Subsidy Reform: Is The Time Nigh?

BMI View: With fiscal and current account deficits in the Middle East and North Africa's net oil importers continuing to expand, the urgency of pushing ahead with broad economic reform programmes is gradually increasing. At the same time, with elections approaching and governments hesitant about provoking public unrest, the willingness to pursue such measures is minimal. Below, we assess the likelihood of governments across the region pursuing one of the most urgent measures - namely energy subsidy reform - before more acute economic crises materialise.

The near-term outlook for net oil importers across the Middle East and North Africa (MENA) remains precarious. As we have highlighted on numerous occasions previously, since the start of 2011 the economies of Morocco, Tunisia, Egypt, Jordan and Lebanon have been hit by a perfect storm of rising global energy prices, slower foreign capital inflows, lower tourist arrivals, elevated political instability and growing demands for increased government spending. Growth has slowed to a crawl, and appears set to remain anaemic over the coming quarters.

A Rough Ride For Equity Markets
MENA - Equity Markets Rebased to 100, January 1, 2011

In this context, one of the defining features of the post-Arab Spring economic landscape across MENA has not been unprecedented change, but rather continuity . Rather than pushing through reforms which could help address some of the structural economic and social issues which drove the regional political revolution, new governments in Egypt and Tunisia and the existing regimes in Morocco and Jordan have pursued broadly si milar policies as were seen prior to 2011 , albeit with more of an emphasis on government spending . Reforms which could have negative short-ter m repercussions have been avoided, as fears over large-sca le social upheavals remain salient . That said, there has been some degree of variation, with Morocco having been listed as the top reformer in the World Bank ' s 2012 Doing Business survey, while Egypt has seen a deterioration in almost every respect (corruption, competitiveness , etc) .

Twin Deficits Expanding
MENA - Budget (LHS) and Current Account (RHS) Deficits, % of GDP

As the accompanying charts highlight, one of the clearest indications of how the regional turmoil has undermined economic stability is through the massive expansion in current and fiscal account deficits over the past two years. For net oil importers, one of the main factors behind this has been the push higher in global energy prices, with Brent crude oil having averaged US$108/bbl and US$106/bbl in 2012 and 2011 respectively, compared to US$87/bbl and US$78/bbl in 2010 and 2009. Despite these increasing costs, particularly at a time of declining exports and weaker fiscal revenues, there has been little willingness to pursue more pronounced changes to energy subsidy regimes for fe ars of the sharp public backlash that is assumed would accompany such measures. As subsidies have taken up an increasingly large share of the budget, less funding has been made available for more productive capital expenditure.

An Expensive 'Birth Right'
Fossil Fuel Consumption Subsidy Rates as a Proportion of the Full Cost of Supply, 2011

The recent experience of Jordan would certainly suggest that pur suing such reforms will not be easy. Having signed an IMF Stand-By Arrangement (SBA) in August 2012 , the government announced it was raising energy prices in September, causing an immediate outburst in public protests, and then a swift backtracking on the part of Amman. With officials having warned that the country could no longer afford its subsidisation regime, particularly given the fiscal burden of ongoing transfers to the state electricity firm, price hikes were finally pushed through in November, which set off some of the most pronounced public demonstrations in the kingdom ' s history. Any government looking at Jordan 's experience would certainly be c autious about following a similar strategy.

A Dangerous Decline
MENA - FX Reserves, % chg y-o-y

With little possibility of global energy prices taking a more pronounced leg down in the near term, pressures on MENA oil importers ' fiscal and current accounts are unlikely to dissipate anytime soon. At the same time, with unemployment across the region likely to remain elevated amidst a potentially prolonged period of low economic growth, the willingness of many governments to push ahead with such unpopular policies as raising domestic energy prices is low. As a result, t he tension between ensuring economic stability on the one hand, and avoiding a widespread poli tical backlash on the other, will soon be stretched to breaking point . What is clear , is that a ' day of reckoning ' will eventually come, when either more pronounced reforms are pushed through, or more acute economic crises will emerge. Below, we highlight several factors which we believe provide an indication of which governments are likely to implement more stringent economic reforms in 2013.

