## Real per Capita GDP Growth

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### Introduction — long-run performance and recent acceleration
- Egypt’s long-run growth during 1980–2000 was strong relative to the average emerging market economy but below high-growth Asian emerging markets.
- During 2001–05 Egypt grew less than most regional peers and much less than the average developing country or emerging market.
- Since 2004 growth has been accelerating in step with implementation of a series of ambitious reforms.
- Objective: identify constraints that held back Egypt’s growth, whether recent reforms removed the most binding constraints, and which constraints may become binding in the near future.
- Definition used in the paper: a “growth spurt” is any period longer than two years during which per capita growth exceeded 2 percent in each year.
  - Egypt experienced two such growth spurts since 1980: 1982–86 and 1996–2001, with another underway since 2004.

### Methodological approach — growth diagnostics and limitations
- Follows Hausmann, Pritchett, and Rodrik (2004): treat growth as optimization under constraints and search for the “most” binding constraints whose removal allows temporary growth spurts.
- Recognizes the theory of second best (Lipsey and Lancaster, 1956): removal of one distortion in the presence of others can produce negative indirect effects; approach assumes removing the “most binding” distortion yields a net positive effect.
- Diagnostic decision tree (Hausmann, Rodrik, and Velasco, 2005) classifies candidate constraints into:
  - Access to finance
  - Appropriability of returns
  - Availability of complementary factors of production
- Data and survey limitations: economy-wide surveys may miss sector-specific constraints (e.g., agriculture, small enterprises).

### Key comparative statistics
- Per capita growth, 1980–2000 / 2001–2005 (as presented in Table 1 excerpt)
  - World               2.23.1
  - Developing Countries2.45.1
  - Emerging Market Economies2.65.0
  - Industrial Countries2.11.4
  - Brazil0.70.7
  - Egypt2.41.7
  - Malaysia3.92.5
  - South Africa-0.22.7
  - Turkey2.22.9
  - Morocco1.23.0
  - Tunisia2.23.3
  - Indonesia3.33.3
  - Jordan-0.13.5
  - India3.44.7
- Source for the table: IMF World Economic Outlook Database (September 2006).

### Is it Financing? — evidence on financial constraints
- Business surveys (WEF Executive Opinion Surveys) consistently ranked “access to finance” as the top (or second-most important) obstacle in recent years.
- National savings and real interest rates:
  - National savings persistently well below Asian comparators and mostly below regional peers; only Brazil and South Africa had slightly lower savings rates among peers.
  - Real bank lending rates during 1995–2002 fluctuated in a range of 5–12 percent.
  - During 2003–06, Egypt’s real lending rates declined sharply, to 2–3 percent in 2005–06.
- Private sector credit and investment:
  - Private sector credit growth (particularly lending to corporates) remained subdued even as real lending rates fell in 2003–06.
  - Private sector credit as a share of GDP gradually declined during 2001–05.
- Access to foreign savings and capital account indicators:
  - Concerns about “foreign currency regulations” ranked fairly high in WEF surveys in 2003/04 and 2004/05 but dropped to twelfth place in 2005/06 and remained there for 2006/07 after 2004 reforms establishing an interbank foreign exchange market and removing restrictions on current account transactions.
  - Foreign debt was around 30 percent of GDP in recent years.
  - A continuing, if declining, current account surplus indicated little pressure to mobilize foreign savings.
  - Large companies tapped foreign savings reflected in a spectacular surge in FDI and a strong capital account in recent years.
  - PE ratios averaged 13.2 during 2004 and 18.3 during 2005 on the Cairo and Alexandria Stock Exchange (CASE).
  - Relatively modest spreads for domestic treasuries and eurobond issues and stable or improving credit rankings suggest access to foreign capital was not an important constraint.
- Banking system structure and credit allocation:
  - System dominated by state banks and joint venture banks with heavy state influence; these lent generously in the 1990s.
  - Real credit grew faster in Egypt than most peers in the late 1990s, but build-up of large NPLs and low growth indicates inefficient credit allocation.
  - Official data reported NPLs reached 26 percent of total loans in 2004/05.
  - Nominal lending rates since the early 1990s fluctuated narrowly around 13 percent; anecdotal evidence suggests lower interest margins at state banks compared to private banks, pointing to noncommercial considerations.
  - Retrenchment in lending around 2001—possibly driven by rising NPLs and start of financial sector reforms—ended “easy credit” and may have contributed to business perceptions that access to finance became problematic.

### Diagnostic inference from the financing evidence
- Low national savings do not appear to have been a binding constraint on growth during the recent acceleration given:
  - falling real lending rates,
  - improved access to foreign capital,
  - continued current account surplus,
  - significant FDI inflows.
- 2004 reforms liberalizing the foreign exchange regime and establishing an interbank market likely removed a prior constraint and helped Egypt benefit from the regional boom.
- Perceptions of financing constraints plausibly reflect:
  - a shift from easy, state-directed credit to tighter credit as NPLs rose and reform advanced;
  - persistent governance and financial intermediation problems limiting efficient allocation of credit despite macro improvements.

### Access to finance — summary findings (additional evidence)
- Indicators and trends:
  - In 2003 only 17.4 percent of private firms had an outstanding loan from a financial institution (Dobronogov and Iqbal (2004)).
  - High and rising lending-deposit spreads; underdeveloped credit registry.
  - World Bank Doing Business indicators: access-to-finance indicators remained broadly unchanged through the period discussed.
  - Private credit (share of GDP) continued to stagnate.
  - NPLs peaked in 2005.
  - Share of public sector debt in banks’ portfolios grew further.
  - Spreads between lending and deposit rates widened steadily during 2000–06.
- Borrower-side and institutional constraints:
  - Small firms face limitations producing documentation and providing enforceable collateral; institutional weaknesses in property rights enforcement.
  - Creane and others (2006) Financial Development Index 2002/03: Egypt ranked poorly under the “institutional environment” pillar, relatively strongly under six other components.
  - Hypothesis: many SMEs; access-to-finance constraints may bind only above a firm-size threshold, allowing creation of small enterprises but hindering SME growth.
- Macro and factor-price evidence on capital scarcity:
  - Rapidly rising real estate prices in recent years.
  - Real wages rising on average 3.9 percent annually during 1999–2004.
  - Returns on basic education relatively low but drifting upwards.
- Conclusion: access to finance does not seem to have been a major binding constraint on aggregate growth in recent years, though low national savings and financial sector inefficiencies could become constraining as investment demand rises.

