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Policy Reform for Egypt: 2004-2008 Policy Reform for Egypt: 2004-2008 I. Transition Towards Global Competitiveness: Strategic Framework for Transformation of the Egyptian Economy A. Background The Egyptian economy has introduced a multitude of reforms in recent years to increase levels of competitiveness, accommodate job creation needs, improve human development needs, and sustain GDP growth under stable conditions. In spite of positive developments and improvements within a number of sectors, a number of factors have increased frustration in the efforts to achieve more ambitious targets of economic growth, and more broadly distributed increases in purchasing power. Some have been external, owing to political instability in the region and around the globe, financial crises that have reduced investor interest in most emerging markets, and a more general slowdown in the global economy. However, other factors have been internal, and relate to policy and structural issues in the economy that need to be remedied for faster growth, rising incomes, enhanced physical and social infrastructure, and an overall improvement in living conditions. As Egypt confronts the challenges of the 21st century, it must confront a number of longstanding weaknesses and development obstacles so as to overcome economic, institutional, scientific, technological and digital gaps. In response to this, the proposed note focuses Egypt’s needed structural reform efforts within a strategic movement to develop a globally competitive and knowledge-based economy. Movement in this direction does not preclude continued patterns of work and employment in many traditional areas, such as agriculture in rural areas, and manufacturing and services in urban areas. Instead, it recognizes the need to implement sound policies and reform measures to support economic development, and gain increased access to the benefits which are more readily available as a result of the revolution in information systems and telecommunications in recent years; with a focus on how to apply such benefits to the local economy and institutions. The strategy for transformation identifies the building blocks needed for the transition of the Egyptian economy towards greater global competitiveness. This includes key reforms in the areas of financial sector, private sector, knowledge economy and tax policy. These interventions are designed to accommodate a more competitive, modern economy capable of improving Egypt’s level of economic, institutional, and infrastructure development. The elements of the strategy are all integrated with one another, and work together to help Egypt achieve its broad strategic objectives. 1 Policy Reform for Egypt: 2004-2008 II. Financial Sector Reform A. Overview While Egypt’s financial sector has made progress in many areas in recent years, several areas remain where further progress is needed; in some cases on an accelerated basis. In the banking sector, key priorities include (i) finalizing state bank privatization, (ii) strengthening financial intermediation, (iii) enhancing financial stability, (iv) more fully developing regulatory and supervisory capacity at the CBE, (v) improving corporate governance, and (vi) increasing transparency and accountability. All of these reforms are to run parallel with other areas in which Government of Egypt (GoE) has already made formal commitments, such as movement to RTGS in the payment system. In the non-bank sector, attention should be focused on a combination of activities in the securities markets, insurance and pensions, as well as venture capital, leasing, warehouse receipts, housing finance, and municipal finance. In the securities markets, key objectives include (i) increasing equity market participation, and (ii) developing debt markets— Government and private. In the insurance sector, priorities include (i) strengthening the legal framework and actuarial profession, (ii) bolstering regulatory and supervisory capacity, and (iii) promoting an environment that is conducive to strengthening the market and financial condition of the insurance sector. With regard to pensions, efforts should to be made to introduce a sound second pillar, as government finances and the existing single-pillar scheme are insufficient and are guaranteed to be under-funded, as elsewhere throughout the globe. Venture capital (VC) is considered vital for development of a globally competitive economy. However, for VC to develop, information flows must be open, and exit mechanisms are required for VC firms to sell their shares. As of now, the markets in Egypt do not demonstrate the underlying conditions for vibrant venture capital. Leasing activity needs to accelerate in Egypt, particularly to assist SMEs with new financing vehicles for fixed assets. Linked to all of these areas is the underdevelopment of financial infrastructure for agricultural finance, housing finance, and municipal finance. B. The Banking Sector Egypt’s banking sector is the bulwark of the Egyptian financial system. The financial system is bank-based, and its 571 licensed institutions are responsible for most lending and investment in the economy. Moreover, many of the banks and specialized institutions play a role in “development” needs of the economy, albeit not without cost. However, as elsewhere (e.g. Turkey, transition Europe), experience over the years has shown that directed lending and subsidized credit schemes usually carry painful economic costs. In the banking sector, these are often manifested by eventual recognition of non-performing loans and the need for provisioning, ultimately reducing earnings and capital. For banks serving as agents for governments, the costs are ultimately borne from fiscal and/or monetary sources. As many of the banks are state-owned, the flows are circular, yet the costs ultimately weaken the economy and reduce financial stability. For these reasons, it 1 A recent presentation by the Governor of the CBE noted there were 55 banks. 2 Policy Reform for Egypt: 2004-2008 is imperative for Egypt’s banking sector to embark on a reform effort so as to enable its banks to operate professionally and commercially, while adhering to sound regulations and supervisory requirements to ensure underlying stability. The following reforms are proposed to achieve these objectives. ►Reform #1: State Bank Privatization Egypt has four state-owned commercial banks, two specialized state-owned financial institutions, and 11 joint venture banks with state participation. State banks have recently been recapitalized, and new management/board members have been installed. The program from 2004-08 should be for the state to exit banking, backed by more efficient CBE regulatory/supervisory oversight, plus implementation of effective risk-based supervision that is founded on sound internal systems, ongoing reporting, and risk management capacity at private banks. This will require a diverse strategy encompassing (i) privatization tenders and sales; (ii) mergers and acquisitions; (iii) consolidation and/or resolution via purchase and assumption; and (iv) flotations on the local exchange. Key needs for the Government include the need to map out a strategy and appropriate options for each of the 17 banks, and then to map out requirements that are internal as well as those that would be outsourced. These tasks should be done in FY 2004 and implemented in 2005-06. Thereafter, 2007-08 should be dedicated to the clean-up of any residuals from the privatization program, such as any bad debt collection resulting from the transfer of bad assets prior to privatization transactions. ►Reform #2: Strengthen Financial Intermediation Deposits in banks and specialized institutions approximated $66 billion at end 2002, or nearly $1,000 per capita. Broad money to GDP approximated 86 percent, which is reasonably high by international standards. With real GDP forecast to grow at approximately 3 percent in subsequent years, a simple increase of that amount compounded for five years would translate into deposits increasing to $79 billion by end 2008. Government strategy should be to strengthen the banking environment to ensure the public has confidence in the economy, the currency and the banks to reach this target. This, in turn, will help to increase the flow of funds for commercially viable enterprises and projects, while also bringing down borrowing costs for households and enterprises. Meanwhile, any decline in the broad money-to-GDP ratio should be offset by increases in savings mobilization with insurance companies or pension funds. ►Reform #3: Strengthen Financial Stability Banking system capital in Egypt at end-2002 was $13.5 billion, or $238 million on average.2 Proposed changes are for domestic banks to have LE 500 million in minimum capital by end-2006 (about $75-100 million-equivalent, depending on exchange rates3), Figures derived from “Other Items (Net)” from International Financial Statistics (IMF) for deposit money banks and specialized banks. This figure is spread across 57 banks and specialized institutions. 