metadata: authors: 0: author: Herrera Aguilera,Santiago
1: author: Youssef,Hoda
2: author: Zaki,Chahir
count: Egypt, Arab Republic of
docna: 0: docna: Egypt beyond the crisis : medium-term
            challenges for sustained growth
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Investment and Investment Climate,Economic Adjustment and Lending,Public Sector Economics,Inflation,Employment and Unemployment,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction
teratopic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: The paper analyzes the impact of the
            recent global crisis in the context of the previous two
            decades' growth and capital flows. Growth decomposition
            exercises show that Egyptian growth is driven mostly by
            capital accumulation. To estimate the share of labor in
            national income, the analysis adjusts the national accounts
            statistics to include the compensation of self-employed and
            non-paid family workers. Still, the share of labor, about 30
            percent, is significantly lower than previously estimated.
            The authors estimate the output costs of the current crisis
            by comparing the output trajectory that would have prevailed
            without the crisis with the observed and revised gross
            domestic product projections for the medium term. The fall
            in private investment was the main driver of the output
            cost. Even if private investment recovers its pre-crisis
            levels, there is a permanent loss in gross domestic product
            per capita of about 2 percent with respect to the scenario
            without the crisis. The paper shows how the shock to
            investment is magnified due to the capital-intensive nature
            of the Egyptian economy: if the economy had the
            traditionally-used share of labor in income (40 percent),
            the output loss would have been reduced by half.
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repnme: repnme: Egypt beyond the crisis : medium-term
            challenges for sustained growth
display_title: Egypt beyond the crisis :
            medium-term challenges for sustained growth
listing_relative_url: /research/2010/10/12883414/egypt-beyond-crisis-medium-term-challenges-sustained-growth
topicv3: Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Fiscal Policy m1327144 445,Unemployment m1504051 2747,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 56
author_keys: 0: author_key: 167039
1: author_key: 1070933
2: author_key: 809665
model_extractions: WPS5451 Policy Research Working Paper 5451

# Egypt beyond the Crisis Medium-Term Challenges for Sustained Growth

_Santiago Herrera Hoda Selim Hoda Youssef Chahir Zaki_ The World Bank Middle East and North Africa Region Poverty Reduction and Economic Management October 2010
Policy Research Working Paper 5451

# **Abstract**

The paper analyzes the impact of the recent global crisis in the context of the previous two decades’ growth and capital flows. Growth decomposition exercises show that Egyptian growth is driven mostly by capital accumulation. To estimate the share of labor in national income, the analysis adjusts the national accounts statistics to include the compensation of self-employed and non-paid family workers. Still, the share of labor, about 30 percent, is significantly lower than previously estimated. The authors estimate the output costs of the current crisis by comparing the output trajectory that would have prevailed without the crisis with the observed and revised gross domestic product projections for the medium term. The fall in private investment was the main driver of the output cost. Even if private investment recovers its pre-crisis levels, there is a permanent loss in gross domestic product per capita of about 2 percent with respect to the scenario without the crisis. The paper shows how the shock to investment is magnified due to the capital-intensive nature of the Egyptian economy: if the economy had the traditionally-used share of labor in income (40 percent), the output loss would have been reduced by half.

This paper—a product of the Poverty Reduction and Economic Management, Middle East and North Africa Region —is part of a larger effort in the department to analyze the drivers of growth and examine the growth prospects of the region’s countries in the medium term. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at sherrera@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **EGYPT BEYOND THE CRISIS: MEDIUM-TERM CHALLENGES FOR SUSTAINED GROWTH**

Santiago Herrera Hoda Selim Hoda Youssef Chahir Zaki.

This paper was written by Santiago Herrera, Hoda Selim, Hoda Youssef and Chahir Zaki. The authors thank Bernard Funck and Sherine El Shawarby for comments to earlier versions of the paper. The opinions expressed in the report are of the authors and do not necessarily represent those of the World Bank or its Executive Directors.
# **INTRODUCTION AND SUMMARY**

In the three years preceding the recent crisis, Egyptian GDP growth averaged over 7 percent per year. The adoption of market-oriented policies, together with a boom in commodity prices and in capital inflows lifted growth to unprecedented levels during three consecutive years. Foreign direct investment flowed into the country and capital formation turned into the driver of growth. The virtuous circle of capital flows, investment, and growth, seemed to have no end. There were some signs of trouble, however: rising inflation, an appreciating currency, and high unemployment rates, especially among women. These challenges seemed manageable, and the diagnosis was that the trickle-down effect from growth would allow polishing off these rough edges. The future seemed to have finally arrived in Egypt.

The global shock that hit Egypt in mid 2008 was mostly an aggregate demand shock that reduced demand for Egyptian exports and lowered private investment due to increased uncertainty and weakened foreign direct investment. The shock led to a revision of expectations and questioning on the growth strategy, on the extent to which the adverse global economic surrounding would affect Egypt, on the country’s growth prospects and on the policy options ahead.

This boom-bust cycle is not the first one in Egypt, and it is certainly nothing new to emerging economies. The objective of this report is to analyze the current slowdown within a historical perspective, and to frame it within the country’s long-term growth challenges. Our analysis of Egyptian growth since the 1990s shows that there are clearly differentiable boom- busts periods tracking international capital flows cycles. The boom periods are associated with rising total factor productivity (TFP), market-oriented reforms and fiscal contraction, while the bust periods are associated with falling productivity, higher public spending and sluggish economic reform. In spite of the procyclical productivity behavior, the growth decomposition exercise shows that capital accumulation is the main driver of growth in Egypt.

The shock led to slower output growth without a corresponding fall in factor utilization. Hence, real production costs increased per unit of output. This brings into consideration the determinants of productivity growth in Egypt in the medium term, and highlights that policy responses to the crises need to support long-term productivity growth. The shock was confronted mostly by a fiscal stimulus package, which was prudent (equivalent to 1.5 percent of GDP). However, some elements of the stabilization package, which were adequate as temporary measures to help firms cope with the fall in productivity or the rise in real cost of production, such as freezing the energy price adjustment program and lowering interest rates, artificially lower the user cost of capital and induce a higher capital intensity than would prevail absent such policy interventions.

In spite of the transitory impact on the growth rate, the crisis will have a permanent effect on the GDP due mainly to the lower capital accumulation during the 2009-2011 period. To regain the 2
output losses, investment has to be higher or productivity has to increase at a faster pace so that potential GDP growth exceeds the 6% prevailing before the crisis. Historical evidence shows that increased public sector spending is associated with lower TFP growth. Hence, given that the blunt of the crisis is over, it would be essential to gradually unwind fiscal stimulus spending and adopt a medium-term fiscal plan that prioritizes spending and supports allocation of resources to their most efficient use. Spending that enhances labor productivity and facilitates job creation, such as transport investment and enhancing the quality of education, should displace other spending items such as the energy subsidy. Such a plan would require targeted social safety nets, and coordination with the central bank to ensure that inflation does not erode the social welfare benefits during the transition period.