### Appropriability of returns — themes and evidence
- Factors weakening appropriability of returns that may discourage investment:
  - Formal taxation and fear of future taxation (debt overhang concerns).
  - Time and money spent on red tape (bureaucratic regulations).
  - Corruption (informal taxation).
  - Cost of innovation and exploration.
- Taxation: perceptions and reforms
  - WEF business surveys: complaints about the level of tax rates rose from sixth place in 2004 to third in 2005, then dropped to tenth place in 2007.
  - Complaints about tax regulations: fourth and second in 2004 and 2005 respectively; fourth in 2006; sixth in 2007.
  - Through 2004 statutory rates were up to 40 percent; Egypt’s top corporate income tax rate had become the highest among the peer group by 1999.
  - Major tax reform in 2005 halved the top income and corporate tax rates to 20 percent.
  - 2005 reforms began phasing out a range of exemptions, overhauled tax administration, moved to self-assessment, prepared a modern VAT to replace a complex sales tax, and began integrating income and sales tax departments.
  - Implication: recent tax reforms may have started to remove a critical growth constraint, consistent with the sharp drop in tax-related concerns in the 2007 WEF survey and recent growth acceleration.
- Macroeconomic imbalances, debt overhang, and investor perceptions
  - Business concern about inflation (WEF surveys): rose slightly from ninth place in 2003/04 to sixth place in 2005/06, and eighth place in 2006/07.
  - CPI inflation rose from 4 percent y/y in March 2006 to 12 percent by end-2006 (surveys around spring 2006 would not reflect H2 2006 acceleration).
  - Egypt dropped from rank 50 to rank 108 in the macro-economy pillar of the WEF’s GCI between 2005/06 and 2006/07, mostly reflecting high fiscal deficit and rising public debt.
  - Public debt at end-2005/06 was around 70 percent of GDP.
  - Despite this, WEF surveys show little trace of debt-overhang concerns among businesses; risk premia implicit in interest rates appear comparatively low; investment rates have been edging up.
  - Dollarization (FCD/M3) has been on a declining trend since 2003/04.
  - Assessment: little evidence that debt overhang currently constrains investment and growth, though continued high fiscal deficits could make this a binding constraint in the future.
- Bureaucratic costs, corruption, enforcement, and reforms
  - World Bank Doing Business Report (2007): Egypt ranked very low and well below peers on costs of dealing with licenses, enforcing contracts, and getting credit.
  - By 2005/06 Egypt moved to middle of its peer group in costs of trading across borders, paying taxes, and closing a business.
  - Transparency International’s Corruption Perceptions Index: 1998–2006 Egypt’s rank held stable at place 60–70 globally.
  - WEF survey: “Inefficient bureaucracy” ranked persistently very high (reaching first place in 2006); corruption ranked seventh to tenth through 2006, moving to fourth in 2007.
  - Recent reforms: streamlining customs regulations in 2004–05 moved Egypt’s Doing Business sub-index ranking on customs to 70th globally in 2005; one-stop processes for business setup; greater transparency via SDDS subscription and publication of Article IV reports.
  - Interpretation: regulatory red tape has been a key growth constraint; reforms coinciding with growth acceleration support this view though much remains to be done.

### Cost of discovery, adaptation, and appropriability of returns
- Growth involves producing new and “better” products; discovery and adaptation are costly and risky, especially for poorer, credit-constrained entrepreneurs.
- Positive externalities from exploration (transferable worker skills) imply high social returns to reducing private costs of exploration.
- Policy caveats: subsidies for “self-discovery” should be confined to innovators generating positive externalities; prevent capture via stringent budget and accountability restrictions; removing government-induced obstacles may be more feasible than targeted interventions.
- Empirical note: relatively high return in Egypt on basic education may reflect critical role of basic skills in capturing externalities from exploring new production lines.

### Egypt’s export structure and movement to sophisticated products
- Export structure:
  - Revealed comparative advantage concentrated in resource-based sectors (textile and clothing, agro processing, and petro-based) rather than skill- or innovation-intensive products.
  - Egypt ranks relatively poorly under the “innovation” pillar in the WEF GCI.
- Trade data (1985–2005):
  - Share of “high-tech” exports rose from 0.3 percent to 1.3 percent.
  - Gains in “medium technology” exports were more substantial and comparable to peers’ gains.
- Historical constraints (Galal and Fawzy, 2001): overvalued exchange rate, high tax rates, high protection, high transaction costs dealing with customs and tax administration, inefficient export-related services.
- Reforms in 2004–05 addressing many constraints:
  - Corporate income tax rates halved.
  - Tariff reform in 2004 reduced weighted average import tariff from 14 to 9 percent (further reduction to 6.9 percent in early 2007).
  - Massive real depreciation on the order of 50 percent during 2001–02 addressed overvaluation concerns.
  - World Bank Doing Business Reports (2006 and 2007) indicate considerable reductions in red tape related to exports.
- Export performance and composition:
  - Non-oil export growth averaged 22 percent (in U.S. dollar terms) during 2002/03–2004/05, then turned slightly negative in 2005/06.
  - Export growth during 2001/02–2004/05 driven mostly by low-tech items (aluminum articles, raw materials, cotton, textiles); pharmaceutical exports also grew strongly.
  - Sustaining export growth in a competitive global environment requires moving into better exports.

