Monday, November 28, 2016

A quick Primer on Egypt's Economy

Steven A. Cook of the Council on Foreign Relations wrote an article that appeared in several publications around the middle of November, 2016. It was published originally under the title: “Egypt's Economic Reform” and the subtitle: “The Good and the Bad”.

The article is composed under several rubrics, one being: “Making Egypt competitive again?” Note the question mark. It indicates that there is doubt the devaluation of the currency will help make Egypt competitive. Why is that? Well, Cook writes a long paragraph (160 words) to explain it. The crucial part of the explanation comes near the end of the paragraph. It says this:

Egypt has to import the intermediary components of the few goods it exports. The high price of intermediate goods may erase the export advantages of devaluation … Egypt does not manufacture substitutes for the components it imports. The net effect on economic growth could be limited”.

It is obvious that Cook is here discussing only the manufactured goods that Egypt exports. He then makes two mistakes that show he had bad advice. He began by saying that Egypt exports only few goods. You may ask compared to what? Well, a good answer would be: compared to the size of the economy. In fact, that's what he had in mind because he ends the paragraph like this: “The effect on economic growth could be limited”.

We now look at the two mistakes. One is this: “Egypt does not manufacture substitutes for the components it imports.” Of course, you silly whatever! It goes without saying that Egypt wouldn't import them if it manufactured them. By the way, this is the negative effect of globalization; if someone has an advantage in something, you buy it from him cheaper than you can make it. As to the other mistake; it is this: “The high price of intermediate goods may erase the export advantages of devaluation.” Much can be said about that, so let's give it a shot. The best way to illustrate what's involved here is to take an example.

Think of two comparable economies in Europe ... France and Italy for example. A French manufacturer of tires that has been selling to French car makers receives an order from an Italian car maker. The tire maker sells to the Italian at the price he sells to the French. But what does the French car maker do normally? Well, he adds a markup on the tires to cover “handling” when computing the price of the complete car before he sells it. And so will the Italian car maker. All things being equal, neither gains something that the other doesn't.

Now think of an Egyptian car manufacturer who – to begin with – is mandated by law to have at least 45% Egyptian content in the car (soon to be 60%.) That would be his value-added which is also Egypt's value-added. Thus, when the currency is devalued, he gains an advantage on that portion of the finished product. But does he gain something from paying more in local currency to buy the tires and then sell them also for more when they are added to the car? The answer is yes, he gains something because the “handling” part is an additional Egyptian value-added that benefits just as well from the devaluation of the currency.

Now, when the Egyptian pound was pegged at a high value, you could say that the Central Bank of Egypt practiced currency manipulation. The thing is, nobody complained because the pound was manipulated upward, not downward. When the Bank decided to let the pound float – which caused it to devalue – it legitimately did what the currency manipulators do to gain advantage over everyone else. Thus, for Steven Cook to say that the devaluation of the currency will not help export, says that he may get a thank you note from the cheating manipulators because that's the false argument they have been putting forward.

We now look at the last sentence in that paragraph: “The effect on economic growth could be limited.” This requires that we look at the structure of the Egyptian economy to see what's happening. Because the Egyptians have so far relied on their large population to grow the economy, you'll find that it is structured differently from the Asian tigers that rely on export to grow. Whereas industry (mostly manufacturing) represents 25% to 35% of these economies, that of Egypt hovers around 15%, a high value compared to where it was when a purely agrarian economy. So how did it get there?

As the standard of living began to rise in Egypt at the end of the 1973 war, people began to purchase cars, appliances and home entertainment units in such quantities that the local manufacturers could not meet the demand. The fastest way to increase their production was to team up with foreign manufacturers. The latter responded by building factories in Egypt, and producing locally for the local market. Shortly thereafter, they started to export when the supply exceeded the demand. After that, the foreign manufacturers started to build factories in Egypt that were large enough to satisfy both the local and export markets.

It is important to understand that when a manufacturer begins an operation in a foreign country, he brings-in the components – called intermediate goods – from the home country, and assembles them where they are consumed. He gradually manufactures more and more of the components locally or buys them from local suppliers. If he does not do so voluntarily, the government mandates a minimum level of local content.

These developments are the norm in Egypt at this time. There are literally thousands of large international corporations building factories in the industrial zones that the government has prepared for them. Right now, the bulk of the country's exports is made of textiles, furniture, raw and processed foods, pharmaceuticals, building materials and petrochemicals – most of which are produced with indigenous raw materials.

While the plan is to expand on these industries, the next phase (already underway to fully industrialize the country) consists of forging ahead with the production and export of home appliances, electronics, hi-tech industries, precision instruments, transport machinery, as well as construction, farm and mining equipment.

Thus, while the devaluation of the pound may have a limited effect on the country's export at this time, the effect will grow in tandem with the growth in export.