The paper is divided into three sections following this introduction. The first one describes the Egyptian boom-bust cycles since the nineties, and subdivides the period into three stages demarcated by the capital flows. The key drivers of growth in each stage are identified by a growth decomposition exercise. The second section quantifies the short-run impact of the crisis and analyzes the policy responses to it. The third section examines the long-run growth prospects and examines the policy implications.

# **I. GROWTH IN EGYPT: STYLIZED FACTS**

This section analyzes the current bust period within Egypt’s growth experience since the early nineties, identifying common elements and differences across different stages. We divide the two decades (1990-2009) into three sub-periods, based on the capital flows: a capital inflow period beginning in the early nineties (1991-1998), a stop in capital flows period (1999-2004) and a capital boom period between 2005 and 2008.<sup>1</sup> This section is divided into three parts. The first one presents some stylized facts of growth over the whole period, the second describes the sub periods, and the third one reports the growth decomposition exercises for each sub-period.

## **A. LONG-TERM GROWTH IN EGYPT: STYLIZED FACTS**

Growth in Egypt has been low and fairly stable. Between the early eighties until 2009, average growth was around 4.9 percent p.a. (Figure 1). This was below the growth in Asian emerging economies. GDP per capita growth was also below that of other non-oil producing MENA countries, though the differences have narrowed considerably in recent years. According to Enders (2007), Egypt experienced only three “growth spurts” (period longer than 2 years during which per capita

> 1 There is no consistent official balance of payments information for the 70’s or 80’s, so we follow the capital flows series constructed by Ikram (2006), particularly useful to compare the late eighties with the early nineties.

3
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intermediation and the appropriability of returns are the most important constraints to growth. Private returns are reduced through the high cost of complex regulations and inefficient government services as well as the cost of innovation and exploration. He further suggests that the recent pick-up in growth was unrelated to efficiency improvements in the financial sector.

# **B. ANALYSIS OF SUB PERIODS**

The two decades since the early 1990s can be roughly divided into three sub-periods, according to the international capital flows: a first period of capital inflow in the early 1990s following the adoption of economic reform (1991-1998); a second period of capital outflow (1999-2004); and a third period of capital inflow (2005-2008).<sup>3</sup> Tables 1.a to 1.d describe policies and outcomes during the three sub-periods. This section shows the commonalities and differences across the sub-periods.

GDP growth is procyclical with the external capital inflow/outflow, though domestic reform also follows a pattern of the external cycle. Following the adoption of the Economic Reform and Structural Adjustment Program (ERSAP) in 1991, GDP grew at an average rate of almost 4 percent in the first period, peaking at 5.5 percent in FY97. The ERSAP aimed at resolving the macro imbalances through market-oriented reforms, namely, increasing the private sector participation, boosting international trade and privatizing many state-owned companies. A large fiscal adjustment brought the fiscal deficit down from 15 percent to 1.2 percent of GDP between FY91 and FY95 (Ikram, 2006). Yet, as a result of reform fatigue, a lack of fiscal discipline, and a shock to external capital flows due to the Russian default and Long Term Capital Management Crisis in the United States in 1998, Egyptian growth reached a trough of 2.4 percent in FY02. Macroeconomic reforms resumed in FY05, the external environment improved and growth picked-up to 6.4 percent between FY05 and FY08 from an average of 4.1 percent in the previous period.

The increase in net foreign assets (NFA) of the central bank was significant in both capital inflow periods. In the first one, NFA increased by US$ 1.2 billion per year on average, while in the second they increased by US$7.5 billion. The difference between both was that the second period flows were mostly foreign direct investment (FDI) which increased from less than 1 percent of GDP in the early 2000s to 8.1 percent in 2008. A topic that deserves further exploration is the relationship between the increase in capital flows and the stagnation or fall in the savings rate in the early 1990s. While Enders (2007) shows a stagnation or slight decline in the savings rate since the mid 1990s, Favaro, Garrido and Stucka (2009) show a significant fall in the savings rate from the early 1990s to the late nineties. This would imply a negative association between capital flows and domestic savings. This fall could also be associated with prevailing negative real interest rates since 2005. The

> 3 Ikram (2006) constructs a consistent BoP series for the period 1952-2000, that show capital flows rising sharply after the adoption of the ERSAP and the Parid Club Agreement in 1991.

6
fall in savings, associated with rising capital inflows, also took place in Latin American and East Asian countries during the 1990s (Reinhart and Talvi, 1998).

**Table 1.a - Real Variables**

|_Period average_|**1987-90**|**1991-98**|**1999-04**|**2005-08**|
|---|---|---|---|---|
|||_Percentage_<br>|_change_<br>||
|**GDP growth**|**5.4**|**4**|**4.1**|**6.4**|
|Imports of goods and services|3.0|3.2|3.7|25.2|
|Gross Fixed Capital Formation|-3.0|4.9|0.4|16.6|
|Private consumption|4.6|3.5|3.4|6.0|
|Public consumption|5.5|5.0|2.9|2.1|
|Exports of goods & services|11.5|3.3|10.2|23.4|
|**Shares**||_Percent_|_of GDP_||
|Imports of goods & non-financial|||||
|services|35.1|28.6|24.1|34.4|
|Gross fixed capital formation|27.4|19.8|18.1|19.9|
|Private consumption|72.2|75|74.2|71.7|
|Public consumption|9.7|10.8|12.1|11.8|
|Exports of goods & non-financial<br>services|23.9|22.9|19.6|30.9|
|**Gross domestic savings**|**16.3**|**14.3**|**13.9**|**16.5**|

_Source: Authors’ calculations based on the Ministery of Economic Development and Central Bank of Egypt data._

**Table 1.b - Fiscal Variables**

|_Period average_|**1987-90**|**1991-98**|**99-2004**|**2005-08**|
|---|---|---|---|---|
|**Budget Sector**|_Percent_|_of GDP (un_|_less otherw_|_ise stated)_|
|Primary Balance|-12.0|3.2|-1.4|-2.0|
|Change in primary deficit (percentage point)|-1.7|1.9|-1.2|0.5|
|Overall Balance|-15.8|-3.8|-7.3|-8.0|
|Change in overall deficit (percentage point)|-2.3|1.8|-1.4|0.7|
|Net Public Sector Debt|na|100.5|92.3|91.2|

