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Slash and burn: Reducing fuel subsidy bill at whose expense?
 
 
Courtesy: Marwan Abd al-Moneim
 

While Egyptians enjoyed their Thursday morning, which the government declared a public holiday last week, the Cabinet announced significant price hikes largely affecting lower-income groups.

Thursday’s suddenly announced public holiday marks the fourth anniversary of the mass protests that led to the ouster of Muslim Brotherhood President Mohamed Morsi. On June 30, 2013 millions of Egyptians demonstrated demanding regime change, two and a half years after deposing longtime autocrat Hosni Mubarak, and amid worsening living conditions following energy crises and fuel subsidy reforms.

Ironically, on the anniversary of the toppling of President Morsi, whose regime was unpopular in part because of a worsening energy crisis, President Abdel Fattah al-Sisi and his government imposed a significant hike in fuel prices that will hurt the poorest the most, despite repeated government claims used to justify the hikes: that the richest benefit the most from subsidies.

With the most recent increase, the government has continued its pattern of targeting price hikes for the fuel types that are subsidized the most, in an attempt to maximize the effect on the fuel subsidy bill. Much of the urgency with which this task is pursued is tied to the deal Egypt made with the International Monetary Fund to phase out energy subsidies by July 2019.

On one hand, the government decision to reduce the fuel subsidy bill without significantly restructuring energy policy exacerbates existing disadvantages for social classes most dependent on certain fuel types. On the other hand, it is unclear how strict the terms of the IMF deal are regarding cost recovery ratios, which may suggest a further hike this year is on the horizon, a hike which will only add more difficulty to the current situation.

Not all are equal

Given that the current fuel subsidy bill allocates the greatest share to the lower classes, any large scale reduction will affect them the most.

The steepest subsidy cuts on Thursday, for example, targeted diesel and butane cylinders (LPG), both of which constitute a large portion of the subsidy bill but also benefit the country’s lowest income earners and agriculture and transportation sectors. On the other hand, 92-octane and 95-octane gasoline have seen less steep price hikes, due to their minimal contribution to the fuel subsidy bill.

The subsidy cuts come two days ahead of a new fiscal year, set to begin this Saturday, and are the second round of cuts in less than a year, and follow the same pattern targeting the most widely used fuel types.

“Historically, the state has focused its fuel subsidies on certain types of fuel,” Omar al-Shenety, managing director at the Dubai-based investment bank Multiples Group, told Mada Masr in an interview earlier this month.

Shenety said that there is a pattern in the government’s priorities in dealing with fuel price hikes. “Subsidies should have been reduced for higher value 92-octane and 95-octane fuel, while leaving diesel subsidies as they are, or reducing them by a lower percentage. However, in practice, the government opted for raising prices significantly on all fuel types. I believe this was driven by the ballooning budget deficit and pressure from the IMF.”

“Notably, the issue of subsidies should not be separated from the IMF agreement, as [Egypt has] been pressured into raising prices for all fuel types and, at the same time, taking other drastic measures without any real phasing out or gradual steps, such as the sudden liberalization of the exchange rate,” Shenety added.

Mazut, a fuel that is mostly used by industry, saw its price increase on Thursday to LE3,500 from LE2,500 per ton, but only for cement companies.

Information on the previous structure of the fuel subsidy bill is not publicly available. However, data for the fuel subsidy structure up until the end of the fiscal year 2014/15 was available, albeit without any information on consumer type.

One month after President Abdel Fattah al-Sisi took office in mid-2014, he began “restructuring” the fuel subsidy bill in the state budget, a task which had long been avoided by former Egyptian leaders due to its social sensitivity.

However, many of the figures suggest that this was not in fact a move to restructure the subsidy bill. Rather, Sisi’s government cut the macro figure but preserved the same structure in allocation by fuel type.

Up until the July 2014 cuts, diesel commanded the lion’s share of the subsidy bill, accounting for around 48 percent of the total fuel subsidy bill, according to a report by Parliament’s Budget and Planning Committee on the final account of the state budget for FY2014/15. It became 53 percent after the cuts.

The report, which Mada Masr obtained a copy of, further shows that gasoline was the second most subsidized petroleum product, accounting for almost 22 percent of the bill before the cut. Afterward, however, the reduction in the gasoline bill’s total share of the fuel subsidy was marginal, coming in at 21.1 percent.  Notably, gasoline subsidies mainly target lowest value 80-octane fuel, while 95-octane receives the lowest portion from subsidies. According to Noaman Khaled, an economist at Cairo-based CI Capital, this disparity in structure of the gasoline subsidy bill remains in place today.

