ECONOMIC REFORMS SHOWING RESULTS, BUT SLOWING

C O N F I D E N T I A L SECTION 01 OF 03 CAIRO 002726

SIPDIS

SIPDIS

E.O. 12958: DECL: 09/05/2017
TAGS: ECON EAID PGOV EG
SUBJECT: ECONOMIC REFORMS SHOWING RESULTS, BUT SLOWING

Classified by DCM Stuart Jones for reasons 1.4 (b) and (d).


1. (U) Summary and introduction: Since 2004, the Nazif
government has cut tariffs and tax rates, fixed the current
exchange system and eliminated the black market, rationalized
fiscal cash managements with its Single Treasury Account,
partially privatized and recapitalized the banking sector,
and sold off several major state-owned enterprises. These
changes generated confidence and set the state for an
economic revival. Business is now growing, foreign direct
investment (FDI) rising and and domestic consumption rates
up. Growth is expected to be 8 percent in 2007/08, up from
7.5 percent this past year. FDI is expected to reach $11
billion by year-end. Non-oil exports were up 42 percent in
June 2007 over last year.


2. (U) While the big picture story is a positive one, a
number of challenges remain. The biggest may be ensuring
that reforms are maintained long enough for growth to reach a
broader section of society. After several years of slow
growth, up to 2004, in which the national poverty rate
actually rose slightly, there is a pent-up demand for
economic benefits.


3. (SBU) On the macroeconomic side, the GOE must reduce the
budget deficit, which was about 7.5 percent of GDP in
2006/07. Inflation can be expected in a time growth and
rising commodity prices, but at 12 percent in the first
quarter of 2007, increases in food, housing and
transportation have hit hard. Some ongoing reforms, such as
trade facilitation, deregulation, and privatization have run
into political opposition. Difficulties faced by small and
medium-sized enterprises (SMEs) are a real obstacle to making
high growth sustainable. And, most significantly, the
average Egyptian is not yet feeling the benefits of growth.
The next round of reforms, to include reducing subsidies, and
improving services in health, education, skills, housing and
transportation, are complex and have the potential to cause
social upheaval. Implementation will require significant
political will. End summary


4. (U) In a rare August 24 press interview, Egyptian
President Hosni Mubarak supported Egypt's economic reform
program, speaking in detail about the program's
accomplishments and future challenges. Mubarak's interview
followed an earlier TV appearance by Prime Minister Nazif, in
which he addressed a number of controversies including
villages that lack clean drinking water, poverty alleviation
and GOE land sales. This was the first time in recent memory
that Mubarak has spoken publicly, and positively, and
economic reform. Most notably, he spoke in some detail about
the importance of the recently announced plan to privatize
Banque du Caire, which has provoked a loud and angry response
in Parliament and from the public.


5. (U) In his remarks, Mubarak said the reforms are intended
to raise living standards. He cited job creation, wage
increases, new factories and housing, and infrastructure
renewal, in addition to the overall positive impact of the
macroeconomic reforms. Cautioning that the results will take
time, Mubarak promised additional resources for lower income
groups. On inflation and wages, he cited recent government
salary increases but said increases are not a "magical
solution" to inflation.


6. (U) In Nazif's August 12 TV appearance, he talked about
the gap between a booming business sector and continued
economic hardship and dissatisfaction for many Egyptians.
Nazif spoke about the need for continued banking sector
reform, pointing to the success of the Bank of Alexandria
sale and resulting improvements in bank services and
management. Nazif also outlined challenges facing the GOE.
He explained that as the economy shifts from a command to a
market economy, there is an unavoidable lag between business
growth and a positive impact on lower income groups. This,
he said, is exacerbated by population growth, Egypt's
"difficult" geographical location and the international
political climate. He underlined, however, that the GOE
would address the social dimension of economic change.

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Some reforms not so hard
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7. (SBU) Both Mubarak and Nazif addressed the benefits of
ongoing financial sector reforms, the gap between the rich
and the poor, and continuing inflation -- areas in which the
GOE remains politically vulnerable. In other sectors, there
is a consensus within the government, and the public, for
reform and new investment, including in transportation,
health care, education and housing. Everyone understands
that these improvements are long overdue, so reforms,

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although difficult, appears to be moving ahead.


8. (SBU) For example, Egyptians agree on the need for
comprehensive education reform. The quality of primary and
secondary education has deteriorated in recent decades and
graduates do not have the skills they need to compete in the
labor market. Students pay teachers for private tutoring to
make up for low teacher salaries and poor quality classroom
instruction, and there are constant calls for school repair
and construction. This consensus allowed for relatively easy
passage of a first round of reform legislation in June, when
the parliament created a new system for hiring, training and
promoting teachers. (NOTE: USAID played an essential role in
guiding the reform legislation.) The situation is similar in
the case of health care, where Egyptians are desperate to see
improved services and where the GOE sees itself in a "hearts
and minds" competition for service provision with the Muslim
Brotherhood.