_Source: Authors’ calculations based on the Ministry of Finance data_

**Table 1.c - Nominal Variables**

|_Period average_|**1987-90**|**1991-98**|**99-2004**|**2005-08**|
|---|---|---|---|---|
||_Pe_|_rcent (unless_|_otherwise sta_|_ted)_|
|CPI inflation|18.8|11.5|4.2|9.6|
|Average exchange rate (LE/US$)|1.8|3.4|5.2|5.6|
|Average tariff rate|na|11.5|10.3|4.3|
|Maximum tariff rate|na|30|28.1|12.3|

7
_Source: Authors’ calculations based on the Central Bank of Egypt data._

**Table 1.d - External Position Variables**

|_Period average_|**1987-90**|**1991-98**|**99-2004**|**2005-08**|
|---|---|---|---|---|
||_Percent o_|_f GDP (unle_|_ss otherwi_|_se stated)_|
|Trade Balance|-7.8|-14.8|-10.5|-12.4|
|Suez Canal dues|na|3.5|2.4|3.3|
|Tourism|na|4.4|4.7|6.7|
|Private remittances|5.0|5.1|3.4|4.9|
|Private remittances (Bn US$)|3.7|4.1|3.0|6. 1|
|Current Account Balance|-1.3|2.5|0.7|1.8|
|Foreign Direct Investment (Bn US$)|1.0|1.0|0.7|8.6|
|Foreign Direct Investment|1.3|1.9|0.8|6.7|
|Capital flows|_Billion_|_US$ (unless_|_otherwise_|_stated)_|
|Net International Reserves|1.7|14.1|13.6|25.2|
|Not Foreign Assets, annual inflows|1.1|1.2|-0.9|7.5|
|External Debt|42.2|31.8|29.5|31.1|
|External Debt to Exports (%)|583|215.5|156|78.3|

_Source: Authors’ calculations based on the Central Bank of Egypt and International Finance Statistics._ The current account, which represents the balance of saving of the economy with the rest of the world, shows a clear structural change in its level in the early 1990s. From being a capital importer from the rest of the world (negative current account), the country became a savings exporter in the early 1990s (positive current account). The structural shift coincides with the adoption of ERSAP. In 2009, the current account balance turned negative again, indicating a need for external savings in a period of crisis when the world financial system came to almost a complete halt.

The current account also shows an oscillating pattern around a given level. While that level was negative up to the late 1980s, it became positive since then. To examine the determinants of the current account behavior in Egypt we use a simple version of the Obstfeld and Rogoff (1996) intertemporal consumption smoothing model according to which the current account is determined by transitory deviations of income from its permanent level, by fluctuations of investment around their trend, and by transitory deviations of public spending. A simple regression shows that income and investment are statistically significant explanatory variables of the current account behavior in Egypt (see Annex 1). Figure 5 shows how investment is the main driver of the current account oscillation. In particular, the fall of investment up to the mid 1990s is associated with the change in the current account. The fall in public investment implicit in the economic reform program explains the fall in overall investment. The predicted values would be those that the consumption smoothing 8
Figure 3 - Current Account Balance and Investment 1967-2009 Figure 6 - Observed and Predicted Current Account Balances 1967-2009 <!-- Start of picture text --> " a<br>éieee endaF4a<br>tRik. a A eo fe<br>H ' . i Li ._ - -. 7 ed 7<br>wok if ; amaviad FY /* 4<br>|<br>5 ; — |. ;affNe<br>7 7s ao as oo os Li] os 5 78 B a ps = a A<br>"Investment = deviation from trend<br>—— Deviation ofobserved from predicted<br>“Observed ~~ Predicted<br><!-- End of picture text -->

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|I<br>Periodaverage<br>1991-1998<br>|99-2004<br>2005-08<br>|
|---|---|
|||
|144.7<br> <br>|63.3<br>44.5<br><br>|
|PrivateConsumption<br>127.4|54.7<br>40.5|
|PublicConsumption<br>17.3|8.6<br>3.9|
|<br><br>Investment<br>-52.8|20.2<br>49.7|
|PrivateInvestment<br>50.6<br> <br>|-13.6<br>11.4<br><br>|
|PublicInvestment<br>-67.8|29.9<br>40.9|
|Exports<br>33.8|36.8<br>147.1|
|Imports<br>25.8|20.3<br>141.3|
|SounociAuthorscalculationsromt|eMinsnyoF|
|<br>EconomicDevelopmentdata||

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# **_3) Growth decomposition by factors of production_**

This section decomposes growth into factor accumulation and productivity change, based on similar exercises done previously for Egypt by Loayza and Honorati (2007) and Favaro, Garrido and Stucka (2009). The rate of change of physical capital is estimated based on historical investment figures with a constant depreciation rate. The rate of change in human capital is estimated as in Ghosh and Kray (2000) and applied to Egypt by Favaro et al. (2009), but we modify it along three lines: first, we consider the share of labor income to be 40 percent, rather than the 60 percent used in the previous application to Egypt.<sup>4</sup> Previous growth decompositions exercises for Egypt considered a higher share of labor, believing that the share of labor income could be underestimated because the income of self-employed is imputed as capital income (Gollin, 2002 and Bernanke and Gurkaynak 2001).

While such an adjustment could have produced significant changes in estimating the labor share in national income in the past, presently its effect might not be as large given the decline in selfemployment in Egypt, from 25 percent in 1986 (El Ehwany and El Laithy, 2001) to about 11 percent at present (Assaad, 2009).<sup>5</sup> Annex 2 describes our calculation of the share of labor in national income, which oscillates between 32 and 36 percent. In order to avoid overstating this point, we arbitrarily raise the share to 40 percent, still significantly lower than the 60 percent used in traditional growth decomposition exercises. The capital intensive nature of the Egyptian economy is an important feature for at least two reasons: first, there will be low elasticity of employment with respect to output; and second, the higher the share of capital the larger will be the impact on GDP of any shock to investment. Both implications of the capital-intensive feature of the Egyptian economy have important consequences for the analysis of the impact of the crisis on Egypt as will be seen in the next two sections.

Two other differences with previous growth decomposition studies are the use of a variable rate of return to education through time, as well as a changing participation rate in the last years (Said, 2009). The rising rate of return to education in the decade between 1998 and 2006, as well as the increasing rate of labor participation imply higher rates of human capital accumulation.

> **4** Using social accounting matrices, several studies found that the share of capital in output increased from 68 percent in 1988, to 69 percent in 2001, and to 73 percent in 2007 (Eckaus et al., 1981; Akhter et al, 2001; and Kantor Management, 2009). Yet, the share of labor income might be underestimated because the income of self-employed is imputed as capital income (Gollin, 2002 and Bernanke and Gurkaymak 2001).