3 With the exchange rate at 6.13 per $1 as of October 30, 2003, this would be equivalent to $81.5 million on that date. 2 3 Policy Reform for Egypt: 2004-2008 and foreign bank branches to have $50 million in minimum capital. Such minimum capital requirements would be substantial by international standards. However, based on comparative “financial strength” measures, the changes appear to be warranted, considering that Egypt’s scores are relatively low by global standards.4 Assuming a simple 3 percent year-on-year growth figure, average capital should grow from nearly $238 million in 2002 to about $285 million by 2008. This figure may change if there is significant consolidation via mergers and acquisition, and purchase and assumption. However, based on the existing number of 57 institutions, a $285 million capital target per licensed bank is reasonable.5 Such capital figures will need to be tested for risk, putting the onus on CBE and banks to ensure proper identification of risks so that these can be managed without adverse effects on financial stability. In this regard, it is recommended that the government increase minimum capital adequacy ratios to 12 percent no later than 2007 to account for market risk premia that countries like Egypt face. When there are early warnings of risks, these should be managed and administered with the intention to getting bank CARs to, and above, the minimum required in the shortest possible time. This calls for an explicit prompt corrective action policy to be articulated and effectively implemented based on explicit triggers. This may include asset sales from weaker to stronger banks, highlighting the importance of the need for more developed secondary markets in the Egyptian financial system, as well as a more active syndicated loan market in Egypt. Other measures include the termination of dividend payments (as already exercised by CBE), freezing of salaries and benefits, limits on lending authority, etc. Credit risk is largely related to inadequate or incorrect information, poor credit risk evaluation capacity, financing deals run through affiliates and connected parties, lack of financial discipline, past reliance on subsidies and refinancing, and allocation of credit on non-commercial grounds. Some of the risk associated with inadequate recognition of non-performing loans relates to taxes applied against provisions. There is currently a 10 percent tax exemption applied to general provisions. While there is always concern about For instance, Moody’s Financial Strength Index puts Egypt at 22.9 (on a scale of 100) as of May 2003, placing it 43rd among 60 countries on a weighted average basis. (See “Global Financial Stability Report”, IMF, September 2003.) 5 Assuming average assets of $114.7 billion-equivalent, this would require roughly a 1.5 percent annual RoAA. Such earnings would approximate an RoAE of 11.2 percent. These returns are fairly consistent with more advanced economies. For instance, in 2002, US banks’ ROA was 1.3 percent, and ROE was 14.5 percent. In Europe, after-tax ROA was 0.3 percent, and after-tax ROE was 8.2 percent. They are also roughly on target for Egyptian ROE measures, which have declined y-o-y since 2001, but were 12.4 percent in 2001 and 11.1 percent in 2002. However, the RoAA figure is considerably higher than the norm for Egypt, as its ROA has declined from 0.8-0.9 percent in 1998-2001 down to 0.7 percent in 2002 and 0.6 percent in 2003. Thus, with tightened regulations, Egyptian banks will need to increase earning assets as a share of total, which also should point to the need for better loan classification, more accurate provisioning, and essentially better credit risk management. (The Egyptian asset figure is derived from IFS assets for banks and specialized banks at end 2002, converted to dollars, and then applying average real growth of 3 percent per year through 2008. US, European and Egyptian ROA and ROE figures are from the “Global Financial Stability Report”, IMF, September 2003.) 4 4 Policy Reform for Egypt: 2004-2008 banks over-provisioning for tax purposes, the other side is that under-provisioning obscures the weakening solvency and financial position of the institution. At a minimum, an evaluation should be conducted to determine if the tax system is appropriate for modern banking practices, particularly with upcoming changes to be applied as part of the second Basel Capital Accord. Fundamental liquidity and market risks are related to (i) the exchange rate under the recently introduced floating rate regime,6 given that external liabilities reported by banks tend to be about 3:1 to assets7; and (ii) interest rate risk, particularly in local currency.8 Other risks may apply in terms of maturity mismatches, excess credit and investment concentrations or exposures, and weaknesses in internal operating and information systems. At a minimum, this will put pressure on banks to demonstrate their liquidity management systems are adequate relative to gaps, exposures and risks. The onus here is on the CBE as well as bank management teams to ensure their risk management systems are operating properly, and that there is compliance with prudential norms. There should be a progressive strengthening of macro-prudential risk detection at CBE and the banks, with banks taking the lead and the CBE testing and certifying banks’ systems as adequate in risk detection. There should also be no forbearance under any circumstances for state banks, particularly as this would send a signal that recent recapitalization, new management and boards, and the terms of performance contracts are less than serious. ►Reform #4: Enhance CBE Regulatory and Supervisory Capacity With growing liberalization of financial services and a proliferation of banks in the 1990s, there has been a need to adapt to a more open, market-based system. Thus, CBE needs to strengthen its off-site surveillance, on-site inspection capacity, policy coordination, and contingency planning for stress and downside risks. This includes implementation of CAMELS, and the introduction of an articulated corrective action plan for banks that fall below 10 percent CARs. CBE acknowledges its need to develop a program by which regular stress testing will be conducted as a function of strengthening monetary policy implementation, financial sector stability, and the role played by banking supervision. Additional tools that may be included would be newly articulated criteria for deposit-taking institutions to meet deposit safety criteria, and for non-compliance to trigger corrective actions. 6 For example, the exchange rate was 3.44 to $1 in 1999, gradually weakening to as low as 6.08 in 2Q 2002. By end 2002, the rate was 4.50. As of October 31, 2003, the exchange rate was 6.13 per $1. Thus, the local currency has shown significant movement in recent years. 7 Banks’ external liabilities were $21.4 billion at March 31, 2003, as compared with only $7.9 billion in external assets. Meanwhile, for non-banks, external liabilities were $8.3 billion, and assets were $5.2 billion. Thus, non-banks also have exposures and gaps, although the ratio is not as wide as with the banks. All together, the consolidated foreign claims of reporting banks are $10.4 billion on a risk-adjusted basis. (See “BIS Quarterly Review”, September 2003). 8 As an example, Treasury bill rates were 6.3 percent in January 2003, 7.5 percent in February 2003, and 13.6 percent in March 2003. (See International Financial Statistics, IMF.) 5 Policy Reform for Egypt: 2004-2008 In general, financial information needs to be timely, complete and accurate. The introduction of consolidated accounting for banks and other licensed financial institutions should be a starting point to meet such information requirements. This information should be complemented by regulatory reports that can draw on automated systems running consolidated accounting systems (see Reform #6 below). ►Reform #5: Improve Corporate Governance Banks need better systems for credit risk evaluation, portfolio management, identification of risks to asset values and earnings declines, and risks to solvency and liquidity. State banks are now under commercialized management, and performance contracts are in effect to strengthen the recently recapitalized state banks. Audit committees and the internal audit function should be mandatory, autonomous, and effective. All banks should have internal risk rating systems for loans, clients, investments and portfolios for assetliability management, general portfolio management, strategic planning, investor relations, and regulatory reporting purposes. In general, banks should be particularly market-focused, as they are expected to tap into domestic and international markets for additional funding (borrowings from syndicated lines) and investment (to further boost capital). Key measures for banks to take, and for CBE to ensure are functioning properly, include (i) required MIS for risk management purposes and regulatory reporting, (ii) internal rating systems for prudential purposes, (iii) effective committees in place (legal, audit, credit, investment, treasury, risk oversight) reflecting risk-based banking and properly functioning, (iv) functional, autonomous internal audit function, and (v) “fit and proper” shareholders and senior management. Again, there should be no double standard for state banks vs. private banks. These reforms should be fully demonstrated by 2004, and evaluated continuously through the supervisory process. ►Reform #6: Increase Transparency and Accountability Egyptian banks need to increase their levels of transparency and accountability to attract greater investment, and for regulatory authorities and the public to have increased confidence in their solvency, liquidity, management, and general (and ongoing) operating condition. These two themes are essential, and germane to above mentioned reforms. For example, for banks to meet rising capital figures, it is likely that outside investment will be required as tighter rules apply to loan classification and other asset valuation (e.g. real estate), and as traditional ROA measures suggest more than retained earnings will be required. Moreover, a better flow of sound information is needed to restore and maintain depositor confidence, as well as the confidence of institutions lending to banks. Thus, more complete, accurate and timely information is needed for markets and regulators. All banks should have their information systems (branches and headquarters consolidated for submission to CBE) in condition to connect to the CBE credit risk information network by 2004.9 This should be coordinated through introduction of a Uniform Bank Performance Report for the largest banks, and required for all remaining banks no later 9 According to CBE, 37 of 57 met requirements as of June 2003. Connections are expected to be fully functioning by end 2003. 