Report No. 4136-EGT Arab Republic of Egypt Issues of Trade Strategy and Investment Planning January 14, 1983 EMENA Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. ARAB REPUBLIC OF EGYPT Currency Equivalents Official Foreign Exchange Rate 1 Egyptian Pound (LE) - US$1.43 1 US Dollar (US$) - LE 0.70 Rate for Commercial Bank Transactions 1 Egyptian Pound (LE) - US$1.20 1 US DOllar (US$) - LE 0.84 Fiscal Year July 1 to June 30 FOR OFFICIAL USE ONLY EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING This Report is based on the work of two World Bank economic missions which visited Egypt in December 1981 and June 1982 and on the findings of a joint study of Trade Strategy and Comparative Advantage in Egyptian Industry carried out by the Ministry of Industry and Mineral Wealth and the World Bank. The team that worked on this Report consisted of the following: Kemal Dervis, Chief of Mission (Egypt Division, EMENA) Amar Bhattacharya (Egypt Division, EMENA) Heba Handoussa (Consultant, Ministry of Industry and Mineral Wealth) Hassan Khedr (Consultant, Ministry of Agriculture) Ricardo Martin (Development Research Department) Michelle de Nevers (Egypt Division, EMENA) John Page (Development Research Department) Sweder van Wijnbergen (Development Research Department) The report was discussed with the Government in October and November of 1982. Mr. Vinod Dubey, Chief Economist, EMENA, participated in these discussions. Assistance to the Mission's work in Washington and Cairo was provided by Nadia Abdel Azim, Deborah Bateman, Kathleen Jordan, Anne Milne, MUrat Kbpriul, Mona Kaddah, Mourad Wahba, Amr Sabet, Samy Zaki and Mohammed Omran. The work on this Report has benefitted throughout from the support and advice of the Government of the Arab Republic of Egypt. This document has a restricted distribution and may be used by recipients only ifi the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. ABSTRACT The report addresses issues of trade strategy and investment planning in Egypt with particular emphasis on linking microeconomic and macroeconomic considerations in the analysis of policies and future prospects. After an Introduction and Summary in English and in Arabic, Part I presents an economy-wide and long-run dynamic optimizing model of the economy, distinguishing a tradable, a non-tradable and the oil and gas sector in the economy. Key macroeconomic shadow prices are derived from the optimizing model and then integrated with an extensive, input-output based computation of commodity and factor shadow prices. Parts II and III of the report deal respectively with agriculture and industry, using the analytical framework developed in Part I to evaluate the efficiency and competitiveness at economic prices of various agricultural and industrial activities, and analyzing the impact of existing policies and incentive structures on the performance of the economy. The central thesis of the report is that Egypt will have to achieve a major structural transformation before the end of this century. The transformation requires moderation of the trend towards larger and larger agricultural deficits by resolute policy reform and investment efforts in agriculture, and the generation of large amounts of manufactured exports complemented by efficient import substitution in industry. While this transformation requires careful planning based on economic prices, it also requires comprehensive reforms in the pricing, incentive and human resource policies and the institutional mechanisms supporting Egypt's development effort. The data and analysis presented in the report show that there are many profitable investment opportunities and that the economic challenge can be met provided efficient economic management receives top political priority and broad based support. C O U N T R Y D A T A - E G Y P T AREA (Thousand) POPULATION DENSITY 1, 1001.4 sq. km 43.5 million (1980/81) 38.8 persons per sq. km. 1364.7 persons per sq. km. of agricultural land POPULATION CHARACTERISTICS I! HEALTH Crude Birth Rate (per 1,000) 