### Constraints outside export sector and access to finance (sectoral detail)
- Poor farmers reluctant to shift from low-return traditional agriculture to high-return nontraditional cash crops due to higher risk and little access to finance to smooth consumption (World Bank, 2004a).
- Small land holdings unsuitable as collateral limit access to finance; microfinance access can be a binding constraint in certain sectors.
- By late 2006, financial sector reform shifted more than half of the banking sector to private ownership; governance reform at remaining state banks and broader modernization underway.
- Ongoing reforms tackle a constraint that could become binding soon.
- Low national savings (reflecting high public dissavings) could become critical unless access to foreign savings, notably higher FDI dedicated to greenfield investments, is durably expanded.

### Complementary factors: infrastructure and human capital
- Infrastructure:
  - “Inadequate infrastructure” ranked low in WEF surveys but moved up to seventh place in 2007.
  - Egypt’s WEF GCI infrastructure component ranking close to its general GCI ranking; slight improvement during 2004/05–2006/07.
  - Strengths: dense road network in lower Egypt, Cairo-Alexandria highway, major ports in Suez and Alexandria, new Cairo airport; electricity and natural gas are cheap and highly subsidized.
  - Conclusion: evidence does not signal infrastructure as among the currently most binding constraints.
- Human capital / education:
  - Enrollment ratios look fairly good; “inadequately educated workforce” ranked relatively low among businessmen’s concerns (eighth to seventh place) in 2004–2006 WEF surveys.
  - Returns on education modest through 2000: Psacharopoulos and Patrinos (2002) report a 5.2 percent increase in average earnings per additional school year in Egypt.
  - Returns on basic skills high; returns on primary-cum-secondary education low—possibly reflecting low quality.
  - Returns on university education relatively high; Egypt ranked lower on “higher education” component of the WEF GCI than on overall GCI.
  - Recent indicators: in the 2007 WEF survey concern about labor skills jumped to third place; “availability of skilled labor” moved sharply up in the 2006 ECES “Business Barometer.”
  - Consensus: skills produced by public education poorly match market needs; education has become a more pressing constraint as economy moves towards sophisticated products.

### Findings, implications, and policy recommendations
- Prime suspects deserving deeper investigation:
  - Appropriability of returns (cost of bureaucracy, taxes, corruption, cost of innovation) appears to be a critical constraint.
  - Access to finance is not the main aggregate obstacle currently but may be binding for small firms, farmers, and specific sectors; ongoing financial sector reform is addressing vulnerabilities.
  - Complementary factors (infrastructure, education) are not currently the top binding constraints, but education—especially skills matching market needs—has risen as a concern and will become critical as the economy moves to more sophisticated products.
- Evidence and interpretation:
  - Recent bold reforms (tax system, trade regulations) focused on appropriability of returns and are consistent with subsequent pick-up in growth.
  - Persistent or renewed real appreciation pressures from temporary capital inflows may be costly for growth.
- Short- and medium-term policy priorities:
  - Continue reforms that ease the cost of regulations; likely to yield high payoffs and remain politically feasible.
  - Use political and economic “tailwinds” from recent reforms to tackle more challenging constraints:
    - Revamp education to improve matching of skills to market needs and raise human capital quality.
    - Rein in the fiscal deficit as planned (authorities aim to halve it to around 4 percent of GDP by 2010) to bring public debt onto a declining trajectory—this would help prevent debt overhang effects, improve financial intermediation efficiency, and raise national savings.
  - Expand durable access to foreign savings, notably attracting FDI geared to greenfield investments rather than one-off privatizations.
- Strategic rationale:
  - Removing the single most critical constraint typically yields the fastest and largest growth payoff; focusing on appropriability of returns has been effective.
  - As reforms advance, addressing deeper constraints (education, fiscal consolidation) is necessary to avoid a growth spurt that fizzles out because deeper constraints remain unaddressed.

### Key structural reforms, July 2004–February 2007 (selected measures)
- Exchange rate system:
  - Set up interbank market allowing banks to freely trade foreign exchange (late 2004).
  - Abolished surrender requirement on export proceeds (December 2004).
- Trade regime:
  - Cut average weighted tariff rate from 14.6 percent to 9.1 percent, reduced number of tariff bands, and eliminated import fees and surcharges (September 2004).
  - Reduced average tariff rate further to 6.9 percent (February 2007).
- Public sector:
  - Raised prices of subsidized fuel (September 2004, July 2006) and electricity (December 2004).
  - Income Tax Law modified (mid-2005), simplifying rates, broadening base, cutting personal and corporate income tax rates, and setting a higher minimum threshold.
  - Broadening and streamlining of stamp tax (August 2006).
  - Public expenditure management reforms launched in 2004: upgrade budget classification; establish Treasury Single Account; rationalize financial relations between general government institutions.
  - Tax administration reforms: large taxpayer unit established (2005); income tax and indirect tax departments merged (2006).
- Financial sector:
  - Comprehensive restructuring plan launched September 2004: bank mergers, sale of stakes in joint venture banks, resolution of NPLs, privatization of a state bank, reform of nonbank financial sector.
  - Banks to meet minimum LE 500 million in paid up capital (June 2005).
  - Sale of most joint-venture banks to private sector (2004–06) and sale of the Bank of Alexandria to a foreign bank (December 2006), putting well over half of banking assets in private ownership.
  - Over half of private sector NPLs restructured by mid-2006; public sector NPLs being cleared with capital infusion financed mostly from privatization receipts.
- Privatization:
  - Between mid-2004 and mid-2006 privatization and related sales generated proceeds of about LE 16 billion; allocation of 3G mobile network to UAE-Egyptian consortium for US$2.9 billion (late 2006).
- Transparency:
  - Subscription to SDDS (January 2005).
  - Publication of 2005 and 2006 Article IV Staff Reports.
  - Publication of monetary policy statement and communiqués following monetary policy meetings (since 2005).

*Italic: IMF staff paper excerpt (Real per Capita GDP Growth section of IMF working paper WP/07/57).*

### 1.     Real per Capita GDP Growth ......................................................................................

