Subsidies and the Egyptian economy
The new Egyptian government is living up to its promises to make difficult decisions necessary to revive the nearly moribund economy, including a promise to cut subsidies that eat up nearly a quarter of the government budget.
Starting July 5, the official price of fuel rose by up to 78 percent. The price increases, which went into effect at midnight Friday, followed a hike in electricity prices.
The main reason for these moves is to reduce the budget deficit, which has reached a very dangerous level. These measures may help save the government around $6 billion, or about 5 percent of the annual budget.
According to the official announcement, the price for 80-octane gasoline, used for old cars, rose by 78 percent, to 22 cents a liter, while for the 92-octane gasoline, the price would rise by 40 percent, to 37 cents a liter. The price of diesel fuel rose 64 percent, to 25 cents a liter.
While the hike in fuel prices may seem high in percentage terms, the new fuel prices remain very low in magnitude compared with other countries. The global average price of a liter of gasoline is about $1.36, or about five times as high as the new average price of gasoline in Egypt, thus indicating that even the new energy prices include a level of implicit economic “subsidy.”
Previous Egyptian governments faced the dilemma of fuel subsidies but were unable to take action, leading to steady deterioration in government finances and frequent disagreements with the International Monetary Fund (IMF). The IMF made financial reform, including fuel subsidies, a priority for Egypt, and a prerequisite for IMF loans and an IMF clean bill of financial health for Egypt.
Energy subsidies, direct or implicit, are an international challenge, but most widespread in the Middle East and North Africa (MENA). In oil exporting countries, energy is sold locally at a price lower than the international price, but there is no “subsidy” per se, but the difference between the two prices acts economically as a subsidy. About one half of total energy subsidies in the MENA region are accounted for by petroleum products, while the remainder represents subsidies on electricity and natural gas.
About half of global energy subsidies are believed to be in the MENA region. While these subsidies provide some support to poor consumers, their benefits go mainly to the rich. They also sap government finances at the expense of much-needed investment in health care, education and infrastructure. Furthermore, they lead to waste, damage to the environment and frustrate efforts at conservation.
For these reasons, subsidy reform can have significant payoffs in terms of higher growth and greater equity. However, reform is complex technically and tough politically, especially the latter.
Energy subsidies appeal to bureaucrats because they are relatively easy to administer, compared to more targeted, social safety net measures, such as cash transfer schemes and direct income support. They benefit households directly through lower prices for energy used for cooking, heating, lighting and personal transport, but also indirectly by reducing production costs for other goods and services that use energy as an input.
However, this comes at an incredibly high cost. For the MENA region as a whole, energy “subsidies” cost about $250 billion, when measured as the difference between the value of consumption at domestic and global prices. This amount is equivalent to 8 percent of GDP, or 20 percent of government revenues. Other subsidies pale in comparison; for example food subsidies are estimated at about $20 billion across the region.
In addition, subsidies create serious distortions, which is important even in countries that are large energy producers and are therefore less concerned about the budgetary and balance of payments implications of energy subsidies. For one thing, energy subsidies accentuate income inequality, contrary to their intended consequences. They mostly benefit upper income groups. For instance, in Sudan, it was found that the poorest 20 percent of the population receives only about 3 percent of fuel subsidies, whereas the richest 20 percent captures more than 50 percent. The situation is similar in many other countries across the MENA region.
There are also negative environmental effects from energy subsidies. They encourage waste of energy and discourage investment in energy efficiency, public transport and renewable energies. As such, they frustrate government and private efforts to conserve resources for future generations, protect the environment and reduce pollution and traffic congestion.
However, some have objected to the reduction in energy subsidies in Egypt on equality grounds. As about half of Egypt’s 87 million people live below poverty level, on about $2 a day, the effects of the new fuel price hike may be felt sharply by the poor. However, with the new savings the government could design direct cash subsidy to the poor that would make up for the rise in the fuel prices.
Egypt will most likely discover that subsidy reform, far from aggravating poverty, could boost growth, reduce poverty and improve income equality. Reallocating the financial resources made available by subsidy reduction to more productive programs could help boost economic growth. The removal of subsidies, accompanied by a well-designed social safety net and an increase in pro-poor spending, could yield significant improvements in the well being of low-income groups.
As I pointed out at the beginning of this essay, reduction of fuel subsidies in Egypt would directly lower budget deficit by about 5 percent. The improved financial picture would reduce the cost of borrowing and stimulate private-sector investment.
As we have seen in other countries that have adopted similar reforms, reducing fuel subsidies could increase incentives to invest in energy-saving technologies. The public health payoff would also be significant, by reducing pollution and traffic congestion.
Other countries in the region, especially financially-strapped countries such as Yemen and Sudan, may soon follow Egypt’s example.