40.9 Population per physician 2/ 1046.0 Crude Death Rate (per 1,000) 10.9 Population per hospital bed 3/ 459.2 Infant Mortality (per 1,000 live births) 103.4 ACCESS TO SAFE WATER ACCESS TO ELECTRICITY 3/ Total (X of population) 66.0 2 of dwellings: total 45.7 rural 18.6 NUTRITION (1977) EDUCATION I/ Per capnta calorie supply 117.6 Adult literacy rate (X) 44.0 (1977) (X of requirements) Primary school enrollment (X) 75.0 Pcr capita protein supply (grams/day) 81.1 Secondary school enrollment (X) 48.0 INCOME DISTRIBUTION _/ S Bhare of household income, lowest quintile 5.1 highest quintile 49.2 GNP PER CAPITA : US$584 (1980/81) 5/ Amount (million Annual Growth Rates (2) US$ at current Share of GDP at Market Prices (X) prices) 80/81 A C T U A L EST. (at current prices) 1975 1976 1977 1978 1979 1980/81 1960 1970 1975 1979 1980/81 National Accounts Cross Domestic Product 6/ 24233.0 9.3 8.3 11.1 8.0 9.7 9.2 Gross Domestic Product Agriculture 4901.0 6.1 1.6 -3.0 5.5 4.2 4.3 Agriculture 27.9 25.3 28.2 19.9 20.2 Industry 4154.0 9.2 5.2 8.0 10.6 8.4 7.9 Industry 6 Petroleum 23.7 26.1 24.4 33.1 35.5 Petroleum 4440.0 40.t 51.7 54.9 22.0 10.3 18.9 Services 9640.0 9.8 11.5 16.6 6.3 12.7 10.6 Services 42.9 40.8 44.4 42.2 39.8 Consumption 20147.0 1.5 8.8 7.4 5.3 5.7 12.3 Consumption 87.3 90.6 87.7 79.8 83.1 Gross Investment 7309.0 62.0 -2.5 12.5 11.5 11.7 5.2 Gross Investment 13.3 13.9 33.4 32.8 30.2 EIports of GNPS 8205.0 35.3 26.4 9.0 3.0 4.4 10.7 Exports of GNFS 19.5 14.2 20.2 30.7 33.9 Imports of GNFS 11429.0 20.2 -5.6 2.5 4.2 9.2 13.8 Imports of GNFS 20.1 18.8 41.3 45.7 47.2 Gross National Saving 5019.3 133.0 74.8 19.1 12.1 0.3 -1.0 Gross National Saving 12.9 7.7 14.6 27.0, 20.7 Prices GDP Deflator 50.8 57.2 62.9 69.8 85.4 101.0 Exchange Rate 7/ 2.15 2.21 2.07 1.85 1.43 1.43 As 2 of GDP 1960 1970 1975 1979 Public Finance Current Revenue 18.5 21.3 34.1 37.2 Current Expenditure 21.5 22.0 39.9 33.9 Surplus (s) or Deficit (-) -3.0 -0.7 -5.8 3.3 Capital Expenditure 11.8 11.1 16.6 23.0 Foreign Financing - - 16.0 4.4 1/ Data is the most recent estimate and refer to sny year between 1978 and 1980. T/ 1977 data for registered physicians, not all practicing in the country. 3/ 1976 data. 4/ National, 1974-75. 5/ At unified rate. The average effective rate in FY80/81 was about 1.32. Per capita GNP at this average rate would be 5540. 6/ GDP for 1980 at current prices is valuedat market prices. Rates of growth concern GDP at factor cost. 7/ Effective rate computed as a weighted average of official and parallel market rates. (million US$ Annual Growth Rates (M) Share of Trade Share of Trade Share of Trade at correct at Constant 1980/81 Prices With Idustrial With Developing With Capital Surplas prices) ACTUAL EST. Countries (7) Countries (0) Oil Exporters (Z) 1980/81 *1975 1976 1977 1978 1979 80/81 1965 1970 1975 1965 1970 1975 1965 1970 1975 EXTERNAL TRADE DIRECTION OF TRADE Mercha-dise Exports 6002 27.2 19.6 3.1 7.7 9.6 10.8 Exports 27.0 17.0 1.0 18.0 22.0 i0.0 1.0 1.0 4.0 Prirary 1/ 664 -15.3 -8.5 25.7 -29.8 4.5 5.2 Primary 29.0 19.0 1.0 17.0 22.0 11.0 - 1.0 3.0 Manufactures 1/ 920 24.8 -14.6 -27.3 17.9 -29.6 9.2 Masufactores 19.0 12.0 ^;.0 23.0 23,0 9.0 4.0 3.0 5.0 Petroleom 4442 72.0 63.3 11.1 16.1 22.6 12.1 M-rchandioe 1mpurts 10039 14.1 -5.0 -1.1 8.5 5.9 18.0 Imports 55.0 42.0 65.0 18.0 25.0 14.0 - - 4.0 Food 2556 27.4 16.9 -18.1 25.8 -7.0 21.2 _ Petcoleum 333 -34.2 -23.3 -53.3 2.7 -11.6 17.7 Machinery and Equipment 3900 59.5 24.8 21.4 -0.7 25.6 14.3 Others 3250 17.9 -26.2 10.7 7.5 0.2 20.0 Price Expert Price Index 51.5 49.9 52.3 52.9 76.0 100.0 Impart Price Inde- 60.6 63.5 70.4 76.1 87.9 100.0 Tacos of Trade Iden 85.0 78.6 74.3 69.5 86.5 100.0 (M I L L I O N U S A T C U R R E N T P R I C E S) Esr. Est. 1974 1975 1976 1977 1978 1979 1980/81 1974 1975 1976 1977 1978 1979 1980/81 BALANCE OF PAYMENTS EXT. CAPITAL & DEBT Eaport of Goods & Non-Factor Services 2251 2503 3319 3888 4099 5585 8205 Gross Disborsemests 2185 3522 2218 3286 2758 2291 2562 - of ehich merchandise f.o.b. 1818 1875 2169 2346 2558 4024 6002 Official Grants 6/ 1261 986 705 382 291 72 279 Ixporta of goods 4 no.