9. (SBU) The Ministry of Transportation has an ambitious
plan to renew dilapidated transport infrastructure and
improve safety. Minister of Transport Mohamed Mansour hopes
to reduce the role of road transport in hauling Egypt's good,
in favor of increase shipping by rail and river transport.
Mansour is receiving substantial budget support for his
program. These long overdue infrastructure investments will
support economic growth and meet the public's demands for
improved services. The challenge on the reform side is to
ensure that the government agencies that run these services
improve their maintenance and repair record; reforms to
increase cost recovery are essential but will be difficult.

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While others are harder
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10. (SBU) While progress is made on some fronts, change has
slowed elsewhere. Additional efforts are still needed in the
financial sector, on insurance, microfinance regulation, and
the development of security and mortgage markets. Although
budget transparency has improved, security and defense
spending remains off-budget. Press reports of alleged wheat
shortages stirred fears of bread shortages, which the
opposition claims the GOE will use as a pretext to reduce
subsidies. The GOE has assured the public that food
subsidies will continue, though the GOE would like to target
them more effectively.


11. (SBU) The GOE is making progress on energy subsidies.
On August 14, it announced plans to phase out fuel subsidies
over the next three years for the largest corporate
beneficiaries (ie., cement, steel and petrochemical
companies),to increase natural gas prices, and to move
toward the economic pricing of electricity. Energy subsidies
are estimated to cost nearly LE 40 billion ($7b) per year, or
about five percent of GDP, and benefit mainly heavy industry.



12. (U) Privatizations continue, but the pace has slowed a
bit from 2005/06 to 2006/07, with sales volume dropping from
LE 14.6 billion ($2.5b) to LE 13.6 billion ($2.3b) during
that period. The GOE recently cancelled some sales of
pharmaceutical, chemical and fertilizer companies after
opposition parties and unions complained that the companies
were too important to the economic security of the country to
be sold. While results vary, overall results of
privatization are positive, as profits are rising, management
improving and labor resistance minimal.


13. (SBU) Other sectors where reform is proving tougher than
expected include trade facilitation and business
deregulation. Although progress has been made, establishing
a company in Egypt remains difficult and most small
proprietors much prefer to remain unofficial. This vast
group of informal sector businesses do not have access to
bank financing, and many plan to stay that way rather than
subject themselves to the corruption and harassment that come
with dealing with government licensing and inspections. The
bloated public sector itself, and the need to reduce
employment rolls while improving public services, has not
even been publicly discussed. Civil service reform will need
to go hand in hand with training that can provide workers
with skills needed by Egyptian companies. Such programs have
been implemented elsewhere, but they require coordination and
vision. Other areas in need of reform include agriculture
and water policies, and corporate governance.

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Comment
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14. (C) Why does the prospect for future reform not look
more rosy, given the eye-catching measures that the GOE has

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taken in recent years? This is primarily because the next
round of reforms will be harder, more controversial, and
inter-related. They will require tough decisions, with
potential political fall-out. Most reforms, including of
macroeconomic policies, and changes to customs and taxes,
have been led by Minister of Finance Yousef Boutros-Ghali.
Other ministers must now step up and make some tough
political decisions, particularly in the case of Minister of
Trade and Industry Rachid, but also in Agriculture,
Irrigation, Housing and others.


15. (C) It is worth noting that the failure of the FTA is
seen by some in the business community as having derailed, at
least temporarily, some of those changes. AmCham's executive
director recently argued that the FTA provided a framework
and an impetus for many of the changes that need to be made.
Without the momentum of the negotiations, these efforts lost
their focus. Those who were pushing the FTA within the
government were humiliated by the setback, within political
circles, and lost a certain degree of their credibility and
influence over their opponents within the system. They are
clawing their way back, and growth figures certainly help
them to make their case that reform for its own sake is worth
the effort, but this will be a long struggle.


16. (C) As reforms become more difficult, support from the
top is essential to persuading Egyptians to accept the
changes, and to have patience rather than back-pedaling. In
a recent conversation with the Ambassador, leading reformer
and Minister of Investment Mahmoud Mohieddin admitted that
the GOE has not done a good job of selling, or even
explaining, the reform program to the public. If Mubarak's
comments, his first about economic reform in recent memory,
are an indication of a trend, this is good news for the
reformers, and the change may have come just in time.
RICCIARDONE