The Budget and Planning Committee’s report further pegged butane cylinders (LPG) as the third most subsidized, taking in 16.7 percent of the fuel subsidy bill. The LPG’s share increased to 17.3 percent afterward.  

While subsidy allocations for natural gas flattened out to zero after 2014, which may suggest some intention to restructure this aspect of the bill, a look at Egypt’s industrial sector paints a different story, as production had almost halted on the back of growing arrears to foreign oil companies.

However, the Finance Ministry noted in its state budget bill for FY2017/18 that it expects a return of natural gas supplies to industry producers following an estimated 30 percent rise in production since the discovery of the Zohr and Noras gas fields. It is unclear whether these will be supplied to industry members at subsidized rates or higher.

Mazut, mostly used by industry, contributed 8.4 percent to the total subsidy bill at the end of FY2014/15.

The impact of targeting certain fuel types in price hikes gains importance when the consumer types of each fuel are considered. While much of this information is not available, there are estimates showing that transportation, agriculture and tourism are the greatest beneficiaries of diesel subsidies. As such, they stand to lose the most. Both transportation and agriculture have a direct impact on general price levels as well as the low-income earners.

“The financial costs of energy subsidies are not treated in a transparent manner in the government’s budget and are therefore not straightforward to estimate,” according to economist Thomas Laursen, the co-author of a report titled “Egypt: Guiding Reform of Energy Subsidies Long-Term” that was published by the World Bank in February 2016.

In their report, the authors used a dynamic computable general equilibrium model with 56 productive sectors, including 11 energy sub sectors, to estimate the distribution of fuel subsidies in Egypt. The report found that in FY2013/14, prior to Sisi’s first round of subsidy cuts, most diesel subsidies went to the transportation, tourism and agriculture sectors, while high energy manufacturing, glass, tile, and cement sectors had already seen their share of fuel subsidies plunge.  Gasoline solely benefits transportation.

Shenety believes that significantly raising prices of socially sensitive fuel types, such as diesel, for all income strata comes at the expense of low-income earners. He argues instead for targeting higher value fuels such as 92 and 95-octane, while implementing the rationing system through fuel smart cards to allow for targeted subsidies for public and semi-official transportation and sectors that directly impact prices in key areas, such as the agriculture sector.

The Finance Ministry expects the smart card scheme to go into effect in FY2017/18, but it has made similar announcements over the past few years. Both analysts say that there is a possibility this will happen, but do not believe it is likely. “They would then be presented with the challenge of developing a data base and the necessary infrastructure,” Shenety said.

The smart card scheme faces structural impediments, according to researcher Nataša Kubíková, who points to “inefficient downstream infrastructure and low production output at local refineries.” In an analysis piece published in the Egypt Oil and Gas magazine in February 2016, Kubíková wrote, “The gap between subsidized price of fuel and market price of gasoline and diesel are incomparable with bread prices [which relies on the smart card system], which in itself is almost an invitation for joining unlawful fuel trading.”

In Thursday’s press conference, Petroleum Minister Tarek al-Molla said that the government aims to invest in developing and upgrading its infrastructure using the savings from cutting subsidies, which he said should improve the availability of high quality fuel and allow Egypt to enter the export market.

Missed opportunity for a gradual cut

Nonetheless, there were points in Egypt’s recent history when the government could have implemented changes that are now being taken in broad and painful strokes.

It was expected that Sisi’s July 2014 fuel price hikes would be followed by another round of increases in FY2015/16, but the still fragile government opted to keep prices the same, instead making use of falling international oil prices, which would require less subsidizing on their part, and result in a lower fuel subsidy bill.

“We had a golden opportunity to make use of the global drop in oil prices that started in 2014, which fell from US$100 per barrel to $25-$30 per barrel. If we had started to cut subsidies continuously, we would have given the economy a great chance to adapt to the concept of free market prices but on a good note, on a downtrend,” Khaled said to Mada Masr earlier in June. “Now, we are doing it, but on an uptrend.”

Strict targets?

Despite the government’s choice not to raise prices in FY2015/16, it seems adamant about achieving a near complete cost recovery ratio as per the IMF deal. However, as the other drastic measures within the same deal inflate fuel costs, continuing on this path implies a need for further significant price hikes.

When Egypt turned to the IMF for emergency funding in November 2016 as part of a three year, US$12 billion deal to tighten its fiscal deficit and liberalize its economy, a move to raise prices following the liberalization of the the foreign currency exchange rate became a necessary measure, despite the inflationary repercussions on the economy and state budget. The government implemented the second round of fuel price hikes on the same day as floating the pound.