-factor Coscessional Loans 120 1444 668 1855 1600 996 1276 servicos -3959 -5141 -5182 -5879 -6612 -8300 -11429 - of which merchandise c.i.f. -3618 -4608 -4659 5110 -5998 -7336 -10039 - DAC 55 199 421 591 799 833 1103 - OPEC 3 1142 171 137 93 43 69 Net Factor Iemon 70 122 413 472 1098 1143 850 - IDA 12 49 42 42 45 55 48 - Others 50 54 3i 1085 663 65 56 Net Private Transfers 42 90 87 63 54 88 60 Noo-Cancession.I Loans 804 1092 845 1049 867 1223 1007 Correct Account Balance -1596 -2426 -1363 -1456 -1361 -1484 -2314 - Official Export Private Direct Investment 87 225 444 477 387 710 1170 Credits 379 639 214 24 44 50 83 - IBRD - 14 36 37 57 118 146 MLT Leans & Grants (Net) 69 270 647 730 1141 1471 1516 - Other Multilater-l - 6 - 256 18 5 4 - Private 425 433 595 732 748 1050 774 - Ofiicial Loans & Grunts -21 210 490 803 1026 1034 1213 Gap Financing External Debt Other Capitol (Net) 5/ 1393 1907 191 339 -181 -599 -705 Change is Reserves 47 24 -81 -90 14 -98 333 Disbursed 2830 4830 5770 8090 9920 11330 13505 Isteroatiesal Reserves 516 678 642 880 1106 1098 1300 - Official 1990 3890 4720 6800 8500 9470 11296 - of which gold 102 102 102 104 104 104 - - Private 840 940 1050 1290 1420 1860 2210 - Gap Fisancing Reserves as Months Imports 4/ 1.7 1.8 1.2 2.1 2.2 1.8 1.5 U1ndisbursed Debt 1602 2426 3014 4515 4390 4629 5951 Debt Service Total Service Payment 517 595 665 1099 1211 1040 2334 - Interest 70 115 111 340 387 236 684 - Payment as % of Exports 3/ 21% 21.6% 16.8% 23.9% 21.8% 14.6% 15.6% Average ITterest Rats on New Loans 6.3 4.7 5.1 5.1 4.6 6.4 6.5 - Official - Private Average Maturity of New Loans (years) 17.2 18.5 23.3 18.7 27.9 24.5 19.5 - Official - Private 1/ Not iocludiog oil and oil products. 2/ Foreigo assets of Central Bank. 3/ Esports of goods and services net iacluding foreign oil companiss' esparts. 4/ Merchandise osly. 5/ Inlading comrcial bank operations, residual foreign financing and spatial balanca of payments finascing. T/ Includisg apecial balaoce of payments grants. EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING Table of Contents Page No. Introduction and Summary ..........................i - xxi Introduction and Summary (Arabic). PART I : AN ECONOMY-WIDE PERSPECTIVE Chapter 1 Economic Growth and Structural Change in the Long Run ........................................... 1 1.1 A Long-Run View ........................................... 1 1.2 The Initial Conditions : Egypt at the beginning of the 1980's ................................................ 3 1.3 An Optimal Growth Model ................................... 10 1.4 Experiments with Fixed Total Investment ................... 18 1.5 Experiments with Endogenous Investment .................... 36 1.6 Conclusion ................................................ 45 Chapter 2 : Shadow Prices for Trade Strategy and Investment Planning ...... 47 2.1 Prices and Planning : Some Fundamental Macroeconomic Indicators .......... 47 2.2 The Economic Price of Energy .............................. 69 2.3 Price Distortions in the Egyptian Economy : A Comprehensive Overview .................................. 76 2.4 Conclusion ................................................ 90 PART II ; AGRICULTURE Chapter 3 : Recent Agricultural Trends and Trade Performance ....... 96 3.1 Background and Overview ................................... 96 3.2 Production Structure and Cropping Pattern ................. 107 Chapter 4 : Incentives and Comparative Costs ....................... 140 4.1 Macroeconomic Environment and Sectoral Terms of Trade ............................................. 140 4.2 Comparative Costs and Returns to Land in Egyptian Agriculture .......................................... 145 Page No. Chapter 5 : An Analysis of Selected Agricultural Projects ......... 166 5.1 An Overview of Investment Allocation in Agriculture ...... 166 5.2 West Nubariya New Lands Development Project .............. 169 5.3 West Beheira Rehabilitation Project ...................... 