MENA - Key Economic Indicators
Country Budget Deficit, % of GDP Public Sector Debt-to-GDP, % Subsidies, % of Expenditures
Source: BMI
Egypt 2012: 10.6%; 2010: 7.7% 2012: 73.5%; 2010: 63.6% Fuel: 18%; Total: 40%
Jordan 2012 (e): 12.1%; 2010: 5.6% 2012 (e): 87.9%; 2010: 67.0% Fuel: 9%
Morocco 2012 (e): 7.1%; 2010: 4.7% 2012 (e): 59.2%; 2010: 50.8% Fuel: 18%; Food: 4%
Tunisia 2012: 8.1%; 2010: 4.6% 2012 (e): 46.2%; 2010: 40.1% Total: 20%; Fuel: 8%

Urgency Of Reform: While subsidy reform needs to be implemented for every economy over the long term, the issue is more pressing for some. We have highlighted six indicators which we believe provide some insight into the urgency of the matter , which include: budget deficit (% of GDP), public debt (% of GDP), costs of subsidies (% of expenditure), government securities held by banking sector (% of total assets), FX reserves (months of imports and pace of depletion), and access to international debt market s (recent success in tapping markets resulting in less pressure for reform).

Type Of IMF Agreement: G overnments which have signed, or are about to finalise, emergency Stand-By Arrangements with the IMF are more likely to push ahead with reforming their domestic energy subsidy systems. While the conditionalities attached to SBAs are often country-specific, energy reform is likely to feature prominently, in our view. In contrast, states which have secured either Precautionary Liquidity Lines or Precautionary SBAs will face less direct pressure from the Fund to push ahead with such reforms , as these programmes often lack conditionality.

Major Foreign Aid Pledges: G overnments with ready access to bilateral financing which is not conditional on reforms or an IMF agreement will have greater leeway when it comes to domestic policy. The greater the unconditional external aid, the less likely unpopular reforms will be passed.

Election Schedule: Upcoming parliamentary or presidential elections make the prospects of drastic reforms less likely, as politicians will seek to avoid any decisions that could undermine their chance of victory at the ballot box. In our view, this is one of the most salient factors likely to determine economic policy in 2013.

Mandate For Reform: Loose coalition governments have less scope to pursue economic reforms, whereas countries with monarchies at the head of government are able to push through legislation with relatively little opposition. Of course, a strong mandate for reform means little if the willingness to pursue such policies is not present.

MENA - Key Variables in Determining Prospects for Reform
Country Type of IMF Agreement Major Aid Pledges Election Upcoming? Willingness to Reform Mandate for Reform
Source: BMI *denotes aid programmes which have not been finalised
Egypt US$4.8bn SBA* Qatar: US$5bn; EU: US$6.3bn*; KSA: US$4bn Parliamentary April '13 Weak Weak
Jordan US$2bn SBA GCC: US$2.5bn; Minor bilateral and mutilateral grants Parliamentary held Jan 23 '13 Moderate Moderate
Morocco US$6.2bn Precautionary Liquidity Line GCC: US$2.5bn None Moderate Moderate
Tunisia US$1.2bn Precautionary SBA* World Bank: US$0.5bn; ADB: US0.5bn; US: US0.5bn Parliamentary/Presidential June 23 '13 Weak Weak

Country-Specific Factors

Egypt: Undoubtedly, the government of President Mohamed Morsi is in the most precarious position at the moment. In terms of the urgency of reforms, it is clear the North African state is being pushed to the brink. Energy subsidies alone account for 18% of total spending, and despite the government's plan to reduce such costs by over 25% in its FY2012/13 budget, data through the first five m onths of the fiscal year show these expenditures increasing by 227%. To be sure, in November Cairo finally committed to the full removal of subsi dies on octane 95 gasoline . From early December moreover , the government partially removed subsidies on butane gas cylinders for households, pushing a 12.5 kg cylinder price from EGP2.75 (US$0.45) to EGP8 (US$1.3).

In the near term we do not expect to see any firm decisions to push ahead with further subsidy reforms , despite their importance to securing the US$4.8bn IMF SBA . Foreign aid from the Gulf, particularly Qatar, is helping to stave off a more acute balance of payments crisis, while parliamentary elections likely to take place in April will ensure that President Morsi does not make any unpopular decisions that could prove detrimental to the Muslim Brotherhood , with which he is still loosely affiliated . Nevertheless, such reforms will be crucial if Cairo has any chance of rationalising consumption, reducing waste and freeing up resources for export. As a result, our baseline scenario sees further energy price hikes being pushed through, but only after April ' s election, which should help pave the way for a n influx of IMF and additional bilateral assistance later in the year .