6 Policy Reform for Egypt: 2004-2008 than 2005. Credit information provided by CBE should be complemented with private credit ratings10 for companies and households. More generally, for markets to better function, consolidated accounting should be required of all licensed financial institutions. This should be introduced for the largest financial institutions (including insurance companies) by 2004, for all banks and insurance companies with deposits and/or savings exceeding $1 million-equivalent by 2005, all banks and insurance companies by 2006, and all institutions by 2008. Such accounting reform should be verified by international auditors, and all institutions’ financial statements should meet ISA standards of audit and be consistent with consolidated accounting standards according to IAS by 2005.11 This includes mark-tomarket accounting for real estate values held as assets on bank balance sheets, as well as any adjustments required regarding classified assets following international guidelines and any revisions to prudential norms and risk weights that might be required by CBE between now and then. C. The Securities Markets and Venture Capital Egypt is generally inactive in international equity markets, while its exposure to international debt markets fluctuates. With the exception of a $300 million12 equity issue in 2000, there have been no recorded issues (by nationality of issuer). 13 This is broadly in keeping with regional trends. Middle East markets in general point to low levels of stock market capitalization and debt securities, relying more on bank-oriented systems.14 The markets in Egypt suggest slightly more market development relative to GDP than as compared to these trends, but still well below most other regional markets. Total “emerging market financing” (loans to, bonds, and equity investments in) for Egypt has fluctuated in recent years, from as high as $2.545 billion in 2001 to as low as $646 million in 1998 and $670 million in 2002. (No figures were published for 2003.) The 2001 figure was largely due to $1.5 billion issued in bonds, with the rest from international loan syndications. Equities have remained limited, as noted earlier.15 Meanwhile, price-earnings ratios in Egypt are generally about half the norm for emerging markets in Europe and the Middle East, and just slightly better than half the ratios of emerging markets in general. There also appears to be a penchant for paying out dividends, rather than retaining earnings for needed investment and growth. Egypt’s dividend-yield ratios have been among the highest in emerging markets since 1998, averaging about three times the norm for emerging markets and three to four times the 10 At the moment, there is no private credit information bureau in Egypt. Banks have reported according to IAS since 2000. 12 Another source cites this as $319 million. (See “Global Financial Stability Report”, IMF, September 2003.) 13 See “BIS Quarterly Review”, September 2003. 14 The Middle East stock market capitalization in 2002 was $52.5 billion, or 6.5 percent of GDP. Bond markets were valued at $18.9 billion, or 2.3 percent of GDP. By contrast, bank assets were 103.8 percent of GDP. (See “Global Financial Stability Report”, IMF, September 2003.) 15 International equity issues totaled $102 million in 1998, $89 million in 1999, and $319 million in 2000. Figures since 2001 have been zero. (See “Global Financial Stability Report”, IMF, September 2003.) 11 7 Policy Reform for Egypt: 2004-2008 norm as compared to emerging markets in Europe and the Middle East. This may partly reflect the need to pay out dividends to attract short-term investment, as well as relatively easy access to bank credit for listed firms. All of these trends point to the need to bolster domestic securities markets, while also pursuing international issues. For markets to function closer to their potential, Egyptian enterprises need to become more competitive to attract needed investment and credit, from foreign as well as domestic sources (see Private Sector Reforms below). In this regard, financial sector reforms are critical in the banking system to increase the provision of needed services. However, with several internationally recognized and rated banks in Egypt, the problem is less access to needed financial services (albeit cost is an issue for many firms), and more the ability to implement needed efficiencies at the firm level to attract institutional investment. This is more likely to occur in the domestic market than from abroad. At a minimum, increasing the domestic securities market reduces the risk of institutional investors from abroad reducing their exposures to Egypt for exogenous (to Egypt) portfolio management reasons, while also reducing the risks to local enterprises of dependency on bank borrowings. Furthermore, development of the domestic markets would also facilitate local development via municipal financing, greater housing finance as has occurred with recent changes in mortgage markets, and consumer finance through various asset-backed securities that can be marketed and securitized. Beyond these market development needs, there is a strong push around the globe to develop venture capital markets. The link to advanced technologies and innovative processes is directly tied to these markets, as evidenced by pioneering products and services from the United States and other markets where venture capital has figured prominently. Nonetheless, for VC to function, information needs to be openly disseminated, standards need to be in place, products and markets need to exist, and exit mechanisms need to be in place for VC investors to generate the returns needed to sustain their businesses and investments. These are generally lacking in Egypt, as evidenced by low levels of transactions on the Cairo and Alexandria exchanges. In addition to the fundamental private sector reforms needed for innovative businesses to have an opportunity, the markets in Egypt do not appear positioned to absorb and trade such companies. Open market operations require greater levels of financial information and transparency for these transactions to occur, and for sufficient liquidity to be available. Moreover, in many cases, such firms are bought and sold via private placements, which are affected by discriminatory treatment in the tax code.16 Thus, substantial market development will be required for viable VC to take off in Egypt. 16 Capital gains legislation treats bonds and income from other securities issued by joint-stock companies as exempt if they are publicly traded and registered with one of the stock exchanges in Egypt. However, for securities not publicly trade, the tax rate is 32 percent. (See “Egypt: tax regulations”, Economist Intelligence Unit, August 19, 2003.) 8 Policy Reform for Egypt: 2004-2008 The following reforms are proposed to more fully develop the securities markets: ►Reform #1: Increase Equity Market Participation There are currently 79 firms with equities traded on the Cairo and Alexandria Stock Exchanges, with stock market capitalization equivalent to $7.3-billion as of October 31, 2003.17 Meanwhile, international equity listings have been limited in number and value, with no activity since 2001. In fact, since 1998, international equity listings by Egyptian firms have approximated $510 million, against an emerging market total of $102 billion, equivalent to 0.5 percent. Reforms should be focused on increasing market capitalization (including international equity listings as contribution to capital) to levels that approximate emerging standards by 2006-08. Notional targets should be as follows: Stock Market Capitalization Targets Increasing market capitalization (including international equity listings as contribution to capital) to: 2006 Half the norm for emerging markets (12.35% of GDP), or notionally about $12 billion. 