177 5.4 Maryut Fish Farming Project .............................. 178 5.5 Minya Agricultural Development Project ................... 179 Chapter 6: Growth Prospects and Po]icy Conclusions ................ 182 6.1 Growth Potential of the Agricultural Sector .............. 182 6.2 An Agricultural Growth Modlel for Egypt : Summary and Structure .......................... 193 6.3 Growth Prospects in the Medium Term . ............ 198 6.4 A Policy Package for Accelerated Growth . ........... 205 PART III : INDUSTRY Chapter 7 : The Historical and Institutional Context .............. 212 7.1 Background ............................................... 212 7.2 Evolution in the Political and Institutional Framework, 1952-82 ...................,.,.,........ 213 Chapter 8 : Productivity Growth in Egyptian Public Sector Industry: 1973-1979 ........ . ... . . 224 8.1 The Measuring and Measurement of Total Factor Productivity ........................................... 224 8.2 Output Growth and Productivity Change in Public Sector Industry ....... . . . . .......... 228 8.3 The Nature of Productivity Change in Egyptian ]:ndustry... 236 8.4 Capacity Utilization and TFP Change ...................... 258 8.5 Conclusion . 263 Chapter 9 : Comparative Costs and Incentives in the Industrial Sector: A Selective Overview . 265 9.1 Introduction to the Techniques of Measurement . 265 9.2 Product Mix, The Choice of Technique, and Technical Efficiency: Sources of Variation in the DRC . 275 9.3 Economic Efficiency and Comparative Advantage in Egypt's Public Industrial Sector. . 278 9.4 Incentives and Relative Efficiency in the Private Sector. 297 9.5 Comparative Costs and Incentives in Egypt's Industrial Sector .... . 347 Page No. Chapter 10 : Selected Issues for Industrial Policy ................ 360 10.1 Problems of Price Policy and Public Sector Reform .. 360 10.2 Expanding Manufactured Exports: Project Identification, Exchange Rate Management and Incentives to Exporters . 367 10.3 Human Resources, Employment and Wages . 379 10.4 Prices, Markets and Planning: A Concluding Statement . 385 Appendix A-2 : Accounting Ratios for Traded Commodities Appendix A-8 : Estimation of the Frontier Production Function Appendix B : The Macroeconomic Data EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING INTRODUCTION AND SUMMARY i Introduction and Summary Over the last two years, a renewed and serious discussion started in Egypt on development policy and economic strategy. Few deny the substantial progress achieved during the 1970's. Oil production increased from 7 million tons a year in the early 1970's to 31 million tons by 1981, the Suez Canal was reopened and enlarged, workers remittances reached almost $3 billion in 1981, tourism grew into an important sector and foreign investment contributed resources to Egypt's development effort. As a result of these factors, overall GDP growth was rapid, averaging between 8 and 9 percent per annum from 1974 to 1981. These are very significant achievements. During the same period, however, inflation increased from less than 5 percent in the 1960's to between 15 and 20 percent in the late 1970's, reflecting pressures due to the worldwide increase in prices as well as domestic deficit spending. This increase in inflation had important implications for the structure of prices and incentives and the distribution of income. While excessive profits appeared, particularly linked to import trade, large segments of the Egyptian population had great difficulties protecting their already low real incomes from inflation. The economy acquired an increasingly dualistic structure with some parts characterized by high prices, high profits and high wages, and other, much larger parts, still characterized by low administered prices, low productivity and low nominal wages although bonus payments and income from parallel economic activities play an increasingly important compensating role. While there was a substantial investment effort, both in the public and private sector, there were also delays in