### 1.     Real per Capita GDP Growth

### Introduction — long-run performance and recent acceleration
- Egypt’s long-run growth performance during 1980–2000 was strong compared to the average emerging market economy, although well below the high-growth emerging market countries in Asia.
- During 2001–05 Egypt grew less than most of its regional peers and much less than the average developing country or emerging market.
- Since 2004, growth has again been accelerating in step with the implementation of a series of ambitious reforms (Appendix I).
- The paper seeks to identify constraints that may have held back Egypt’s growth during the recent past, whether recent reforms have removed the most binding constraints, and which constraints may become binding in the near future.

### Methodological approach — growth diagnostics and limitations
- Follows the approach developed in Hausmann, Pritchett, and Rodrik (2004), treating growth as the result of an optimization under constraints and searching for the “most” binding constraints whose removal allows temporary growth spurts.
- Recognizes the theory of second best (Lipsey and Lancaster, 1956): removal of one distortion in presence of others can produce negative indirect effects; therefore the approach assumes removal of the “most binding” distortion yields a net positive effect.
- Empirical support: temporary growth spurts are frequent; some spurt episodes correlate with policy reform while others may reflect exogenous shocks (e.g., oil price run-ups). Historical low correlation between oil prices and Egypt’s growth suggests binding domestic constraints limited gains from favorable external environments.
- Definition used in the paper: a “growth spurt” is any period longer than two years during which per capita growth exceeded 2 percent in each year.
  - Egypt experienced two such growth spurts since 1980: 1982–86 and 1996–2001, with another one underway since 2004.
- Diagnostic decision tree (Hausmann, Rodrik, and Velasco, 2005) classifies candidate constraints into three broad categories:
  - Access to finance
  - Appropriability of returns
  - Availability of complementary factors of production
- Data and survey limitations are noted; economy-wide surveys may miss sector-specific constraints (e.g., agriculture, small enterprises).

### Key comparative statistics (as presented in Table 1 excerpt)
- 1980–2000 / 2001–2005
  - World               2.23.1
  - Developing Countries2.45.1
  - Emerging Market Economies2.65.0
  - Industrial Countries2.11.4
  - Brazil0.70.7
  - Egypt2.41.7
  - Malaysia3.92.5
  - South Africa-0.22.7
  - Turkey2.22.9
  - Morocco1.23.0
  - Tunisia2.23.3
  - Indonesia3.33.3
  - Jordan-0.13.5
  - India3.44.7
- Source for the table: IMF World Economic Outlook Database (September 2006).

### Is it Financing? — evidence on financial constraints
- Business surveys (WEF Executive Opinion Surveys) consistently ranked “access to finance” as the top (or second-most important) obstacle to business in recent years (Table 2).
- National savings and real interest rates:
  - National savings have been persistently well below the Asian comparators and mostly below those of regional peers; only Brazil and South Africa had slightly lower savings rates among peers.
  - Real bank lending rates during 1995–2002 fluctuated in a range of 5–12 percent, broadly in line with most peers (except much higher rates in Brazil and more volatile rates in Turkey and Asia).
  - During 2003–06, Egypt’s real lending rates declined sharply, to 2–3 percent in 2005–06.
- Private sector credit and investment:
  - Private sector credit growth (and in particular lending to corporates) remained subdued even as real lending rates fell in 2003–06.
  - Private sector credit as a share of GDP gradually declined during 2001–05.
- Access to foreign savings and capital account indicators:
  - Concerns about “foreign currency regulations” ranked fairly high in WEF surveys in 2003/04 and 2004/05 but dropped to twelfth place in the 2005/06 WEF survey and remained there for 2006/07, following sweeping 2004 reforms that established an interbank foreign exchange market and removed restrictions on current account transactions.
  - Foreign debt was around 30 percent of GDP in recent years.
  - A continuing, if declining, current account surplus indicated little pressure to mobilize foreign savings.
  - Large companies tapped foreign savings as reflected in a spectacular surge in FDI and a strong capital account in recent years.
  - PE ratios averaged 13.2 during 2004 and 18.3 during 2005 on the Cairo and Alexandria Stock Exchange (CASE).
  - Relatively modest spreads for domestic treasuries and eurobond issues over U.S. treasuries and stable or improving credit rankings suggest access to foreign capital was not an important constraint.
- Banking system structure and credit allocation:
  - The banking system was dominated by state banks and joint venture banks with heavy state influence, which lent generously in the 1990s.
  - Real credit grew faster in Egypt than in most peers in the late 1990s, suggesting financial deepening, but the build-up of large amounts of NPLs and low growth indicates credit was not efficiently allocated.
  - Official data reported NPLs reached 26 percent of total loans in 2004/05.
  - Nominal lending rates since the early 1990s fluctuated narrowly around 13 percent; anecdotal evidence suggests lower interest margins at state banks compared to private banks, pointing to noncommercial considerations in credit allocation.
  - The retrenchment in lending around 2001—possibly driven by rising NPLs and the start of financial sector reforms—ended “easy credit” and may have contributed to business perceptions that access to finance became problematic, especially among firms previously dependent on state bank credit.

### Diagnostic inference from the financing evidence
- Low national savings do not appear to have been a binding constraint on growth during the recent acceleration (given falling real lending rates, improved access to foreign capital, continued current account surplus, and significant FDI inflows), but could become binding if investment continues to rise and lending rates increase.
- Reforms in 2004 liberalizing the foreign exchange regime and establishing an interbank market likely removed a prior constraint and helped Egypt benefit from the regional boom associated with higher oil prices.
- Perceptions of financing constraints in business surveys plausibly reflect:
  - A shift from an era of easy, state-directed credit to tighter credit conditions as NPLs rose and financial sector reform advanced.
  - Persistent governance and financial intermediation problems that limited efficient allocation of credit despite overall improvements in macro and access-to-capital indicators.