2008 The norm for emerging markets (24.7% of GDP), or about $26 billion.18 To achieve these targets, significant reforms need to occur in the real sector as these are the firms that are currently underserved by the financial markets. (The financial sector also needs to pursue reforms, particularly if they want to eventually issue equities and bonds. However, the issues are more pressing for enterprises.) Basic reforms include: Requiring companies that list to be fully compliant with IAS Increasing the availability of timely information with notes for the investment community to evaluate company prospects and performance in detail Promoting development of the NBFI sector to increase the involvement and role of institutional investors in the market Ensuring the depository continues to function properly and meet all requirements for integrity and operational efficiency Maintaining an investment-friendly environment to attract investment from abroad Promoting the issuance of small-value denominations to increase retail participation in the equity markets Promoting development of secondary markets to encourage liquidity and turnover Eliminating any tax discrimination that serves as a disincentive to equity investment 17 See http://www.egyptse.com/main.asp. Exchange rate cited from CBE web site. The emerging market norm was stock market capitalization equivalent to 24.7 percent of GDP in 2002. Thus, if the same in 2008, this would be equivalent to about $25.6 billion if real GDP grows at 3 percent per year through 2008. 18 9 Policy Reform for Egypt: 2004-2008 ►Reform #2: Develop Debt Markets As equity markets are underdeveloped in Egypt, so to are debt markets. In the Middle East, debt markets account for less of a share of GDP than do the feeble equity markets. In Egypt, this is not the case, with debt markets accounting for about 10 percent of GDP.19 Further development of the money market is expected with recent changes in the design and implementation of monetary policy in Egypt. However, the corporate debt market and asset-backed securities market is underdeveloped throughout the Middle East, including in Egypt. Thus, a reasonable target is to achieve emerging market norms by 2008, largely by promoting non-governmental debt securities during the five-year period so that there is a reasonable mix of public and private debt in the markets by 2008. Targets for achievement in the distribution of public and private debt are comparable to ratios achieved in global emerging markets. These would be: Bond Market Value Targets Establish a viable debt market and asset-backed securities (bond) market, including for mortgages, municipal bonds, and Government securities to: 2005 Half the norm for emerging markets (17.3% of GDP), or notionally about $17 billion. 2008 The norm for emerging markets (34.6% of GDP), or notionally about $36 billion.20 Meanwhile, based on emerging markets norms for 2002, Government bonds (including municipals) could approximate 58 percent of total debt markets, while private debt securities (mainly corporate and financial institutions) could account for 42 percent in 2008. Based on the above notional targets for debt securities, this would translate into about $21 billion in government financing, and about $15 billion in corporate and financial institutions’ debt financing. All of these figures are still small relative to bank financing, particularly if capital and deposits grow, and considering that banks would be among the leading issuers of corporate debt securities. Nonetheless, they add new instruments, and impose new kinds of discipline on issuers that are beneficial in terms of financial management and economic competitiveness. Basic reforms needed to build debt markets are similar to those referenced above in terms of equity markets. D. Reform of the Insurance Sector and Pension Funding Egypt’s underdeveloped insurance sector deprives businesses and households of needed protection, and the capital markets of needed long-term investors. Life insurance is a particular challenge in the region. Life insurance sales are undermined in the Middle East region by generous retirement benefits and religious objections. However, in the case of the former, many governments including Egypt cannot afford these benefits. Meanwhile, 19 See http://www.egyptse.com/main.asp. Exchange rate cited from CBE web site. The emerging market norm was debt securities market values equivalent to 34.6 percent of GDP, of which about 58 percent is government and 42 percent is private. Thus, if the same in Egypt in 2008, this would be equivalent to $35.6 billion if real GDP grows at 3 percent per year through 2008. 20 10 Policy Reform for Egypt: 2004-2008 other forms of insurance resembling life insurance might be devised without being inconsistent with religious norms. Key reforms that should be pursued include: ►Reform #1: Strengthen the Legal Framework for Insurance A modern legal framework that promotes a sound and well-managed insurance sector can help to attract investment, strengthen institutions, and encourage business growth. Any legal changes in the insurance framework should accommodate measures that would reduce impediments to market development on the condition they are also consistent with principles of financial stability, good governance, market efficiency and consumer protection. This might include mandatory health insurance (e.g. for foreign workers) and motor insurance, and any other areas where fiscal imbalances may be deepened as a result of insurance omissions, as well as movement towards pension reform to encourage employees to contribute to professionally managed savings plans. Basic measures include: Bringing legislation in line with IAIS guidelines Separating insurance from banking Separating life and non-life Bringing investment policy guidelines in line with international standards Establishing consumer protection measures that apply to rate-setting, policies and claims Establishing an Ombudsman for dispute settlement ►Reform #2: Strengthen the Regulatory and Supervisory Framework A sound insurance sector cannot emerge without suitable regulations and supervisory oversight. As with banks, failures in the insurance sector undermine public confidence. Likewise, abuses by companies also weaken prospects for market development. On the other hand, the business of insurance is about providing financial coverage for risks. Thus, rights and responsibilities should be fully understood by all parties. Standardized contracts may reduce the risk of abuse, while also clarifying payment obligations on both ends. Key reforms in this area should include: Bringing prudential norms and ratios in line with IAIS-recommended guidelines and/or in countries where models appear potentially relevant and useful to Egypt Establishing reporting guidelines consistent with international standards so that financial information is timely and accurate Building capacity for surveillance and inspections to verify financial information (e.g. solvency ratios) Developing capacity for contingency planning in the event that major insurance failures cause distress for large numbers of households, or potentially adversely impact the financial sector and the economy 11 Policy Reform for Egypt: 2004-2008 ►Reform #3: Support Development of the Actuarial Profession Development of an actuarial profession takes time and reliable statistical data. At the same time, incentives must be available to encourage a sufficient number of trained actuaries to take on the profession in the first place. Development of the insurance sector depends on actuaries and sufficient information for actuarial sciences to be applied. Insurance sector development, along with pension reform, would provide the incentive needed to further develop the profession, as market demand along with public sector requirements would increase demand for such high-level information and services. Moreover, development of actuarial sciences is in keeping with efforts to achieve a more knowledge-based economy. Basic reform efforts should focus on establishing and refining standards and guidelines by 2004, and then constructing and refining databases for insurance companies to evaluate risk and introduce insurance products accordingly. Such development would also have a “knock-on” effect in other financial markets, such as housing finance, and would increase the knowledge base for broader portfolio and risk management applications. ►Reform #4: Link Insurance Sector Development with Pension Reform As Egypt stabilizes its fiscal position and seeks to expand its fiscal base, it will need to project out the degree of funding needed to cover the first pillar of the pension system. More importantly for the next generations, Egypt will need to move forward to establish a vibrant 2nd pillar of the pension system, and preferably a 3rd pillar in time as long-term confidence grows, markets mature, and resources are available for voluntary discretionary savings. In the meantime, efforts need to be made to ensure that preconditions for effective 2nd pillar management are in place. These include (i) regulatory capacity to ensure mandatory pensions are prudently managed according to investment policy parameters, (ii) custodial capacity to ensure the safety and veracity of transactions and portfolio information by account, and (iii) general reporting mechanisms to ensure that all financial and accounting data are accurate. Movement in this direction should serve