implementation and many projects are appearing not to provide the economy with the full returns that were expected. A clear sense of priorities did not emerge from the 1970's. Economic policy and investment planning took place only in a fragmented framework without enough central purpose or continuity. No doubt the process of coordination and planning was made more difficult by the great political uncertainties characterizing that period in the Middle East linked to the difficult search for a lasting peace. The sharp decline in the price of oil that occurred in 1982 and other related difficulties leading to a slowdown in receipts from remittances, tourism and the Suez Canal, showed clearly how important it was to reduce the economy's dependence on these "exogenous" sources of foreign exchange. While short-term fluctuations are normal and unavoidable, in 1982 Egypt realized, perhaps more clearly than before, that it is the domestic economy and domestic resources that must become the basis of continued long-term and self- sustaining economic progress. Against this background and encouraged by President Mubarak, there was a search for new directions, new policies and new institutions that would build on what had been achieved to strengthen the domestic productive economy and gradually increase Egypt's independence from the uncertainties associated with remittances, oil and foreign assistance. In particular, it is increasingly recognized that even with very optimistic assumptions about new discoveries oil will not be able to provide continuously growing income to the economy and the government budget. On the contrary, unless very large new discoveries are made, some time in the 1990's, oil revenues will start declining and other exports will have to take their place. Figure 1.1 below plots the ratio of exogenous resources to total resources available to the Egyptian economy for the 1974-1982 period. - 11 - FIGURE 1 EGYPT: 1974-1982 SHARE OF EXOGENOUS RESOURCES IN TOTAL RESOURCES ci 1 o - Uw N- IX U-, o - I~~~~~~~~~~~~ . l 1973 137 !975 !9763 1977 1979 197:3 1900 !981 i9gz 1ss3 YEARS Exogenous resources here are defined as Egypt's share of petroleum and gas output valued at world prices (deducting the foreign companies' share), workers' remittances, Suez Canal earnings and net foreign capital inflows. The Figure tells a striking story. The ratio of exogenous to total resources went from about 6 percent in 1974 to 45 percent in the early 1980's. The most dramatic part of the increase occurred between 1976 and 1980. After 1980 the ratio starts showing a slow decline. Crucial questions facing Egyptian policy makers and planners relate to the impact the exogenous resource ratio has on the domestic economy and its most likely behavior in the future. Will exogenous resources continue to grow in absolute terms? Will they grow or decline as a percentage of total resources? What implications do alternative growth patterns in these resources have for overall economic growth? For future patterns of trade? For investment allocation? For exchange rate policy? For project selection? These are some of the difficult questions that lie behind the policy debate in Egypt. An important challenge is to try to derive from the macroeconomic analysis operational implications for investment planning and project appraisal. Egyptian leaders and policymakers are aware of the challenge and are working on developing a national strategy that will allow Egypt to achieve the wide ranging structural change that is required. During 1982, a new 5-Year Plan has been prepared, emphasizing productive investment in the tradable sectors and equity in the distribution of income. Transformations that involve restructuring a whole economy are always difficult and there are no easy solutions that can be implemented overnight. Change will have to be gradual and economic policy must find the best compromise between what appears - iii - to be required quickly by economic efficiency and the social and political constraints that limit the policymakers