*Source: IMF staff paper (excerpt): Real per Capita GDP Growth section of the IMF working paper (WP/07/57) content unit provided.*

### 13.      The prominent place of “access to finance” in surveys of business concerns could,

### 13.      The prominent place of “access to finance” in surveys of business concerns could,

### Access to finance — summary findings
- Surveys place “access to finance” prominently among business concerns; this could reflect financial system inefficiency in allocating savings to entrepreneurs rather than the availability of foreign or domestic savings.
- Dobronogov and Iqbal (2004) argue access to finance has been the key recent constraint on growth, citing:
  - In 2003 only 17.4 percent of private firms had an outstanding loan from a financial institution.
  - High and rising lending-deposit spreads.
  - An underdeveloped credit registry.
- The inefficiency is attributed to:
  - Government control over a large chunk of the banking system.
  - The dominant role of government securities in banks’ portfolios.
- These factors are said to weaken efficiency by politicizing and softening budget constraints and reducing incentives for banks to serve risky private investors.

### Evidence from indicators and trends
- World Bank’s Doing Business indicators: access-to-finance indicators (such as credit registry coverage) remained broadly unchanged through the period discussed.
- Private credit (as a share of GDP) continued to stagnate.
- Nonperforming loans (NPLs) peaked in 2005.
- The share of public sector debt in banks’ portfolios grew further through the period.
- Spreads between lending and deposit rates widened steadily during 2000–06, indicating continued or rising inefficiency of financial intermediation.
- Despite weak intermediation, growth picked up sharply during 2004–06, which appears unrelated to improvements in financial sector efficiency.

### Borrower-side and institutional constraints
- For small firms, access to finance constraints may reflect borrower-side limitations:
  - Limited capacity to produce necessary documentation (business plan, license, title for collateral), linked to lack of education or inefficient government services.
  - Difficulties creating and collecting on collateral reflect institutional weaknesses in defining and protecting property rights.
- Creane and others (2006) Financial Development Index 2002/03:
  - Egypt ranked poorly under the “institutional environment” pillar, but relatively strongly under six other components of the index.
- Hypothesis: Egypt may have a relatively large number of small and medium-sized enterprises (SMEs); access-to-finance constraints may bind only above a certain firm size threshold, allowing creation of small enterprises (via internal or informal finance) but hindering SME growth beyond that size.

### Macro and factor-price evidence on capital scarcity
- If a dearth of capital constrained entrepreneurial activity, returns on complementary factors (land or labor) should be depressed; evidence shows:
  - Rapidly rising real estate prices in recent years.
  - Real wages rising on average 3.9 percent annually during 1999–2004.
  - Returns on human capital (education) are relatively low but seem to be drifting upwards.
- Conclusion: On balance, access to finance does not seem to have been a major binding constraint on growth in recent years, though low national savings and financial sector inefficiencies could become constraining as demand for investment financing rises.

### Appropriability of returns — themes and evidence
- Factors weakening appropriability of returns that may discourage investment include:
  - Formal taxation and fear of future taxation (debt overhang concerns).
  - Time and money spent on red tape (bureaucratic regulations).
  - Corruption (informal taxation).
  - Cost of innovation and exploration.

### Taxation: perceptions and reforms
- WEF business surveys:
  - Complaints about the level of tax rates rose from sixth place in 2004 to third in 2005, then dropped to tenth place in 2007.
  - Complaints about tax regulations ranked fourth and second in 2004 and 2005 respectively, fourth in 2006, and sixth in 2007.
- Tax policy changes:
  - Through 2004 statutory rates were up to 40 percent; Egypt’s top corporate income tax rate had become the highest among the peer group by 1999.
  - A major tax reform in 2005 halved the top income and corporate tax rates to 20 percent.
  - The 2005 reforms began phasing out a range of exemptions, overhauled tax administration, moved to self-assessment, prepared a modern VAT to replace a complex sales tax, and began integrating income and sales tax departments.
- Implication: Recent tax reforms may have started to remove a critical growth constraint, consistent with the sharp drop in tax-related concerns in the 2007 WEF survey and with recent growth acceleration.

### Macroeconomic imbalances, debt overhang, and investor perceptions
- Business concern about inflation (WEF surveys):
  - Rose slightly from ninth place in 2003/04 to sixth place in 2005/06, and eighth place in 2006/07.
  - Surveys conducted around spring 2006 would not yet reflect the sharp acceleration of inflation in H2 2006 (CPI inflation rose from 4 percent y/y in March 2006 to 12 percent by end-2006).
- Fiscal and public debt concerns:
  - Egypt dropped from rank 50 to rank 108 in the macro-economy pillar of the WEF’s GCI between 2005/06 and 2006/07, mostly reflecting high fiscal deficit and rising public debt.
  - Public debt at end-2005/06 was around 70 percent of GDP.
  - Despite this, WEF surveys show little trace of debt-overhang concerns among businesses.
  - Risk premia implicit in interest rates on domestic or foreign debt appear comparatively low.
  - Investment rates have been edging up in recent years rather than declining.
  - Dollarization (FCD/M3) has been on a declining trend since 2003/04 (a drop in early 2005 largely reflecting steep appreciation of the LE/$ rate at that time).
- Assessment: Little evidence that debt overhang concerns currently constrain investment and growth, though continued high fiscal deficits could make this a binding constraint in the future.