as an incentive for life insurance firms to play more of a role in the financial sector, including as major institutional players in securities markets. Meanwhile, movement in the direction of a 2nd pillar should then serve as a potential harbinger of eventual movement towards a 3rd pillar, adding to financial market opportunities and instruments. E. Other NBFI Issues In addition to the major components of financial sector development—banking, securities markets, and contractual savings—there is room for development of other specialized areas of finance. These include leasing, factoring, warehouse receipt financing, housing finance, and municipal finance. Leasing is largely an asset-based credit function by which equipment value secures the loan. The benefit of an active leasing market is that it provides SMEs with financing operations without requiring large down payments. Key incentives to develop this market 12 Policy Reform for Egypt: 2004-2008 are depreciation schedules, and the impact on taxes paid. There is also a need for secondary market trading in equipment to establish salvage values. For growth to increase among SMEs, a more active leasing market would help. Factoring is largely a commercial credit function in which portfolios of small credits are bundled and sold at a discount for immediate cash. This resembles the syndicated loan function. A key ingredient is consumer credit data to test for credit worthiness. Absence of such information either makes this market impossible to function, or at least adds significantly to the risk of assuming the portfolio. The three other areas—warehouse receipts, housing, and municipal finance—are all closely related to the development of securities markets. Warehouse receipts are largely secured financing transactions backed by inventories that have been weighed, graded, and in some cases processed and prepared for shipment. Housing finance in Egypt is currently bank-based, with little market development beyond basic home loans. Municipal finance exists at a low level. In all three areas, there are prerequisites to adding to the financing volume that could eventually be used as products for securities markets development. Warehouse receipts are an obvious product in a country with large numbers employed in the primary sector. Housing finance is likewise an area of potential growth, particularly with urbanization and high population growth rates. Meanwhile, municipal finance would be expected to grow over time as local governments build capacity to administer some local infrastructure and service needs. In this regard, housing finance trends are closely linked to municipal finance capacity, as property tax assessments are often the main financing source for municipalities. ►Reform #5: Promote Development of a Broad Range of NBFIs Several areas can be supported to stimulate growth of NBFIs. Accounting and tax reform related to more accelerated depreciation schedules for equipment might serve as a useful stimulus for leasing market development, triggering increased lending to and investment in SMEs. Expansion of the credit information effort of the CBE might assist with the development of factoring markets. An evaluation should be made as to whether it would be commercially feasible to establish a private credit information agency. 21 Electronic information flows might help make markets in the agricultural sector, facilitating development of a warehouse receipts market on local exchanges. A clear legal framework (based on creditors’ rights) for secured housing transactions would help pave the way for primary financing of housing, as well as eventual secondary market purchases via bonds or other securities. Adoption of modernized appraisal standards and mark-to-market accounting for property values would assist local governments with property tax assessments, increasing their capacity to float bonds for needed investment and services. 21 This would not require government involvement. Rather, it could simply be an announcement of changes (or planned changes) to make the environment more conducive, and then solicitation of expressions of interest to establish a private credit bureau. 13 Policy Reform for Egypt: 2004-2008 III. Private Sector Reform A. Background Egypt’s GDP is fairly large, ranking about 38th in the world in 2001.22 Recent economic performance also has highlighted many sound macroeconomic fundamentals, including reasonable inflation rates, low fiscal deficits, adequate hard currency reserves, a stable debt profile, and recent improvement in export performance (including non-oil, and a rise in services).23 However, GNI per capita is only about $1,470, which is fairly low by international standards. Compared with 13 Middle East countries for which data are available,24 Egypt ranked higher only than Yemen, Morocco and Syria. As compared to Portugal, which has the lowest per capita income among EU countries at $10,840, Egypt’s GNI per capita would only represent 13.6 percent in relation. While the unemployment rate was last listed in 1999 at 8.1 percent, this figure is considered low when accounting for levels of under-employment. Meanwhile, recent reports produced by the Arab Fund for Economic and Social Development and UNDP put many of Egypt’s human development indicators at fairly low levels, and certainly sub-optimal levels relative to potential.25 Therefore, a number of reforms are needed to further galvanize Egypt’s efforts to narrow the income gap with advanced and middle-income countries, to provide needed stability, and to increase access to quality education, health care and jobs for sustainable development. B. Policy and Institutional Reforms As noted above, an appropriate policy and institutional framework is needed to increase the effective use of information across all sectors of the economy, and to promote entrepreneurship to better use and adapt such knowledge and information for economic growth and development. Key policies (with supporting laws, regulations and institutions) include: Macroeconomic stability Good governance Judicial systems that help to improve enforcement of a sound legal framework. Openness to trade and (foreign direct) investment as a function of free and fair competition Low barriers to entry and exit Credit, investment and financial sector policies to deepen financial intermediation Labor market flexibility combined with investment to increase the supply of knowledge-workers while providing incentives to companies to hire and retain through enhanced productivity and performance 22 See Swiss Re. See Abul-Eyoun, “Egypt: Economic Performance FY 2002/03”, CBE, 2003. 24 Algeria, Iran, Israel, Jordan, Lebanon, Morocco, Oman, Saudi Arabia, Syria, Tunisia, UAE and Yemen. 25 See “Arab Human Development Report” for 2002 and 2003. 23 14 Policy Reform for Egypt: 2004-2008 Specific to the business environment, Egypt shows positive developments in some areas, and the need for progress in others. According to the World Bank, 26 areas in which Egypt is not too far from recommended OECD standards and/or is consistent with regional norms among the Middle East countries cited are (i) flexibility in hiring employees, (ii) number of procedures and days to enforce contracts, (iii) procedural complexity in the enforcement of contracts, and (iv) the cost and efficiency of closing a business. Thus, there has been some clear labor and judicial reform, as well as progress in reducing barriers to bankruptcy, restructuring and liquidation. However, areas where Egypt’s performance lags are several. These include: 26 Business Start-up: Starting a business requires 13 procedures and 43 days. This is typical of many regional economies, as well as some of the less efficient or developed OECD countries. However, it is significantly more than the most competitive OECD countries, and several of the countries in the region with higher GNIs than Egypt. Importantly, the cost of business start-up is high, at 61 percent of GNI per capita (about $900). Among “high” OECD countries, only Greece is higher as a percentage of GNI. Italy is the second lowest performer among the OECD countries, at 24 percent, about 40 percent of the relative cost in Egypt. Furthermore, minimum capital to start a business is high in Egypt, at 788.6 percent of GNI (about $11,600). Only four of the Middle East countries have higher ratios, and none of the OECD countries are anywhere close. (Greece and Austria are about 140-145 percent.) Thus, Egypt has very high costs of entry, and this stifles private sector development and fiscal base expansion. Conditions of Employment: Egypt’s conditions of employment appear protective of workers, making it difficult to release unneeded workers. Such an impediment carries the risk that companies are less interested in taking on permanent employees, while also possibly overstating employment rates in national statistics due to difficulties releasing those currently employed yet de facto redundant. This adds to cost, undermines productivity, and reduces economic competitiveness. Contract Enforcement: Egypt’s performance with regard to contract enforcement is comparatively good. However, it is costly to firms, as indicated by the high cost of enforcement. In Egypt, contract enforcement costs are equivalent to 30.7 percent of GNI, or about $450. While cheap by OECD