freedom of action. In the Egypt of the 1980's, economic reforms can be feasible and effective only if they reflect objectives that are broadly agreed upon and if they are clearly perceived to further these objectives. The recent debate in Egypt, the many task forces created and the policy papers prepared by distinguished Egyptian experts, are all part of this renewed search for consensus on national priorities. In a region torn by strife and war, the Egyptian government is particularly concerned that economic progress proceed within a framework of social equity and stability. While this search for optimal policies and nationally agreed priorities is essential, it should also be recognized that for gradualism to succeed the speed of reform should be sufficient for steady progress, otherwise the difficulties facing the country will only become greater and more difficult to overcome. Some hard choices must be made and the passage of time will not make the solutions any easier. It is essential, therefore, to find the right pace for gradual reforms. Change should not come too abruptly and reforms should be enacted with the understanding and support of the people of Egypt. On the other hand reforms must be comprehensive and far reaching enough to strengthen the productive capacity and efficiency of the Egyptian economy. This Report, prepared by a team of Egyptian and World Bank economists in close collaboration with many government officials, attempts to provide a contribution to the analysis and formulation of economic policy by focussing on problems of investment planning and trade strategy. These issues are intimately linked since it is by a series of well directed investments that Egypt can best achieve particular objectives of trade strategy. Part I presents an economy-wide and long-term perspective. Part II deals with issues of investment planning and trade strategy in agriculture. Part III is based on a study of trade strategy and efficiency problems in Egyptian industry carried out jointly with the Ministry of Industry and Mineral Wealth. Throughout, the analysis is quantitative and attempts to focus on concrete problems at various levels of aggregation and abstraction, without, however, trying to cover all sectors or being exhaustive. We hope that the information contained in the various parts of the study and the economic analysis undetrtaken can be useful to policy formulation and can thereby make a contribution to Egypt's national effort aimed at achieving rapid, efficient and equitable economic growth. The central thesis of the Report presented in Chapter 1 is that Egypt will have to achieve a very substantial structural transformation before the end of this century. The transformation is required because the share of "exogenous" resources in the total resources of the economy is bound to decline. These exogenous resources (oil, remittances, foreign aid, Suez Canal revenues) will not disappear suddenly. On the contrary, with supportive economic policies, they may continue to grow for several years. They cannot be expected, however, to keep pace with Egypt's investment and import needs. - iv - Moreover, revenues from oil and gas, which at present consltitute more than 50 percent of "exogenous resources", are a very special kind of "income". They imply decumulation of wealth unless they are converted into other productive or income earning assets. In the medium to long-run their share in Egypt's total expenditure will decline even with fairly optimistic assumptions about new discoveries and the rapid development of natural gas. This has two major implications for economic strategy: (i) The "special" nature of oil and gas revenues shouLd be fully recognized and should be a central concern of economic strategy in Egypt. The gradual depletion of Egypt's oil and gas reserves requires a large investment effort aimed at replacing these assets with productive human and physical capital that can sustain the economy after hydrocarbon reserves have been used up and other exogenous resources