### Bureaucratic costs, corruption, enforcement, and reforms
- International rankings and indicators:
  - World Bank Doing Business Report (2007): Egypt ranked very low and well below peers in the comparator group, reflecting high costs related to dealing with licenses, enforcing contracts, and getting credit.
  - By 2005/06 Egypt had moved to the middle of its peer group in costs of trading across borders, paying taxes, and closing a business.
  - Transparency International’s Corruption Perceptions Index: during 1998–2006 Egypt’s rank held stable at place 60–70 globally, broadly middle of the pack but near the bottom of its peer group (ahead of India and Indonesia).
  - Heritage Foundation’s “Freedom Index” shows a virtually identical pattern.
- WEF survey rankings of business concerns:
  - “Inefficient bureaucracy” ranked persistently very high (reaching first place in 2006).
  - Corruption ranked seventh to tenth through 2006, moving to fourth place in 2007.
  - Rigidity of labor hiring/firing regulations ranked eighth to ninth.
- Recent reform actions:
  - Streamlining of customs regulations in 2004–05 moved Egypt’s ranking on the corresponding Doing Business sub-index up to 70th place globally in 2005, earning Egypt a place among the top global reformers (and the top reformer in its peer group) in the 2006 report.
  - One-stop processes for setting up and operating businesses have started to reduce red tape and potential for corruption.
  - Greater transparency on economic-financial data and policies: participation in an IMF/World Bank Review of Standards and Codes (ROSC) in statistics, subscription to the Special Data Dissemination Standard (SDDS), regular publication of key economic and public finance statistics, and publication of IMF Article IV consultation reports.
- Interpretation: The persistent prominence of inefficient bureaucracy in business surveys, Egypt’s continued low ranking in global governance indicators, and the coincidence of reforms in customs and taxes with sharp growth acceleration support the view that regulatory red tape has been a key growth constraint; despite reforms, much remains to be done to further relax this constraint.

*Source: Excerpt from the IMF working paper chapter provided in the supplied content unit.*

### 23.      Growth typically involves the production of new and “better” products—products that

### 23.      Growth typically involves the production of new and “better” products—products that

### Cost of discovery, adaptation, and appropriability of returns
- Growth requires producing new and “better” products: higher value added, better access to fast-growing markets, or “near” other products generating positive externalities.
- Developing such products can be very costly and risky because:
  - Absorbing technology from advanced countries requires exploring new combinations of local factors.
  - Exploration is costly and risky; risk is a larger obstacle for poorer, credit-constrained entrepreneurs because failure could push them below subsistence income.
- Positive externalities from exploration (e.g., transferable worker skills) mean reducing the private cost of exploration could yield high social returns.
- Policy caveats on subsidies for “self-discovery”:
  - Subsidies should be confined to innovators who generate positive externalities and not to imitators.
  - Preventing capture by special interests requires stringent budget and accountability restrictions and capable public administration.
  - Alternatively, removing government-induced obstacles may be more feasible than designing targeted interventions.
- Empirical/interpretive note: The relatively high return in Egypt on basic education may reflect that basic skills are critical to capture externalities associated with exploring new production lines and adapting foreign technologies.

### Egypt’s export structure and difficulty moving to sophisticated products
- Egypt’s revealed comparative advantage remains concentrated in resource-based sectors (textile and clothing, agro processing, and petro-based) rather than skill-intensive or innovation-intensive products.
- Egypt ranks relatively poorly under the “innovation” pillar in the WEF GCI, both compared to its overall GCI ranking and relative to peers.
- Trade data (1985–2005):
  - Share of “high-tech” exports rose from 0.3 percent to 1.3 percent.
  - Gains in “medium technology” exports were more substantial and comparable to peers’ gains.
  - Crude trade categories may miss sophistication within resource-based products, but for Egypt oil and gas dominate resource-based exports, making such within-category upgrades unlikely to matter much.
  - Excluding oil and gas does not materially change the story (see Appendix III in source).
- Historical constraints identified (Galal and Fawzy, 2001):
  - Macroeconomic: overvalued exchange rate, high tax rates, high protection attracting resources to import-competing activities.
  - Microeconomic: high transaction costs dealing with customs and tax administration, inefficient export-related services (finance and insurance, handling and shipping at port, transportation and communication).
- Reforms in 2004–05 that likely addressed many constraints:
  - Corporate income tax rates were halved.
  - Major tariff reform in 2004 reduced the weighted average import tariff from 14 to 9 percent (with a further reduction to 6.9 percent in early 2007).
  - Massive real depreciation on the order of 50 percent during 2001–02 addressed overvaluation concerns.
  - World Bank Doing Business Reports (2006 and 2007) indicate considerable reductions in red tape related to exports.
- Export performance and composition:
  - Non-oil export growth averaged 22 percent (in U.S. dollar terms) during 2002/03–2004/05, then turned slightly negative in 2005/06.
  - Export growth during 2001/02–2004/05 was driven mostly by low-tech items (aluminum articles, raw materials, cotton, textiles), although pharmaceutical exports also grew strongly.
  - High non-oil export growth in a competitive global environment likely requires new production and movement into better exports to sustain growth and escape competition.

### Constraints outside export sector and access to finance
- Discovery of “better” products constrained in non-export sectors as well:
  - Poor farmers, especially in rural upper Egypt, reluctant to shift from low-return traditional agriculture to high-return nontraditional cash crops due to higher risk and little access to finance to smooth consumption (World Bank, 2004a).
  - Small land holdings unsuitable as collateral limit access to finance; suggests microfinance access can be a binding constraint in certain sectors.
- Access to financing generally:
  - Access to financing does not appear to be the main recent or current obstacle to aggregate growth: real interest rates are modest and no strong signs that businesses are competing for funding of abundant profitable investment ideas.
  - However, business complaints about limited access to finance may reflect nonprice rationing of credit (especially through state banks) and could be binding for small enterprises and farmers.
  - By late 2006, financial sector reform had shifted more than half of the banking sector to private ownership, with governance reform at remaining state banks and broader modernization and liberalization of financial institutions.
  - Ongoing reforms tackle a constraint that could become binding soon.
  - Low national savings (reflecting high public dissavings) could become critical unless access to foreign savings, notably higher FDI dedicated to greenfield investments, is durably expanded.