standards, Egypt’s costs relative to GNI are twice that of Finland, where relative costs are highest among “high” OECD countries. The average cost is also high by regional standards, with only Israel, Lebanon and Syria having higher relative costs. Business Closure: While contract enforcement appears largely adequate in Egypt, business closure takes an exceptionally long time. The average is 4.3 years, with only Denmark and Switzerland (among “high” OECD countries) taking as long. In the Middle East, Egypt’s performance is in the mid-range, with several countries taking approximately as much time, and Oman and UAE taking 5-7 See “Doing Business”, World Bank. 15 Policy Reform for Egypt: 2004-2008 years. However, such long proceedings and closure procedures run the risk of asset stripping, political and judicial corruption, and higher costs of contract enforcement. To remedy these weaknesses, needed reforms include: ►Reform #1: Broad Policy and Institutional Reforms Business start-up costs are far too high and need to come down as a percentage of GNI. This calls for the streamlining of procedures, lowering overall costs of licenses/permits for start-up, and lowering capital requirements for non-financial enterprises. Conditions of employment need greater flexibility, and less employee protection. Contract enforcement mechanisms appear costly, and efforts should be made to streamline these costs if possible. Business closures should not take more than four years. Thus, more efficient resolution procedures, including specialized commercial courts or other forms of alternative dispute resolution should be introduced. IV. Movement Towards a Knowledge-based Economy The progression towards a knowledge-based economy within Egypt should focus on (i) developing a coherent national strategy to build and sustain a knowledge-based economy; and (ii) providing the conditions needed for establishment of a knowledgebased economy, including the infrastructure for networking and sharing of knowledge, as well as the openness and transparency of information flows needed for cooperation, coordination and balanced development of key sectors of the economy. Both actions should be broad-based in approach, involving government and private sector actors across all sectors of the economy, and should target the development of the following synergies between stakeholders: 16 Policy Reform for Egypt: 2004-2008 Egypt should work towards building a comprehensive program to achieve movement toward a knowledge-based economy. This program would emphasize the following characteristics: An appropriate policy and institutional framework that provides economic and other incentives to increase the use of information across all sectors of the economy, irrespective of the source of that information (i.e., domestic or foreign), and to promote entrepreneurship to harness the use and adaptation of such knowledge and information for economic growth and development. Basic components of such an effort include macroeconomic stability, governance standards and the rule of law, competition policy, labor market flexibility, the regulatory environment, openness of trade and investment, entry/exit of firms, credit and financial sector development, and intellectual property rights. Establishment and maintenance of a skilled, flexible and innovative work force with increased access to education and opportunities, based on a mix of public and private sector funding. Such focus on education and human capital investment can be measured in a number of ways, from basic literacy/numeracy and enrollment in primary, secondary and tertiary institutions to more efficient and effective R&D, issuance of new patents, and general levels of intellectual property development. Development of a dynamic information systems infrastructure—Information and Communications Technologies (ICTs)—that thrives on increasing competition and innovation in the use of information, and that is harnessed to adapt/apply such information and processes to all sectors of the economy to support rising efficiency and competitiveness. This includes high-end systems such as the internet and mobile telephony, as well as lower end methods of transmission (e.g. radio, television, other media, computers) and storage/archiving. Coordination of firms, scientists, engineers, research centers, universities, think tanks, and other institutions to help implement the knowledge-based framework, including elimination of duplicative efforts, and simultaneously pooling efforts/resources when feasible for large-scale and ambitious projects. A. Enablement of e-Government Services (G2G, G2B and G2C) With efforts to further professionalize the civil service, enhance public sector service delivery, and reduce the scope for corruption, Egypt’s reform program should include modernization, use of advanced technologies and information systems, and increased application of electronic services. These may include: Establishing an e-civil service registry compatible with the current payroll system to permit cross-referencing of staffing and salary data. 17 Policy Reform for Egypt: 2004-2008 B. Introducing electronic intra-governmental interaction to modernize systems and processes, and to enhance communications and information flows within and between ministries and different governmental organizations. This initiative might include e-budgeting to enhance efficiency and transparency in public expenditures, as well as to facilitate the monitoring of revenues, expenditures and variances for ongoing management and planning needs. Establishing an e-taxation system to improve revenue collection, enhance transparency, and increase the efficiency of collection. Increasing electronic applications to more broadly disseminate information, and to better deliver Government services. These could include: o e-Justice, to streamline and automate case handling and reporting systems, with the objective of reducing multi-year backlogs and increasing efficiency in the courts. o e-Health, to provide access to vital information for service providers, and statistics to enhance service delivery. o e-Land Cadastre, to improve access to land records and title information for the development of land markets, and to promote investment in housing and commercial property development. Innovation and the Work Force (G2B, B2B and E2B) Establishment and maintenance of a skilled, flexible and innovative work force is a prerequisite for a competitive economy. Thus, education at all levels is essential, as is recognition of the permanence of the process. A corollary to this point is recognition that on-the-job training is sometimes the most effective method of education and training for people on an ongoing basis, notwithstanding the clear importance of literacy and numeracy for entry into most jobs. From a policy standpoint, this must be accompanied by an open and conducive environment for free and fair competition. ►Reform #1: Enforcing a Sound Competition Policy Domestic competition policy should be designed to promote sustained economic growth, and to ease the entry and exit of firms into and from the market. In recent years, Egypt has been fairly open to entry. However, exit has been a different matter, adding to distortions in the market. Measures that can be pursued to ensure Egypt’s competition policy is consistent with best practice and international standards include (i) aligning the country’s intellectual property rights regime with that of the WTO; (ii) enforcing antimonopoly regulations, and strengthening anti-monopoly institutions; (iii) promoting private sector investment into new technological ventures without biasing the incentive structure in favour of specific firms vs. other non-preferred firms; (iv) supporting a more efficient banking system, and the formation and growth of non-banks (e.g. venture capital, leasing, insurance, private pension funds, mutual funds) and markets (e.g. securities markets, venture capital markets); and (v) adopting tax policies that are 18 Policy Reform for Egypt: 2004-2008 straightforward, easily understood, easily administered, fairly regular in terms of rates and conditions (to encourage investor certainty and investment planning predictability), and competitive with or better than tax rates and administrative practices abroad (to reduce the risk premium associated with investment in Egypt). ►Reform #2: e-procurement The e-procurement initiative would need to be accompanied by a review of procurement processes, including thresholds for types of firms and methods of awarding contracts, as well as the criteria used to evaluate bids and the general process of scoring and announcing awards. However, recognizing that these are universal challenges, movement in this direction would represent progress, stimulate competition, potentially reduce costs of government services, and provide greater private sector opportunities. ►Reform #3: e-licensing/registration Movement to introduce a web-based license application and renewal process would streamline bureaucratic procedures, reduce corruption, and stimulate business formation and investment. Such a process would need to be accompanied by information verification procedures and company identification numbers (linked to tax and customs administration). However, by and large, such a process would contribute