Egypt's Economy Needs to Change. It Won't

The six-story Arcadia Mall, a symbol of modern commerce on the Nile, is a charred ruin, torched by protesters in the Jan. 25 revolution. Military officers now rule in place of Western-educated businessmen. Spending by a government already in debt is heading up.

This is Egypt after the fall of Hosni Mubarak, and if its future seems uncertain, it has nonetheless drawn investor cheers as officials promise to pursue market-oriented policies. The Market Vectors Egypt Index ETF (EGPT), an exchange-traded fund, has risen 7 percent since Jan. 27, when the Egyptian exchange was shut down as protests intensified.

Yet a history of on-again, off-again economic reform and the rise of forces, including the military, that have resisted liberalization suggests the path to a competitive economy will be difficult. "In the near term, the impulse is to beat up on the capitalists, not reward them," says Jon Alterman, a former member of the State Dept.'s policy planning staff now at the Center for Strategic and International Studies in Washington. "I don't see a champion of economic reform arising out of this process."

Post-Mubarak Egypt inherits a legacy of incomplete attempts at change, including the controversial privatization of some state assets. The political costs of shedding state workers or levying new taxes likely will challenge Egypt's next leader. Little action is expected on trimming fuel subsidies that devour more than 5 percent of gross domestic product. "This is not the time to scale back on subsidies. If anything, they may increase," says Samer Soliman, a professor of political economy at the American University in Cairo.

For two decades officials from the U.S. government and Washington-based international organizations encouraged Egypt to overhaul its statist economy in hopes that prosperity would foster stability. Instead, Egypt imbibed enough globalization to enrich an elite, though not enough to become broadly prosperous. About 18 percent of the overall population and 40 percent of rural dwellers live below the poverty line, according to the World Bank. Simon Johnson, former International Monetary Fund chief economist and currently a Bloomberg News contributor, calls the approach "trickle-down economics without the trickle."

Despite its position astride trade routes in Africa, Europe, and the Middle East, Egypt hasn't secured a role in global supply chains. Nike (NKE), for example, buys shoes and clothing from 42 Vietnamese manufacturers that employ more than 198,000 workers, according to its website. Egypt, with a similar population, is handicapped by numerous taxes, uncertain contract enforcement, and insufficient skilled labor. Just five Egyptian companies employing 5,129 people supply finished products to Nike.

From 2004 to 2009, per capita income rose 20 percent in Egypt. Vietnam posted a 34 percent income gain over that period. "They really need to penetrate global industrial supply networks," says Marcus Noland, author of The Arab Economies in a Changing World. Between 1990 and 2009, Egypt's per capita exports of goods and services rose at an average annual rate of less than 5 percent—about half the rate of India and one-third of China, says the IMF.

Egypt, which has endured unemployment above 8 percent for years, must create 9.4 million jobs by 2020 to absorb the jobless as well as new entrants into the workforce. To do so, GDP would have to grow almost 10 percent a year, about twice the rate since 2000, says the IMF.

The Egyptian government has been able to repeatedly defer reforms because it could count on certain financial flows regardless of the state of the economy. For the past two years the government reaped almost $5 billion annually from Suez Canal fees and $1.5 billion in U.S. aid. Remittances from Egyptians working in Saudi oil fields or Bahraini hotels brought in around $8 billion, while the country's oil wells contributed about $9 billion. Combined, that amounted to about 12 percent of GDP.

Mubarak in his last days hiked state workers' salaries and deferred cuts in fuel and food subsidies. He jettisoned Cabinet officials considered probusiness, such as Housing Minister Ahmed El Maghrabi, former chairman of Accor Hotels Egypt. El Maghrabi and other members of the business elite, such as Ezz Steel Chairman Ahmed Ezz, were barred from traveling and had their bank accounts frozen. The prosecutor's office said it was investigating claims of "public funds embezzlement."

"There's going to be a much more populist take on where the economy should go," says Michele Dunne of the Carnegie Endowment for International Peace, who served in the U.S. Embassy in Cairo. Egypt's martial law administration says it will embrace change. "There is no relapse into state intervention," says Finance Minister Samir Radwan, named by Mubarak on Jan. 31. He says Egypt has "a fantastic opportunity to have a new phase of reform, to deepen the reforms that have taken place."

The bottom line: Egypt after Mubarak shows signs of resistance to the free-market reforms it must adopt before it connects with the global economy.

    Before it's here, it's on the Bloomberg Terminal.