> **5** Note that the first study is based on Household Income and Expenditure Surveys (HIES) while the second one is based on Labor Market Surveys.

12
Total factor productivity (TFP) growth is the residual of the actual GDP growth rates and the growth rates in physical and human capital, multiplied by their shares in national income. Results in Table 4 show that: 1) factor accumulation is the driver of growth in Egypt, similar to results of Kheir el Din and Moursi (2007) and Favaro et al. (2009); 2) physical capital accumulation is the main driving force in periods in which FDI is booming (early 1990s and late 2000s); and 3) TFP growth is positive during the reform periods, and negative in the policy reversal sub period. The results are worrying in terms of the prospects for growth, to the extent that capital accumulation is subject to decreasing marginal returns. This was the base of Krugman’s (1994) pessimism on the growth prospects of East Asian countries whose growth was also driven by capital accumulation.

International experience shows that productivity growth accounts for most of the difference between successful growth experiences and unsuccessful ones (Easterly and Levine, 2001). But it also shows that countries growth may be driven by factor accumulation initially, and then be driven by productivity growth such as in the US experience in the late 19<sup>th</sup> century and Japan during the early 20<sup>th</sup> century (Kim, 2001).

**Table 4 - Contribution to Growth by Factor Accumulation and TFP Growth**

|_Period average_|**1991-1998**|**1999-2004**|**2005-08**|
|---|---|---|---|
|||_percent_||
|Human Capital|0.22|3.18|2.32|
|Physical Capital|1.94|2.42|3.36|
|TFP|1.79|-1.49|0.7|
|**GDP growth rate**|**3.9**|**4.1**|**6.4**|

_Source: Authors’ calculations_ The rise in capital intensity, especially since 2001, is partly explained by the energy subsidies and the negative real interest rates. With the increase in energy prices worldwide, the economic value of the subsidy in Egypt tends to increase, giving domestic producers an unsustainable competitive edge. On the other hand, negative interest rates experienced in Egypt induce a low cost of capital, which explains the acceleration of investment described in the above section.

Evidence for Egypt shows that TFP falls when unsustainable policies are adopted and rises during periods of market-oriented reform. From Figure 9, it can be seen that TFP growth was negative until the 1990s, when it turned positive. After a brief reversal during the late 1990s and early 2000s, TFP growth turned positive again. This evolution matches closely the three sub periods in which we subdivided the analysis in the present paper. The positive productivity growth sub periods match those of market-oriented reforms. The recovery of TFP growth in the 1990s is particularly related to two factors. First, the trade policy reform reduced the simple average tariff from 42 percent in 1991 to 26 percent in 1998. The reform process stalled in the early 2000s: during 2000-2004, the trade13
Figure 9 - TFP Growth 1970<!-- Start of picture text --> ior.<br>1%.<br>saeins<br>Lor.<br>oor.<br>Lo gO BP FP FB PPP PP RS TP<br>2s.<br>1%<br>som<br>“_<br><!-- End of picture text --> Figure 10 - TFP Levels 1970-2008 <!-- Start of picture text --> 150<br>os6<br>oS2<br>O8s<br>oOg4<br>O80<br>O76<br>13970 7975. 1320 1985 1950 1936. 2000 20065.<br><!-- End of picture text -->
<!-- Start of picture text --> Figure 11 - Trend of the Marginal Productivity of Capital* in Egypt (1975-2008)<br>24<br>20<br>0<br>12<br>2.8<br>3.4<br>7.0<br>2.4 :<br>2.8 : , : .<br>12<br>3<br>1976 1990 1986 1990 19o5 2000 2005<br>Approximated as the ratio of growth to the investment output<br>ratio. Source: Adapted from Favero et al, 2009. Normalized<br>data to make the average of the entire period equal to zero<br><!-- End of picture text -->
# **II. EGYPT AND THE GLOBAL ECONOMIC CRISIS**

The previous section showed that the recent boom period (2005-2008) was driven by external demand and investment. The increased export revenues, the surge in foreign direct investment and augmented remittances from abroad all led to the investment boom and high growth rates. Unfortunately, with the global financial crisis the main external sources of growth were expected to drop off sharply, leading to a considerable slowdown since the mid-2008. This section concentrates on the impact of the crisis on economic growth and analyzes the policy responses to it.

## **A. THE IMPACT OF THE CRISIS ON GDP AND EMPLOYMENT**

## **_1) The impact on economic growth_**

The impact of the global economic crisis on Egypt’s growth was not as large as originally expected. The crisis reduced growth from 7 percent to 4.7 percent in FY09. All components of demand have been affected with lower net exports, consumption growth and investment. However, this is a better than expected outcome since early projections had forecasted FY09 economic growth between 2 and 4 percent.<sup>8</sup> This slowdown was also significantly less than in the developed economies or in most other emerging markets.

The better than expected performance can be explained by five factors. First, because of a lack of integration with the world financial system, Egypt’s traditional banking sector had little direct exposure to the toxic assets in developed economies. Second, a positive – though declining – current account balance since 2005 (around 2 percent of GDP). Egypt’s external needs were low in a context of global financial imbalances. Third, the fiscal stance and high nominal GDP growth led to significant declines in the public debt ratios in the years preceding the crisis. Hence there was room for policy maneuver, as Egypt had cushions that permitted assimilating the shock. Fourth, the limited role of private investment (around 15 percent of GDP in 2008) compared to the rest of the world, minimized the impact of the shock on overall investment, which suffered the bulk of the crisis impact. Also, the confidence crisis had a marginal impact on consumption growth which remained positive (around 5 percent). In the developed economies, for instance, business investment fell by 15 to 20 percent, while consumption only fell by 1 to 5 percent. Fifth, the response to the crisis was

> 8 Other estimates include those of Abou-Aly, 2008 (4 percent in FY09), the IMF, 2009 (3.6 and 3 percent in FY09 and FY10 respectively), and the Ministry of Economic Development, 2009 (4.4 and 4.0 percent in FY09 and FY10 respectively).

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prudent and adequate both in terms of the fiscal and monetary stimulus (see section on the assessment of the crisis). Yet, while these features have sheltered Egypt from the impact of the financial crisis, some of them, namely, limited financial development and low private investments have also been constraints to long-run growth.