### Complementary factors: infrastructure and human capital
- Infrastructure:
  - “Inadequate infrastructure” ranked low in WEF surveys but moved up to seventh place in 2007.
  - In the WEF GCI infrastructure component, Egypt’s ranking is close to its general GCI ranking; Egypt slightly improved its relative strength in infrastructure during 2004/05–2006/07.
  - Observed strengths: dense road network in lower Egypt, Cairo-Alexandria highway, major ports in Suez and Alexandria, new Cairo airport; electricity and natural gas are cheap and highly subsidized.
  - Conclusion: available evidence does not signal infrastructure as among the currently most binding constraints.
- Human capital / education:
  - At first glance, Egypt fares fairly well in enrollment ratios; “inadequately educated workforce” ranked relatively low among businessmen’s concerns (eighth to seventh place) in 2004–2006 WEF surveys.
  - Overall returns on education appeared modest through 2000 (Psacharopoulos and Patrinos (2002) report a 5.2 percent increase in average earnings per additional school year in Egypt), among the lowest in its peer group at the time.
  - Returns on basic skills (reading and writing) were high; returns on overall primary-cum-secondary education were low—possibly reflecting low quality.
  - Returns on university education were relatively high; Egypt has been consistently ranked lower on the “higher education” component of the WEF GCI than on the overall GCI.
  - More recent indicators of rising concern:
    - In the 2007 WEF survey, concern about labor skills jumped to third place.
    - “Availability of skilled labor” moved sharply up the list of obstacles in the 2006 ECES “Business Barometer.”
  - Consensus: skills produced by public education poorly match market needs; recent growth may have brought education constraints closer to binding.
  - Innovation and adaptation of foreign technologies strongly depend on the stock of human capital; moving up the product ladder will increase the importance of bolstering human capital.

### Findings, implications, and policy recommendations
- Prime suspects deserving deeper investigation (Figure 10 decision tree highlights):
  - Appropriability of returns (cost of bureaucracy, taxes, corruption, cost of innovation) appears to be a critical constraint.
  - Access to finance is not the main aggregate obstacle currently, but may be binding for small firms, farmers, and specific sectors; ongoing financial sector reform is addressing vulnerabilities.
  - Complementary factors (infrastructure, education) are not currently the top binding constraints, but education—especially skills matching market needs—has risen as a concern and will become critical as the economy moves toward more sophisticated products.
- Evidence and interpretation:
  - Recent bold reforms (tax system, trade regulations) focused on appropriability of returns and are consistent with the subsequent pick-up in growth.
  - Persistent or renewed real appreciation pressures from temporary capital inflows may be costly for growth.
- Short- and medium-term policy priorities:
  - Continue reforms that ease the cost of regulations; these are likely to yield high payoffs and remain politically feasible.
  - Use the political and economic “tailwinds” from recent reforms to start tackling more challenging constraints:
    - Revamp education to improve matching of skills to market needs and raise human capital quality.
    - Rein in the fiscal deficit as planned (authorities aim to halve it to around 4 percent of GDP by 2010) to bring public debt onto a declining trajectory—this would help prevent debt overhang effects, improve financial intermediation efficiency, and raise national savings.
  - Expand durable access to foreign savings, notably attracting FDI geared to greenfield investments rather than one-off privatizations.
- Strategic rationale:
  - Removing the single most critical constraint typically yields the fastest and largest growth payoff; focusing on appropriability of returns has been effective.
  - As reforms advance, addressing deeper constraints (education, fiscal consolidation) is necessary to avoid a growth spurt that fizzles out because deeper constraints remain unaddressed.

*Source: Excerpt from IMF staff analysis contained in the supplied content unit.*

### 35.      As the various reforms unleash entrepreneurial spirit and investment in Egypt, more

### _wp0757 - 35.      As the various reforms unleash entrepreneurial spirit and investment in Egypt, more

### Key Structural Reforms, July 2004–February 2007
- Exchange rate system
  - Set up interbank market allowing banks to freely trade foreign exchange (late 2004).
  - Abolished surrender requirement on export proceeds (December 2004).
- Trade regime
  - Cut average weighted tariff rate from 14.6 percent to 9.1 percent, reduced number of tariff bands, and eliminated import fees and surcharges (September 2004).
  - Reduced average tariff rate further to 6.9 percent (February 2007).
- Public sector
  - Raised prices of subsidized fuel (September 2004, July 2006) and electricity (December 2004).
  - Income Tax Law modified (mid-2005), simplifying the rate structure, broadening of tax base, cutting personal and corporate income tax rates, and setting a higher minimum threshold.
  - Broadened and streamlined stamp tax (August 2006).
  - Ongoing public expenditure management reforms focus on upgrading budget classification; establishing a Treasury Single Account; and rationalizing financial relations between general government institutions (launched in 2004).
  - Launched reform of tax administration; large taxpayer unit established (2005); and income tax and indirect tax departments merged (2006).
- Financial sector
  - Strong progress on comprehensive financial sector restructuring plan (launched September 2004) comprising bank mergers, sale of stakes in joint venture banks, resolution of NPLs, privatization of a state bank, and reform of nonbank financial sector.
  - Banks to meet minimum LE 500 million in paid up capital (June 2005).
  - Sale of most joint-venture banks to private sector (2004-06) and sale of the Bank of Alexandria to a foreign bank (December 2006), together putting well over half of all banking assets in private ownership.
  - Over half of private sector NPLs restructured by mid-2006; public sector NPLs being cleared with capital infusion by government (ongoing since 2005, financed mostly from privatization receipts).
- Privatization
  - Between mid-2004 and mid-2006, privatization of public sector companies, of public stock in joint ventures, and of public land generated proceeds of about LE 16 billion; allocation of 3G mobile network to UAE-Egyptian consortium for US$2.9 billion (late 2006).
- Transparency
  - Subscription to SDDS (January 2005).
  - Publication of 2005 and 2006 Article IV Staff Reports.
  - Publication of monetary policy statement and of communiques following monetary policy meetings (since 2005).