Quite A Burden
Egypt - Breakdown of Spending, EGPmn

Morocco : While the Precautionary Liquidity Line signed with the IMF in August 2012 urged action in reforming subsidies, such policies are not a condition of the agreement. To be sure, fuel prices were hiked by 15-20% in June after more than half of the 2012 budget allocated to subsidies was spent within four months. In contrast to Jordan, Egypt and Tunisia, political pressure on Rabat is somewhat less pronounced. It is also encouraging that the government has shown a strong willingness to begin addressing the issue. Indeed, under draft plans released by officials in January, the current subsidy system would be fully or partially replaced with monthly cash payments of MAD1,000, with the new programme potentially taking effect as early as June. Rather than a sudden one-off hike in prices however, the process would take around four years. A key concern is what impact this will have on inflation, with some reports indicating that the headline print could head as high as 7.0%, compared to 2.6% y-o-y in December 2012 (note: inflation is a component within our short-term political risk ratings given its history of provoking public backlashes). Going forward, we believe Morocco is the most likely country in MENA to carry out a comprehensive reform agenda. Our baseline scenario sees the programme beginning to be implemented in late H113, with the savings from lower energy subsidies partially offset by higher cash handouts to low-income families.

Time To Reform
Morocco - Subsidies, MADbn

Jordan: Following parli amentary elections on January 23 , the Jordanian government has some leeway to push ahead with further energy sector reforms over the coming months , if they so desire. As previously mentioned, energy subsidies were partially removed in November 2012, which saw transport fuel prices rise 14%, while kerosene and cooking gas prices were hiked by 28% and 54% respectively. The measures are forecast by the government to result in approximately US$1.2bn in savings. With the budget deficit having nearly doubled in percentage of GDP terms from 6.8% in 2011 to 12.1% in 2012, the urgency to carry out such measures is certainly high. Jordan has been hit on multiple fronts in this regard, but is suffering disproportionately due to the cut off in gas supplies from Egypt, and recent shut-off in deliveries from Iraq. As previously mentioned, with foreign reserves continuing their steady decline, and now accounting for just over four months of imports, further action might be needed if the country is to avoid a full blown balance of payments crisis. Given the extent of reforms already pushed through however (not to mention the subsequent blowback), we do not believe the IMF will push Amman for further measures in the near term.

Double Digit Deficit
Jordan - Budget Balance, % of GDP

Tunisia: In the case of Tunisia, we al so hold out very little hope of any type of substantial reforms being carried out in the first half of 2013. With parliamentary and presidential elections set to take place in June , no major policy ini tiatives are likely to gain tract ion over the coming months. As pump prices were hiked by 7% in 2012, we are not expecting any further cutbacks in subsidies. To be sure, as fuel subsidies are a smaller share of total spending relative to regional peers, it remains to be seen what impact any further reforms would have on bolstering underlying stability. With authorities currently in negotiations with the IMF over a potential prec autionary SBA , more clarity will not emerge until H213 following the election . In either case, any reforms wi ll likely be very gradual, and w ould likely be offset through higher cash transfers.

Final Thoughts

Underlying Assumptions: As previously mentioned, our analysis is based on the assumption that oil prices will remain elevated by historical standards, while the other external factors that have been the primary cause of the massive expansion in current and fiscal account deficits will also remain unchanged. Certainly, if oil prices head below US$100/bbl for a prolonged period, the urgency to carry out further reforms would drop.

Economic Impact: Although subsidies have been taking up an increasingly large share of government spending, raising domestic energy prices is by no means a panacea to curing all the economic ills afflicting these countries. Indeed, much will depend on the extent of price hikes, and additional measures s uch as broadening the tax base and adjusting exchange rate regimes. It is clear that inflation will head higher, although we do not believe this will necessarily prove to be a massive problem in the near term due to weaker soft commodity and wheat prices.

Public Backlash Not Guaranteed: Much of our analysis also makes the major assumption that any move to raise domestic energy prices would be met by swift 'blowback' from populations which have endured several years of weak growth and steadily rising unemployment. This need not necessarily be the case. It is possible that some governments can successfully 'sell' further reforms to their electorates, which would help push through further austerity measures.

This article is tagged to:
Sector: Country Risk
Geography: Middle East, Middle East

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