The impact of the crisis fell squarely on the activities that experienced rapid growth in recent years. Only two sectors’ output fell: oil refining (-4.2 percent) and Suez Canal services (-7.2 percent). Restaurants and hotels managed to maintain positive but very low growth at 1.3 percent. On the contrary, some sectors such as construction and building outpaced the previous year, up by 20.2 percent in FY09 compared to 15.7 in FY08. Other sectors kept growing at almost the same modest pace, such as wholesale and trade (at 5.8 percent), agriculture (3.2 percent) and real estate ownership (3.8 percent), while others like the financial services have seen their growth rate declining (4.6 percent compared to around 7.6 percent in FY08).

A World Bank private sector survey (World Bank 2009c) showed that small enterprises’ sales (a proxy for output) fell by more than large enterprises' sales. Sales of small enterprises fell by 32 percent, while those of large firms dropped by 19 percent. Given that the shock was mostly to the tradable sectors, and large firms comprise the majority of exporting units, this was possibly due to the lower initial productivity level of smaller firms. In any event, if output contraction in small enterprises continues, the rise in unemployment will be larger than anticipated.<sup>9</sup> Any policy should, however, be directed towards increasing productivity in these units rather than artificially maintaining unproductive ones in operation.

Input utilization, especially of labor, has been slow to react; this implies lower factor productivity or, alternatively, higher real costs per unit of output.<sup>**10**</sup> The private sector survey showed that the median firm decreased its sales by 29 percent<sup>11</sup> , while employment fell only by 5.6 percent. Hence, while output (measured by sales) fell quickly, employment has been slow to adjust, and the capital stock remains fixed, increasing the cost per unit of output. The fall in measured productivity resulting from external shocks has been documented before. For instance, Calvo et al. (2006) documented it in countries that suffered sudden stops in capital flows.<sup>12</sup>

> 9 El Mahdi and Rasheed estimate that 39 percent of total employment is in SMEs, or enterprises with fewer than 50 workers.

> 10 Harberger (2005) uses interchangeably the terms "productivity growth" and "real cost reduction" (RCR), arguing that growth and production take place at the enterprise level and that the second term is better understood by entrepreneurs.

> 11

> This figure drops to 20 percent when sales-weighted results are considered. Inventories increased moderately by 4 percent, hence the drop in sales implies a fall in output.

> 12 Other studies are: Conesa _et al._ (2007) studied the case of Finland after the collapses of its major trading partner, the Soviet Union. Also, Bergoeing _et al._ analyzed the case of Chile and Mexico after the interest-rate shock of the 1980s.

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# **_2) The impact on unemployment and poverty_**

Overall employment growth will likely decelerate over the next two years. Based on forecasted sector growth rates and each sector’s elasticity of demand for labor, Favaro, Garrido and Stucka (2009) estimate that the employment growth rate would fall to around 2.3 percent, down from the 4.6 percent average registered between 1998 and 2006. This growth estimate is similar to that of ElEhwany and El-Megharbel (2008).<sup>13</sup> However, the Favaro et.al. employment growth forecast was consistent with an overall GDP growth rate of 3.9 percent. But, since growth turned up to be higher than expected, we would need to adjust their forecasted figure. Using an elasticity of employment to output growth of 0.3, we adjust the Favaro, Garrido and Stucka employment growth forecast to about 2.8 percent (see Annex 3).<sup>**14**</sup> The downward trend of unemployment observed since 2005 began to reverse, and the adjustment might be protracted. If employment growth falls to 2.8 percent as indicated above, and the labor force maintains the average growth rate of the past few years (an average of 4.3 percent from 2004 to 2008), the unemployment rate would rise to 9.6 percent by the end of 2009, up from 8.9 percent in FY08. This estimate coincides with econometric calculations based on the historical relation between economic growth and unemployment in Egypt for the period 1980-2007. An autoregressive distributed lag model (ARDL) yields a short-run coefficient of the changes in growth of close to 0.3, implying that a drop of 2.3 percentage points in growth (from 7 to 4.7 percent) would be associated with an increase in unemployment of about 0.7 percentage points (annex 4).<sup>15</sup> Given the relatively low value of the “Okun coefficient”, as well as the low value of the elasticity of employment to output, we expect a jobless recovery.

The labor market is a cause of concern given the lower job creation rates, higher job destruction and increases in the size of the informal labor market. In addition to the effect of the sudden stop on job flows, the World Bank rapid survey (World Bank, 2009c) shows that large manufacturing firms are reducing employment more than small firms, making it likely that informal employment will increase. In emerging economies, the informal labor market expands as economic activity contracts, and hence it is countercyclical in nature (Perry et al. 2008). The expected increase in informality is

> 13 El-Ehwany and EL-Megharbel, 2008 found that a change of 1 percentage point in economic growth would lead to a change of 0.53 percentage points in employment in the same direction.

> 14 The 0.3 elasticity of employment with respect to output is estimated by means of an Autoregressive Distributed Lag (ARDL) model. Using both yearly data for 1980-2009, or quarterly data for 2003-2009, the long run elasticity decreases in value and turns statistically insignificant when a deterministic trend is introduced, and the short run elasticity is 0.1. In the quarterly model, the long run elasticity is 0.3, with insignificant short run elasticity. This elasticity is lower than that reported in the previous footnote and generally used in studies of the labor market in Egypt.

> 15Annex 4 presents the estimation of Okun’s Law, which captures an empirical relationship between changes in unemployment and changes in output growth. The estimated coefficient used in this paper is slightly lower than the .36 average reported by the IMF (2010) for a group of developed economies, and similar to the 0.3 originally estimated by Okun.

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the result of two factors: a) wages are more flexible in the informal sector, and hence falling productivity results in a larger hiring drop in the formal sector; and b) the shock has been primarily to the tradable sector, composed mostly of formal-sector firms. The rise in informality is worrisome because the working conditions of the jobs are in general more precarious than in the formal sector. Herrera and Mohamed (2010) also find that wages in the informal sector are 13 to 14 percent lower than their equivalents in the formal sector.