to the numbers of small businesses operating, reduce government administrative costs, potentially reduce the costs of licenses and renewals, accelerate the process (beneficial to companies), streamline the numbers of permits required, and likely contribute to a broadened fiscal base. ►Reform #4: e-investor Movement to introduce a web-based investment approval process would be similar to the e-licensing/registration service, and would provide prospective investors with information on the status of their investment application process. Such a process would provide confirmation that registration requirements (e.g. tax-related) were in order, and the status of any remaining approvals regarding permits and licenses. This would reduce paperwork, accelerate investment, and likely make the approval process more efficient as the electronic format could be tied to “no objection” triggers based on days required for formal approvals.27 Given that a sound competition policy is adopted, specific measures can and should be taken to strengthen investment in human capital. These include: ►Reform #5: Enhancing Human Capital via Education Egypt has a long tradition of higher education and learning. However, as with many developing countries, there is also a challenge of broad-based access beyond primary 27 Many investment promotion frameworks make approvals automatic if no objection has been issued within a specified time line. 19 Policy Reform for Egypt: 2004-2008 levels. Adult literacy rates are 65 percent for men and only 40 percent for women (1997 figures).28 Meanwhile, many individuals with secondary educations find it difficult to find work commensurate with education and skill levels. Thus, several reforms can be adopted to improve the role of education and training. These include: (i) modernizing curricula and testing/examination processes at all levels to meet the needs of industry and international standards; (ii) aligning students’ academic research towards industry needs; (iii) establishing or restructuring Education Councils and Boards to include private sector representatives and sponsors, to ensure alignment with industry needs, and to introduce commercial practices; (iv) creating Qualification Assurance Systems to certify competencies of individuals and accredit institutions/firms; (v) designing national (unified) testing systems for Higher Education establishments to provide unified requirements to future students and making admissions more transparent, as well as to reduce the cost of the admissions process; (vi) expanding vocational training through private sector partnerships to meet labor market demands; (vii) providing re-training for workers to adapt their skills to the knowledge economy (e.g. internet training, business and marketing skills); (viii) training/assistance for redundant employees to re-orient them towards prospective jobs as well as to teach new skills; (ix) introducing and expanding the use of distance learning—internet-based education; (x) improving computer literacy and internet-based skills by introducing computers, basic programming and software early in schools, and connecting schools, universities and vocational training centers to the internet. With a sound competition policy in place and measures to strengthen human capital, economic “push” and “pull” can come from measures that support the development and increasing efficiency of innovation. A series of reforms can be pursued to broaden the scope of innovative processes and procedures in Egypt. ►Reform #6: Advancing Innovation Several measures can be introduced or expanded to advance innovation in Egypt. These include: (i) support for competitive research programs for research centers, think tanks and universities, including enhanced information dissemination; (ii) support for Metrology and Patent offices with greater legal, institutional and laboratory infrastructure capacity; (iii) establishment and refinement of national standards (in line with international standards) via a National Accreditation and Quality Council; (iv) support for the commercialization of R&D outputs, research centers, think tanks, universities and enterprises by upgrading laboratory facilities and staff skills, modernizing HR systems and business processes, improving marketing and commercialization functions, enhancing incentives for applied research, introducing competitive research programs, and promoting joint projects with industry and other R&D organizations; and (v) promotion of technology parks and centers to encourage integration and niche clusters. 28 See “World Development Report”, World Bank, 2000. 20 Policy Reform for Egypt: 2004-2008 C. Financial Sector Reform and Movement to a Knowledge-based Economy (B2B and G2B) As Egypt’s financial sector modernizes, technology and advanced information systems will be highly featured. This will relate significantly to fundamental financial stability and risk management issues, as well as basic competitiveness requirements at the institutional level. Some additional measures either have been carried out, or can be carried out in Egypt to ensure this process continues for increased economic competitiveness. These include: D. Facilitation of the use of digital signatures, to enhance the speed of business-tobusiness transactions, and to improve the efficiency of business contracting (which would presumably be beneficial to financial sector players as creditors and investors). Introduction of an e-Credit information system to improve the availability of borrowers’ credit histories to financial institutions to enhance access to finance by SMEs. The CBE is in the process of expanding its public credit registry for retail and SME application. Having most banks’ systems linked electronically to that of the CBE constitutes progress to date. All other banks should be required to do so. (Whether this impedes the private credit bureau option should be evaluated.) Facilitation of the increasing use of the e-Pledge registry for movable assets to improve creditors’ rights, and thereby reduce risks of lending to SMEs; moving on to automate the immoveable registry, and to have this available for public review on a computerized basis. Information Systems Infrastructure (G2C, G2B and B2B) Development of a dynamic information systems infrastructure is also a prerequisite for economic modernization, competitiveness and growth. This includes the use of high-end systems (e.g. internet, mobile telephony) as well as more traditional technologies (e.g. radio, television, other media, computers) to assist with the transformation of information dissemination, production, processing, distribution and financing from traditional methods to more electronic methods. Examples would be expected to include business-to-business exchanges of information, as well as business-to-client exchanges of information, services and payments. (Government and financial sector applications are also discussed in subsequent sections.) For this to occur, a policy and program of ICT support should be in place. ►Reform #1: Supporting Information and Communications Technologies Fundamental measures to support ICT include (i) modernizing telecommunications networks, including liberalization and privatization of the traditional fixed line company; (ii) promoting alternative communication tools (wireless services); (iii) universalizing access to telecommunications (including for low-income and rural dwellers) to “bridge the digital divide”; and (iv) promoting affordable internet access. Among other measures, one approach to increasing access is to make these services available at post offices, 21 Policy Reform for Egypt: 2004-2008 libraries, and other public agencies that are commonly found throughout Egypt. Commercialization and partial privatization of the postal system could include such a component for revenue generation to cross-subsidize losses from traditional core operations (along with other electronic upgrades, such as transmission and receipt of domestic and international money orders/transfers/remittances). E. Coordination (G2G, G2B, G2C, B2B and E2B) Coordination of public and private sector institutions is of critical importance for a knowledge-based strategy to be effectively and efficiently implemented. Firms, scientists, engineers, research centers, universities, think tanks, and other institutions are all needed to help conceptualize and implement the knowledge-based framework. This includes areas of focus and investment, the elimination of duplicative efforts, and the pooling of efforts/resources when feasible for large-scale and ambitious projects. ►Reform #1: Supporting a Knowledge-based Economy via Enhanced Coordination Several measures can be taken to improve coordination. This includes (i) setting up and/or strengthening Technology Policy Institutions to enable them to carry out policy studies, serve as data centers on technology issues (for private and public sectors, both locally and internationally), and conduct technology outreach and public awareness activities; (ii) align Science and Higher Education Policy with the needs of the economy; and (iii) improve the research base, while integrating it with the international community through joint collaborations on publications and projects. V. Tax Policy and Government Reform Efforts A. Basic Fiscal Position Egypt’s fiscal balances have tended to be reasonable in recent years, particularly as its debt profile has been well managed. Fiscal deficits have come down since 2001 as a share of GDP, suggesting there has been improvement in fiscal management even though the economy has experienced a slowdown (in dollars) since 2001. (Real growth in 2002/03 was reported by CBE to be 3.1 percent.) The following table highlights revenues, expenditure and balances relative to GDP since 1998.29 Government Balances: 1998-2002 1998 24.32 Fiscal revenue (% of GDP) 25.32 Fiscal expenditure (%GDP) -1.01 Fiscal Balance (%GDP) Sources: HSBC Bank, IMF(IFS), World Bank 1999 24.24 28.45 -4.21 29 2000 21.25 24.57 -3.32 2001 20.5 22.30 -1.8 2002 20.1 21.80 -1.7 These figures are subject to some error as they are derived. Government balances have not been published in International Financial Statistics since 1999. 