Egypt has since, however, faced impediments in adhering to the bi-annual targets to which each disbursement is bound.

In particular, the fuel subsidy bill, a pivotal aspect in the program, has inflated after the value of the pound weakened beyond original estimates in the agreement, and as international oil prices continue to rise.

“The aim to achieve near 100 percent cost recovery ratio on fuel supplies referred to in the agreement with the IMF remains in place. Though, I believe the timeframe is likely to be widened,” said Shenety.

“Originally, the targets were based on two assumptions: first, that the exchange rate would not exceed LE14 to the dollar, and second that oil prices would hover around US$35 per barrel. But as the exchange rate rose to LE18 to the dollar (Or LE16 in the current state budget) and oil prices hit US$55 per barrel, the value of fuels increased significantly.”

Based on these assumptions, the target of the fuel subsidy bill in the first year of the agreement, FY2016/17, was set at LE35 billion. But as the pound proved more vulnerable than originally estimated by both the government and the IMF, and as international oil prices continue to blaze an upward price trajectory, the fuel subsidy bill inflated to LE101 billion in FY2016/17, hitting 2.97 percent of GDP, as opposed to the target of 1.8 percent of GDP.

Consequently, the government first aimed for the fuel subsidy bill in the fiscal year due to start this Saturday to be within the LE140-150 billion range, based on an assumed exchange rate of LE16 to the dollar and the price of a barrel of oil to be between US$55 and $57, as announced by Finance Minister Amr al-Garhy in March. However, the Cabinet later approved the budget with a LE110 billion allocation for fuel subsidies, keeping the assumed prices unchanged. The reduction in the fuel subsidy allocation without any change in the assumptions was a harbinger that there was a plan to hike fuel prices.

It is unclear whether the unaccounted for inflation will prompt a change in the timeframe and targets of the reduction of the fuel subsidy bill.

“What I can say on the fuel subsidies is that we are following the plan outlined by the president and the government to phase out subsidies on major fuel products over 3 years,” the IMF’s director of communications Gerry Rice said in a press briefing on June 8, 2017 when asked about the targets for Egypt’s fuel subsidy bill in FY2017/18.

Phasing out fuel subsidies over three years would indicate that the government is expected to keep its aim of a near complete cost recovery ratio on fuel prices by 2018/19, as shown in the IMF documents on the loan agreement that were released in January.  

According to Khaled’s calculations, petroleum products were sold at a cost recovery ratio of 20 percent, before the latest price increases, “mainly due to the pound depreciation and the pickup in global oil prices.”

“If we assume the same strict attitude from the IMF regarding the agreement, then Egypt should achieve an 85 percent cost recovery ratio for the year 2017/2018, and, assuming the current dollar rate of LE18, Egypt should raise petroleum prices by an average of 250 percent in FY2017/2018,” Khaled said.

Even if there is “some room for negotiation to bring down cost recovery ratio to the range of 65-70 percent and an average dollar rate of LE15, this would mean that the government would raise fuel prices by an average of 170 percent in FY 17/18, which means that the upcoming increase in July can’t be missed and can’t be less than 50-60 percent, followed by another round in November 2017 and March 2018,” Khaled added.

After the hikes

“It is a very tricky situation here, not abiding by the IMF agreement might lead to program termination which would be like ‘jumping off a plane’,” said Khaled. “At the same time, such crazy calculations put social stability at major risk, especially at a time when the social safety nets are far from being ready.”

In a speech on June 21 Sisi announced a social spending package worth LE75 billion for FY2017/18 to counter the impact of the economic austerity measures. “Is what we are providing to each family enough?” Sisi asked in the speech. “It is what is obtainable. This is what the state can offer to citizens to ease the impact of economic reforms.”

The package exceeds the target set in the agreement at LE54.5 billion for additional social spending in the fiscal year 2017/18, bringing the total additional social spending in the first two years of the agreement up to LE87.1 billion (2.1 percent of GDP saved from cutting other subsidies).*

“A hike of around 50-60 percent would bring inflation on a monthly basis up to the 3 percent mark for two to three months consecutively,” Khaled forecast ahead of Thursday’s decision.

Although annual inflation is currently easing after peaking at 32.9 percent in April, “ it could accelerate again in the summer after raising fuel prices,” according to Shenety. “This does not necessarily mean going back to above 30 percent annual inflation rate level, but it could mean inflation will remain above 20 percent.”

*Correction: This paragraph was amended to reflect that the figure LE87.1 billion reflects the total targeted additional social spending for both fiscal years 2016/17 and 2017/18, rather than the target for FY 2017/18.
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