The impact of the global crisis on poverty in Egypt is much less clear-cut than the impact of the crisis on employment and unemployment. Given the low elasticity of employment to output growth and the small size of the Okun coefficient described above, the only likely channel for the crisis to affect poverty is through the household income reduction originated by the fall in remittances from abroad. The balance of payments (BoP) shows that private remittances fell by 10 percent between FY08 and FY09, from US$8.6 billion to US$7.8 billion. Though the fall is moderate, it still leaves the level of post-crisis remittances above historical values. Using household income data for 2009, we found that only 7 percent of households that receive remittances from abroad are poor.<sup>16</sup> How this reduction affects poverty is fuzzy for two reasons. First, because most households that have a migrant are non poor; Roushdy et al. (2008) report that 87 percent of the migrants belong to non-poor households. Our estimates based on household income and expenditure survey reported in the previous paragraph show that in 2009, only 6.6 percent of the households who received remittances were poor. We did a simple partial equilibrium exercise of reducing the value of remittances by 10 percent, and examining how this would change the number of poor households: it increased to 6.7 percent, which is a trivial change. This result confirms Roushdy et.al.’s finding that whether a household receives remittances is not a significant determinant of the poverty likelihood of households. The second reason that explains the difficulty in assessing the impact of remittances on poverty lies in their effect on labor supply decisions, which also affect poverty. Initially Roushdy et al (2008) reported that having a migrant in the household reduces the likelihood of being poor by 4 or 5 percentage points, though the same study reported that receiving remittances did not affect the likelihood of a household being poor. Subsequent work by Assaad and Binzel (2009b) showed that most recipients of remittances are females and that their labor participation rates increase with remittances. Hence, any analysis of the impact on poverty of remittances would have to control for the labor supply effect, which, to our knowledge, has not been done. All this evidence casts serious doubt of any significant poverty impact of reduced remittances from abroad in the case of Egypt.

# **_3) The stabilization package_**

> 16 Poor are defined as those having an income lower than 2,232 LE per person per year (World Bank, 2010). To determine whether the household is poor, we multiply the 2,232 LE by the number of persons in the household and compare it with its income.

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The government adopted a series of measures to stabilize output growth at around 5.5 percent, which was the level consistent with a constant unemployment rate and close to our estimate of the potential growth rate of the Egyptian economy presented in the next section<sup>17</sup> . In FY09, the government increased its spending by LE 13 billion on infrastructure (mainly drinking water and sewerage) and supporting manufacturing. Moreover, additional spending was included in the FY10 budget, taking the projected budget deficit to 8.2 percent of GDP in 2010. In addition to the fiscal stimulus package, the CBE cut its lending interest rate by 375 basis points by November 2009, which was facilitated due to receding inflationary pressures.<sup>18</sup> Also, it eased reserves requirements by counting commercial banks’ loans to small and medium-sized enterprises (SMEs) as reserve requirement holdings. Other measures include freezing the energy subsidy phase-out plan until July 2010, lowering tariffs on over 250 items of imported intermediate and capital goods, and offering sales-tax exemptions on capital goods. This section discusses the medium-term sustainability of the policy mix adopted to confront the crisis.

Regarding the fiscal stimulus package, there are two major issues to address: a) its impact on GDP, and b) its effect on fiscal sustainability given the country’s relatively high debt.

# **_a) The impact of the fiscal stimulus package on GDP_**

The stimulus implied in the government’s spending package is lower than what would be needed to offset the full impact of the fall in external demand. Econometric analysis shows that the increase in public investment necessary to achieve a 1 percent growth in Egypt ranges between 2 and 4 percent of GDP (Favero, Giavazzi and Missale, 2009 and Annex 4). By this measure, the stimulus package of 1.5 percent of GDP (which includes public investment as well as other categories of public spending) would not be sufficient to restore growth to the 2008 level.

The low impact of public investment on GDP is explained by the leakage of resources between investment and capital, and the crowding-out effect of public capital in the short run. It is important to differentiate between investment and public capital, as not every dollar of investment effort is translated into a dollar of capital stock. There are leakages or “inefficacy” of investment, and given accounting practices, some current expenditures may be included as investment. Additionally, there is evidence of strong substitutability between public and private capital in the short run in Egypt. In the long run, however, these two factors may be complements (Annex 4, Fawzy et al., 2006; World Bank, 2008). Both points imply the need for rigorous economic analysis of individual projects to

> 17 A simple regression of the change in unemployment on (non-hydrocarbon) GDP growth during 1998- 2007 shows a constant unemployment rate attained when the growth rate is close to 5.5 percent ( Favero,Giavazzi and Missale, 2009). Also, the last section of this paper has long term GDP forecasts showing potential GDP growth rates stabilizing at 6 percent per year.

> 18 The CBE deposit rates were lowered by 325 basis points in the same period.

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ensure the rationale of public sector intervention, and to minimize the leakage from public investment to public capital. Otherwise, the increase in public spending will not have the desired impact on growth and will leave the economy worse off due to the increased indebtedness or the higher taxation required paying for it.

# **_b) The impact of fiscal stimulus on fiscal sustainability_**

The case for higher public spending must be balanced with a concern for sustainability, given that Egypt’s public debt is already high. Egypt’s net public debt is around 60 percent of GDP in 2009, down from about 83 percent in 2005. This fall was the result of the reduction in primary deficits, high nominal GDP growth, and the appreciation of the currency. Due to the crisis, these factors will not persist in the near future: primary deficits will remain high, inflation and real GDP growth will be lower, and the currency will not continue appreciating. Hence, the rapid fall in the debt-to-GDP ratio will stop, though this should not be a matter of concern in the medium term (Favero, Giavazzi, and Missale, 2009).

As long as the stimulus program is temporary, Egypt’s fiscal situation will continue to be sustainable. The debt sustainability analysis under multiple scenarios of growth, inflation, and exchange-rate depreciation show that, as long as the primary deficit does not exceed the observed 2009 level by too much, and goes back to the planned reduction path, fiscal sustainability should not be a real concern. The most likely event will be a stabilization of the debt ratio in the medium term (until 2012), reverting to a downward trend. The key driver of debt dynamics in Egypt is the high potential growth rate of the economy combined with the relatively low cost of debt. In light of the sustainability concern, the priority should be to implement the already announced stimulus measures and allow the fiscal stimulus to unwind.

The increased flexibility of fiscal policy during the crisis may come at a cost of a higher than expected public debt-to-GDP ratio. To keep the cost of debt servicing under control, which has been one of the key drivers of the past successful debt reduction episode, it is important to consider international evidence of the direct relationship between fiscal variables and the cost of debt service (Caselli, et al., 1998: Drudi and Pratti, 1999; Herrera and Salman, 2008). Based on this evidence, we estimate that an increase of the debt ratio by one percentage point of GDP would raise the cost of funding by up to 40 basis points.<sup>19</sup> To mitigate the immediate impact on the cost, it is essential to

> 19 A panel of developing countries shows that sovereign spreads are a function of the debt ratio (Herrera and Salman, 2008).  The coefficient of the lagged debt ratio in the homogenous panel estimation is around 0.4, or 40 basis points. Allowing heterogeneity in the spread’s response to debt, the range of estimates goes from 13 basis points to almost 60 basis points.  The lowest estimate had an average primary surplus of over 4 percent of GDP during the period, which is far from Egypt’s situation.  A different method, employed by Suescun (2007), calibrates a general equilibrium model for Latin American countries. Adopting his formulation for the cost of debt,  but scaling the initial level of interest rates in Egypt by the ratio of  the marginal productivity of capital in Egypt to the LAC countries estimated by Caselli and Freyer (2006),

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that the excess liquidity is being mopped up by the government as commercial banks increase their holdings of government securities. Further concentration of bank portfolios on government securities would be undesirable, as it would concentrate risk to all parties, and because it might imperil financing of the private sector as the economy recovers from the external shock. Though it is not uncommon in emerging markets for banks to hold relatively high portions of domestic public debt, international experience shows that the potential growth impact of fiscal policy diminishes as the share of public debt held by commercial banks increases (Abbas and Christensen, 2007).