22 Policy Reform for Egypt: 2004-2008 The informal sector is estimated to account for about 35 percent of GNI. This is at the high end for the Middle East countries, with only Morocco and Tunisia estimated to have higher rates. (Egypt, Algeria and Lebanon are similar.) By contrast, “high” OECD countries (apart from Greece at nearly 29 percent) generally do not exceed 23 percent (Belgium, Portugal and Spain), and most are about half that of Egypt or less. All of this points to better systems of collection and compliance, even in the weakest of the “high” OECD countries. ►Reform #1: Reduce Impediments That Keep the Informal Sector Large Many of the private sector reforms proposed would help to bring informal enterprises into the formal sector. While lower tax rates may help, including a flat tax if introduced, many enterprises often stay informal for other reasons. These are because corruption (e.g. bribes) serves as a tax that is unrecorded. Beyond that, the number of licenses, permits, procedures, inspections, etc. becomes so cumbersome, time-consuming, discretionary and costly that formalized procedures are not worth pursuing. In addition, with low incomes, there is an added incentive for people to underreport income to avoid paying taxes. Thus, to reduce the size of the informal sector, a multi-faceted approach to tax administration, tax rates, and public sector management needs to be implemented. Should rates come down and administration become less cumbersome, it is likely that the informal sector share of the economy would decline. Structure of Tax Revenues30 B. Based on data from 1999-2000, Egypt’s revenues approximated 22.8 percent of GDP. This was slightly below the average of 25.3 percent for eight Arab countries.31 Egypt’s revenue contribution to GDP was broadly distributed as follows: 6.8 percent from hydrocarbon revenue fees, dividends, and CBE profits; placing non-tax revenue below the eight-country norm of 7.6 percent 4.5 percent from VAT/general sales and turnover; marginally below the 4.8 percent norm 4.2 percent from corporate taxes; well above the 3.4 percent norm 2.8 percent from import duties; below the 4.3 percent average 1.8 percent from individual taxes; in line with the norm of 1.7 percent 1.5 percent from excise taxes; less than the 2.2 percent average 1.2 social security taxes; slightly above the 1.0 percent norm This structure suggests that there is reasonable distribution. Non-tax revenue serves as a huge supplement to general fiscal revenues, while direct taxes (corporate and individual) account for about 26 percent of total. Egypt’s structure in this regard appears to generate a bit lower revenue than the three Maghreb countries (e.g. Algeria, Morocco, Tunisia), Figures for this section all from K. Nashashibi, “Fiscal Revenues in South Mediterranean Arab Countries: Vulnerabilities and Growth Potential”, IMF, 2002. 31 Algeria, Egypt, Jordan, Lebanon, Morocco, Syria, Tunisia, and West Bank/Gaza. 30 23 Policy Reform for Egypt: 2004-2008 while being consistent with the Mashreq countries (e.g. Jordan, Lebanon, Syria, West Bank/Gaza). By comparison with middle income countries,32 Egypt’s fiscal revenues to GDP appear fairly consistent, although slightly lower than the 23.6 percent recorded on an unweighted basis. However, G-24 countries of the OECD averaged 32.5 percent revenues to GDP, with far higher revenues generated from individual income (7.2 percent of the 32.5 percent), as well as far higher Social Security taxes (8.5 percent). Corporate tax revenue was only 2.6 percent of GDP (less than Egypt), whereas reliance on VAT was 6.2 percent of GDP (greater than Egypt). ►Reform #2: Marginal Reconfiguration of the Structure of Revenues Egypt’s distribution is not too far from many reasonable models. Should there be changes, the main changes needed appear to be (i) slightly expanding the net of VAT/sales tax items, although increasing application of electronics through POS and other systems may suffice; and (ii) tightening customs administration, perhaps to raise collections on imports and associated excise taxes. The main focus is likely to be on reducing rates and closing out exemptions, combined with better collection. C. Tax Rates In several cases, Egypt’s tax rates appear to be reasonable by global standards. For instance, corporate taxes are projected to come down to 32 percent (from 42 percent). 33 The 32 percent rate is already in effect for industrial activities, and would come down in services and trade. While some countries have lower rates, including some of the more dynamic and/or advanced economies, the 32 percent is within range of international norms. Moreover, this rate is uniformly applied to resident and non-resident enterprises, public and private. There may be gaps or abuses in the number of activities that enjoy exemptions, including donations to government agencies and “approved” charities (the latter up to 7 percent of annual taxable “profit”), and remuneration paid to company directors (although this is presumably taxed as personal income). Any move to lower rates and/or to move to a flat tax would also call for the closing of many/most exemptions to broaden the fiscal base without sacrificing revenue. Personal income tax rates range from 20 percent to 48 percent. These are higher than many emerging markets, although these rates are not necessarily inconsistent with many OECD countries. The main challenge for Egypt is to increase individual incomes so that the proportion of individual tax revenues increases by virtue of rising incomes. The role of personal income taxes would also need to be factored into flat tax considerations. By excluding personal income, it lowers the base of taxation to corporations. On the other 32 Includes five transition European countries, Turkey, four southeast Asian countries, and six South American countries. 33 This includes a 2 percent “development duty”. 24 Policy Reform for Egypt: 2004-2008 hand, a flat rate applied to individuals and companies broadens the base, and provides an opportunity to lower rates.34 Sales tax rates in Egypt are a universal 10 percent. Major reform in the general sales tax has transformed this into a VAT. Over time, this should assist with collections and fiscal balances. However, this will also depend on systems for collection, overall compliance, and a sufficient base (few or no exceptions) to keep the rate(s) down. Some attention has been put to introducing a corporate flat tax for simplification. While it has worked well in some countries at certain times,35 there is no guarantee it would solve Egypt’s fiscal challenges. Advantages to this approach include clarity and simplicity, as well as a vehicle to reduce government corruption. However, choosing an appropriate rate is subject to risk if the rate is too low (leading to insufficient revenues) or high (possibly perpetuating high levels of non-compliance). Moreover, there is an issue of what is subject to taxation, which also points to issues such as depreciation schedules and exemptions. On the other hand, progressive tax systems often are complicated, involve exemptions, and invite avoidance and corruption.36 ►Reform #3: Reforms in the Administration of Tax Rates and Collection Basic measures the government can take to improve tax administration and collection include closing exemptions, and reducing the scope for negotiation with Government tax officials. An additional item is to review depreciation schedules to investigate how accelerated rates might encourage more investment. As of now, depreciation schedules are extended, while many of the leading edge industries that are knowledge-focused have far more accelerated schedules. A review of the strengths and weaknesses of moving to a flat-tax regime is also warranted. 34 The Slovak parliament approved a 19 percent flat tax applied to individuals and companies on October 28, 2003. 35 For example, Russia has introduced a 13 percent flat tax, and fiscal revenues have exceeded expectations. However, this coincides with a booming economy, and it is uncertain if the flat tax would work if commodity prices dropped and/or unemployment claims increased with other expenditure during an economic slowdown. 36 The recently adopted flat tax legislation in the Slovak Republic is designed to both increase collections and reduce corruption. This was also one of the motivations in Russia, where the flat tax has achieved results well beyond expectations. 25