertainty which have followed the revolution. In the chart below, the contribution of investment to real GDP growth over 2011-14 is reduced to a barely visible grey strip below zero. The other half of the growth differential was equally split between private consumption and net exports as the overall environment proved detrimental to consumer sentiment and competitiveness.

Faced with this, the government’s strategy was to increase public spending to shore up the economy. As a result, the government’s contribution to annual real GDP growth has increased a little in 2011-14 relative to 2004-10 unlike all the other components.

But this strategy is now reaching its limits. The government’s budget deficit in the fiscal year 2013/14 was 13.8% of GDP. Excluding grants from the Gulf, the deficit was a massive 17.6% of GDP. This is very large and not sustainable for two reasons. First, because domestic banks—which have lent out large sums to the government in recent years—will eventually run out of liquidity. And second, because Egypt’s Gulf backers are showing reluctance to continue writing blank cheques and are seeking a change in the direction of economic policy.

The Egyptian government is therefore moving to a new strategy, which is based on replacing government spending with investment. In its latest survey of the Egyptian economy (which is published for the first time after a five-year pause), the International Monetary Fund (IMF) predicts annual real GDP growth will average 4.5% over 2015-19 despite a significant tightening in government spending. This is because the IMF expects investments to grow at annual rate of 6.1% over the same period, which is high but still lags the 2004-10 rate.

To achieve this, the government has been designing and promoting large infrastructure projects. These include the Suez Canal Regional Development project as well as preliminary plans to build a large number of housing facilities and construct roads. The authorities also aim to attract foreign investment and the forthcoming economic conference on 13-15 March is one platform to advertise the new strategy.

The new strategy is sound in theory but has its risks. After all, the factors which have inhibited investment post-2011 are still largely in place. Egypt needs to attract enough investments not only to counteract the substantial cut in government spending, but also to raise growth from its current levels. This might be a little ambitious given its prevailing circumstances. 

The Iraqi budget and oil: First as tragedy, then as farce

Iraq might approach the IMF for help, just like it did in 2009 when oil prices fell

The Iraqi parliament approved the government’s 2015 budget on 29 January. Merely passing a budget is normally an unremarkable event, except in Iraq where it was met with relief and jubilation. After all, the country went through the whole of 2014 without a budget.

How does the new budget fare? Starting with the broad figures: Government revenue is expected to be around 94.0tn Iraqi dinar ($80.7bn); expenditure is budgeted to reach 119.6tn dinar ($102.6bn) resulting in a fiscal deficit of $21.9bn. A portion of the deficit will be financed externally (around $8.3bn) with the rest financed through domestic borrowing and the issuance of bonds. The broad picture hides two problems, at least as far as raising the required $8.3bn of external financing is concerned.

1. The budget stipulates that Iraq would use $1.8bn of its special drawing rights (SDR) to finance the deficit. But according to the latest accounts at the International Monetary Fund (IMF), Iraq’s remaining holdings of SDR amount to only $0.6bn, which is the maximum it can use. It is not clear how the shortfall be explained or bridged.

2. The budget suggests borrowing $4.5bn from the IMF to finance the deficit. Problem: This can probably only happen if Iraq agrees a programme with the IMF. An IMF programme would imply conditionality, most likely starting with cutting government expenditure.

Now we can blame declining oil prices for Iraq’s fiscal predicament, but Iraqi policymakers do not seem to have learnt from past mistakes. Iraq did rush to seek the IMF’s help last time oil prices fell sharply in 2009. That programme was a failure as the subsequent recovery in oil prices weakened the appetite for reform in Iraq.

Rather than learning from this experience by building up reserves during the oil boom years, Iraq has managed to blow most of its savings. Reserves at the Development Fund of Iraq (DFI)—whose role is precisely to accumulate oil surpluses in the boom years to finance deficits in slumps—declined from almost $23bn in March 2013 to an estimated $4bn in November 2014. This drawdown would have been enough to finance most of the deficit this year. Why did the government tap the DFI at a time when oil prices were so high? No one knows. Conveniently, by the way, the DFI has stopped publishing its balances since March 2014!

So after four years of record high oil prices, Iraq remains fragile. All it took was a quick drop in oil prices (which has not even persisted yet) to make Iraq consider seeking the IMF’s help, just like it did in 2009/10. But while 2009 might have been a tragedy, 2015 looks more like a farce.