## **_c) Other stabilization policies_**

Despite the sudden stop in capital flows, the exchange rate remained largely stable. By the end of FY09, net international reserves were US$31.2 billion, down by US$3 billion from the December 2008 level. This fall understates the decrease in international liquidity because it does not include the CBE’s other foreign currency assets, which fell significantly. At the end of July 2009, international liquidity fell to US$46 billion, a loss close to US$15 billion.<sup>20</sup> The fall in international reserves responds to a fall in demand for LE-denominated assets: M2 in local currency fell to 56 percent of GDP in the last quarter of 2008, and foreigner’s holdings of T-Bills fell from LE 32 billion to LE 11 billion (approximately US$4 billion). In addition, foreigners’ net sales in the stock market are estimated at about US$1 billion during the period August-March 2009. This indicates that the capital outflow has other sources besides foreigners leaving the market in times of crisis. However, the exchange rate only fell by 5 percent, suggesting that the depreciation of the currency has been mitigated by central bank intervention in the foreign exchange market.

Medium-term balance of payments projections indicate that the external sector may become a tighter constraint on growth than in the past. The IMF World Regional Outlook 2010 forecasts a current account deficit of about 2.6 percent of GDP in 2010, reducing to 2.1 percent in 2011. Hence, in the medium term policymakers should expect increased pressure on international reserves. Part of this pressure can be relieved by letting the currency float more freely and by modifying the public debt management strategy.

# **– III. GROWTH PROSPECTS EGYPT BEYOND THE CRISIS**

In the analysis of Egypt’s growth perspectives, it is important to look beyond the short-term effects of the crisis and examine Egypt’s economy long-term transition after the crisis. This section provides an analysis of growth in Egypt in the next decade.

> 20 The US$15 billion corresponds to the difference between the two stocks of international liquidity of the central bank (including international reserves and other assets in foreign currency) US$46 billion and US$31 billion.

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The cyclical fall in productivity must be framed within a longer-term perspective. The procyclical behavior of productivity along the business cycle has been well documented and researched in developed economies (Bernanke, 2000). In these economies, productivity shows a stable long-run trend, and deviations from it are reversed through time. The shocks in these circumstances are transitory, and they explain most of the volatility of the series. Hence, a productivity rebound could take place after the global economy recovers. However, in emerging economies, the productivity trend is more volatile, and hence shocks tend to be more persistent. For instance, in Mexico, factor productivity recovered its pre-Tequila level only five to six years after the shock (Aguiar and Gopinath, 2007).

The crisis may have long-lasting impact on factor productivity for several reasons. First, subdued global demand for Egyptian goods and services is expected to continue for the few years to come. Second, as aggregate demand shifts from tradable producing sectors towards non-tradable sectors, such as construction and retail trade, resources will be reallocated to the latter, generating less value added per worker. Therefore, aggregate productivity will decrease. Moreover, due to costly labor mobility<sup>21</sup> , resources will not be reallocated in tandem with the global recovery. Third, limited and more expensive access to finance for international corporations will slow down foreign direct investment, resulting in lower levels of capital formation. These expected outcomes imply slower technology transfer and lower capital/labor ratios, and hence, lower labor productivity. Fourth, the return of migrants from the GCC countries will imply less worker remittances, which are used productively by households (Assaad _et al._ , 2009a) and have a positive effect on schooling (Assaad, _et al.,_ 2009b). Therefore, to mitigate these likely productivity-depressing long-lasting effects, the Government must resume structural reform policies that support real cost reduction.

# **A. PROSPECTS: IMPACT ON POTENTIAL GDP IN THE LONG RUN**

To estimate potential GDP in the period 2010-2020, we adopt a production function approach. First we construct a potential GDP baseline based on assumed trajectories for human capital, physical capital, and productivity growth had there been no crisis. Second, we examine deviations of the medium-term (defined as ten years after the crisis) level of output from the baseline (or the level it would have reached without the crisis). We assume that the impact on potential GDP will be mostly through the effect of the crisis on capital accumulation, as has been the case in most OECD revisions of potential growth (OECD, 2009). We also assume lower TFP growth as a result of increased public spending (Kheir El-Din and Moursi, 2007) and reduced savings rates (Bernanke and Gurkaynak, 2000).

> 21 The 2008 _Doing Business_ indicators show that Egypt tops the list of countries on ending-employment costs: the cost of firing, in terms of weeks of salary, is 132 weeks, while in India it is 56, in Tunisia 17, in Morocco 85, and in Brazil 37 weeks.

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# **_1) The potential GDP baseline_**

The baseline scenario is the potential GDP that would have prevailed in the absence of the global crisis. The assumptions for physical capital accumulation, human capital accumulation and productivity growth are described in this section. First, the physical capital is projected by assuming as constant the ratio of investment to the GDP of the previous year (as in Favaro et al. 2009).<sup>22</sup> In 2008, the observed investment as a ratio to GDP of the previous year was 30 percent. Our baseline simulation holds this level constant throughout the forecasting scenario. This level is the highest of the decade, though not as high as the 40 percent registered during the nineties. The difference is in the composition of investment between public and private: in 2008 public investment was 32 percent of total gross fixed capital formation, while in the eighties it oscillated around 70 percent. In the baseline scenario the private-public composition is held fixed at the 2008 level. A constant depreciation rate of 3.7 percent is assumed.

The second element of our simulation, human capital, is constructed as in Favaro _et al._ (2009), but with modifications on the participation rate and the rate of return to education described in the first section.<sup>23</sup> The participation rate was forecasted assuming a slight increase from 53 percent to 54 percent in the 2010-2020, continuing the observed trend between 1998 and 2006. The rate of return to education was assumed constant at 8 percent, based on the observed behavior of the return to education between 1998 and 2006 (Said, 2009; Herrera and Mohamed, 2010).