### Growth Constraints and Second-Best Theory — analytical framework and implications
- Modeling setup and resource-constraint case
  - Growth produced as growth = F(x1, ... xn) with F having positive but diminishing marginal product (∂F/∂xi > 0 and ∂2F/∂xi2 < 0 in the relevant range).
  - Supply of each factor xi is limited by xi0 > 0.
  - Policymakers maximize growth: max F(x1,...,xn) subject to xi ≤ xi0 for i = 1..n.
  - Lagrangian formulation shows the interior solution uses all factor supplies (xi = xi0) — i.e., each limited supply constitutes a growth constraint.
  - Lifting any single resource constraint (increasing some xi0) unambiguously increases growth; no second-best problem arises for pure resource constraints.
  - Reformers should prioritize constraints with highest payoff measured by ∂F/∂xi relative to administrative and political costs.
- Second-best problems via relative price distortions
  - Introduce political constraints fixing remunerations wi > 0 for each factor so total growth is distributed across factors. Optimization becomes max F(...) subject to sum wi = F(...).
  - If wi equal marginal products at original solution, original x remains a solution. If distortions offset each other (∑ xiF(x) = ∑ xiwi), x remains feasible.
  - Example: energy (factor 2) is underpriced (∂F/∂x2 < w2) and labor (factor 1) is overpriced (∂F/∂x1 > w1). Liberalizing one market (e.g., labor) to correct its distortion can make the overall outcome worse because remaining distortions interact — removal of one distortion can reduce output.
  - However, expanding any resource constraint (increasing xi0) never worsens the outcome even when relative price distortions are present.
- Policy implications summarized in text
  - Reforms addressing “resource constraints” (e.g., macro-stability, quality of institutions, available supply of labor) should not weaken growth and will not generate second-best worsening.
  - Reforms that liberalize relative prices in one market while leaving distortions in others may produce second-best effects and can make growth outcomes worse.
  - Sustaining growth requires reforms along many dimensions and attention to complex interactions among reforms; simple bold measures may work temporarily but longer-term success needs broad-based reform sequencing and coordination.
- Application to Egypt (discussion in main text)
  - With energy highly subsidized and energy prices in Egypt among the lowest in the world, lifting financing constraints or raising private returns on investment may trigger higher investment in energy-intensive activities that may not optimize social returns — an instance where second-best considerations are relevant.

### The Technological Classification of Products and export composition
- Definitions used (SITC2 classification; export data in current U.S. dollars)
  - Resource-based (RB) exports: primary exports (crude petroleum and natural gas), agricultural products, farm products, minerals; processed agricultural and farm products; wood manufactures; refined petroleum and rubber products; ore and metal concentrates; cement; cut gems; glass; mineral manufactures; iron and steel scrap.
  - Low-tech (LT) exports: textiles, apparel and footwear, furniture, jewelry, toys, plastic products, iron and steel products, paper products, tools and wires, office supplies, musical instruments.
  - Medium-tech (MT) exports: motor vehicles, trucks and automotive components, process industry products (synthetic fibers, chemicals and paints, cosmetics, fertilizers, plastics), high-end iron and steel products, engineering equipment, industrial machinery, manufacturing machinery, ships and boats, radio and sound equipment.
  - High-tech (HT) exports: office and telecommunications equipment, optical instruments, precision instruments, pharmaceuticals, power-generation machinery, electric machinery, aircraft.
- Empirical note on hydrocarbon bias
  - The recent run-up in world prices for hydrocarbon exports imparts a downward bias to Egypt’s share of higher-technology-content exports in recent years, given the relative importance of Egypt’s hydrocarbon exports compared to peers.
  - Recalculating export shares excluding oil and gas indicates an even stronger success of Egypt’s economy in moving toward medium-tech exports, but still little progress in moving into high-tech items.
- Table excerpt (Non-Hydrocarbon Exports to World Trade Partners by Technology Content, 1985-2005; SITC 2; in percent of total non-hydrocarbon exports)
  - Egypt 1/ : R B 56.1  L T 28.0  M T 14.9  H T 1.0 | R B 28.8  L T 40.7  M T 28.3  H T 2.2 | R B 2.2  L T 36.1  M T 22.8  H T 38.9 2.2
  - South Africa 2/ : R B 22.7  L T 56.9  M T 19.2  H T 1.2 | R B 25.5  L T 34.0  M T 36.6  H T 3.9 | R B 26.4  L T 48.8  M T 62.9  H T 5.8
  - India : 44.9 27.3 22.2 5.6 | 26.8 34.9 31.7 6.6 | 20.1 28.6 42.1 9.2
  - Brazil : 52.4 11.6 27.1 8.8 | 44.2 11.7 34.4 9.7 | 44.5 6.3 36.7 12.5
  - Turkey : 36.6 32.2 26.2 5.0 | 25.1 43.7 24.4 6.7 | 14.7 33.6 38.3 13.3
  - Morocco : 57.5 17.2 24.7 0.6 | 48.1 24.0 25.2 2.7 | 33.7 32.7 19.4 14.2
  - Indonesia : 72.5 12.0 13.4 2.2 | 46.5 32.1 11.5 10.0 | 40.7 23.7 18.1 17.5
  - Jordan : 50.0 12.0 30.1 7.9 | 44.7 9.6 33.8 11.9 | 27.3 34.5 23.5 14.7
  - Tunisia : 24.0 37.1 33.2 5.6 | 16.0 53.6 20.7 9.7 | 16.9 44.7 19.0 19.4
  - Malaysia : 55.3 6.6 12.9 25.2 | 20.5 11.2 12.8 55.5 | 13.4 10.3 14.7 61.7
  - Note: RB=resource based, LT=low-tech, MT=medium-tech, HT=high-tech; Hydrocarbon exports are petroleum, petroleum products and natural and manufactured gas.
  - Footnotes: 1/ 2005 data is for 2004. 2/ 1985 data is for 1984.
  - Source indicated in original: UNCTAD COMTRADE (WITS Database).

*Italic: IMF working paper excerpt (appendices and discussion on reforms, second-best theory, and export technology classification).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0757.pdf_