Finally, the baseline scenario assumes TFP growth constant at 0.7 percent per year, the average level registered in 2005-2008. Though this is a high-growth period, TFP growth was not particularly high, compared to previous episodes, or by international standards. For instance, in high GDP growth episodes, countries typically have higher TFP growth (Harberger, 2005): in OECD advanced economies’, TFP grew at a median rate of 3.1 percent per year; the Asian Tigers’ TFP grew at a median yearly rate of 4.4 percent; and Latin American countries’ TFP increased at a 3.4 percent median growth rate. With these assumptions, we estimate the potential GDP level, and its growth rate oscillates around 6 percent.

# **_2) The long-run impact of the crisis on potential GDP_**

> 22This assumption is needed to avoid the circularity that would occur by assuming a constant ratio of investment to the GDP of the same year.

> 23 Favaro _et. al._ construct human capital stocks (H) based on Ghosh and Kraay (2000) specification: Ht = POPt x WAPRt x LFRt x e<sup>ROExSCHt</sup> , where POPt is total population in year “t”, WAPRt is the ratio of working age population (15-64 years) to total population in “t”, LFRt is the participation rate, ROE is a measure of Returns to Education and SCHt is years of schooling.

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Figure 13- Simulation 1: GDP Growth Rates under the Baseline an Crisis Scenarios <!-- Start of picture text --> 715%<br>70% x,<br>*<br>65% “See<br>60%<br>55%<br>5.0%<br>45% ——— ew shock oone=+ Baseline<br>4.0%<br>id it AG iI he il bo ho ww A ha AS =)<br>S 8 &@ &£ &@ &@ @® 2 8 FEE SB<br>oo wa Go = he a - Pa) no sd oo Ls i=<br><!-- End of picture text -->
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These results are similar to those of the World Economic Outlook (WEO, 2009). Considering 88 economies that experienced significant crisis over the last four decades, output was about 8 to 9 percent lower than it would have been without the crisis. Here the impact is much lower, but so was the impact of the crisis on GDP.

The previous exercise has two important limitations: a) it assumes a constant TFP growth in spite of decreased private investment; and b) it assumes that the public capital stock remains constant, and that the productivity of both private and public capital is the same. For the moment we wish to point out that in 1991, the fall in private investment coincided with a rise in public investment of an almost equivalent amount. Given the differences in the productivity of public and private capital estimated by Favero Giavazzi and Missale (2009) and Annex 4, the output drop would occur more from the change in composition than in the levels of capital stock.

TFP growth decreased as a result of the crisis. Empirical studies for Egypt show a negative association between increased public spending and productivity growth (Kheir El DinMoursi, 2007). International evidence (Bernanke-Gurkaynak, 2001) shows that there is a positive association between savings and growth. As a result of the crisis, both public spending increased and national savings rates decreased, and these existing empirical results provide us the only basis to quantify the impact on productivity in Egypt. Kheir El Din and Moursi show that increased public spending of 1 percent of GDP is associated with a fall in TFP growth of about 10 percent, and Bernanke and Gurkaynak estimate that a fall in savings of 1 percent of GDP leads to a similar fall in TFP. Figure 16 shows the deviation of GDP from the baseline given a 10 percent fall in productivity growth in 2010 and 2011, recovering the baseline growth of .7 percent in 2012. By 2020, potential GDP is around 0.25 percent lower than the baseline. The Figure also shows that decline in GDP resulting from a decrease in TFP growth seems to be long-lasting. And again, the higher the capitals share in output, the larger the resulting output loss.

**Figure 16 - Simulation 3: GDP Deviation from the Baseline Level arising from a decrease in TFP growth**

<!-- Start of picture text --> 0.00%<br>-0.05%<br>-0.10%<br>-0.15%<br>-0.20%<br>-0.25%<br>-0.30%<br>with capital share 40% with capital share 60%<br>-0.35%<br>2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020<br><!-- End of picture text --> _Source: Authors calculations. Figures shown are in percentage change with respect to the baseline scenario._ 28
# **B. IMPLICATIONS FOR POLICY**

The only way to recover the long-run GDP losses estimated in the previous section is by adopting policies that lift the potential GDP growth rate above the 6 percent prevailing before the crisis. This can be achieved through higher productivity growth rates or by increasing permanently the rate of capital accumulation, either physical or human. Higher permanent rates of capital accumulation require stable funding sources, such as domestic savings. Given the trend and level of domestic savings in Egypt, this does not seem a viable option in the short term. The rate of human capital accumulation can be changed through increasing the labor force participation and through increases on the return to education. All these are elements of a medium-term agenda. The most viable alternative in the short to medium-term is through higher growth rates of productivity.

We identify two factors that are critical to productivity growth in Egypt. The first one is the public spending channel, particularly in infrastructure and transportation sector. Recent international evidence shows that reducing commuting costs by 10 percent can increase labor productivity by 1 or 2 percent (Rice and Venables, 2004). The critical question is how much public spending can actually reduce commuting costs. Winston and Langer (2006) estimate that for each dollar spent in highway construction, commuter costs decrease by 11 cents. Extrapolating these precise figures to the Egyptian setting to estimate the impact of additional infrastructure spending on commuting costs to infer the resulting increase in productivity would be highly speculative.

Another study of the relationship between infrastructure spending and growth in Egypt (Loayza, et.al. 2009) finds that the country has a level of infrastructure similar to other countries of similar income per capita. The study showed that additional spending in infrastructure by 1 percentage point of GDP could increase growth by half a percentage point after one decade, and could reach 1 percentage point of additional growth after three decades. These results coincide with evidence presented in Annex 4 and in Fawzy (2006), of the complementary nature between public investment and private capital formation: a shock to public capital by 1 percent of GDP is associated with a rise in private capital of around 0.5 percent (equivalent to .6 percent of GDP) 5 to 6 years after the shock.

The more long term issue is how to shift from a factor-accumulation based growth strategy to a productivity growth based process. There are both microeconomic and macroeconomic studies of determinants of productivity in Egypt. On the micro side, studies of productivity of Egyptian firms (Escribano and Pena, 2010) show that the main factors affecting productivity are transportation and logistics costs, labor skills, and product quality and innovation. At the macro level, studies of the determinants of productivity growth in Egypt (Kheir El Din and Moursi, 2007; World Bank, 2008) point at the consolidation of fiscal adjustment, the advancement of trade integration, lowering inflation, improving infrastructure, and advancing institutional reform as necessary factors to support productivity growth. The bulk of the institutional reform, as described elsewhere (World Bank, 29
2009) is related to the creation of the conditions that enable a more dynamic private sector to emerge. These findings, together with the historical perspective of how countries change from a phase of capital accumulation to another of productivity growth, should serve as a roadmap for policymakers as to the strategies to adopt for sustained growth in Egypt.

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