have declined in importance., (ii) The investment effort implicit in this conversion should be directed explicitly at export expansion and import substitution. Oil exports and the other exogenous resources which at present account for such a large fraction of revenues, give Egypt immediate command over imports from the world market. A decline in these resources would mean a decline in Egypt's ability to import and must therefore be counteracted by investments that increase Egypt's net foreign exchange earnings. This objective needs to be bu:ilt in explicitly in the investment planning process. Table A below gives a summary picture of what the structural transformation referred to above might imply for some key aggregates. These summary results reflect the base case run of an optimizing growth model of the economy described in detail in Chapter 1. Table A Macroeconomic Characteristics of a Structural Transformation Path : A Base Case Scenario Optimal Average Annual Growth Rates Investment Rate Percent Non-Oil Oil Other Production of Total Exports Exports Foreign of Resources (vol) 1/ (vol) Exchange Tradables Earnings 1982-1991 32.5 13.5 7.3 3.4 8.7 1992-2001 31.8 11.2 - 10.5 3.7 7.9 2002-2011 30.6 9.0 n.a.Z! 3.9 5.3 1/ Net imports start in the year 2002/2003. 2/ Including Tourism. v The figures in Table A describe a possible and desirable growth scenario. They reflect likely orders of magnitude rather than projections and the parameters of the model used in Part I of this Report are subject to a wide margin of uncertainty. Nevertheless the basic message that one can derive from experimenting with alternative assumptions and exploring different scenarios remains substantially the same. I/ Over the next two decades Egypt has to succeed in a major investment effort directed at the production of tradable commodities. Table A illustrates the argument: between 1982 and 200L the optimal investment rate averages about 32 percent, and the optimal growth rate of domestic production of tradables averages 8.3 percent. When one remembers that this includes agriculture, the magnitude of the challenge becomes obvious. Egyptian planners do not have that much room for manoeuvre. The population is increasing, expectations are growing and the economy must deliver its full potential. This Report argues that the potential is there in agriculture and in industry complemented by foreign exchange earning services such as tourism. There is large scope for economically and financially profitable investments in a large number of subsectors. If the substantial revenues that Egypt is currently deriving from oil exports, and the foreign exchange earned by Egyptian labor abroad can be transformed into productive assets in the domestic economy at a sufficiently rapid rate and if these productive assets can yield high economic returns, the structural transformation can be successful and Egypt can reduce the dependence of the economy on external factors and establish a domestic productive base adequate for its needs. The broad strategy presented in Chapter 1 consisting of a large investment effort directed towards the production of domestic tradable commodities provides no more than a starting point and long-term perspective. The proposed strategy needs to be backed by the "tactics" that will lead to a successful structural transformation: which particular kinds of products or activities deserve priority in the economy-wide effort to expand exports and strengthen import substituting production? Are the price and cost relationships as they appear to private and public producers in Egypt a useful guide to selecting the right "tactics"? Are there some general shadow pricing rules that can be derived from a more detailed analysis of the Egyptian price system? Chapter 2 turns from broad macroeconomic aggregates and long-term growth scenarios to the issue of economic pricing which we consider to be of central importance for trade strategy and investment planning. The results of the optimizing growth model of Chapter 1 are complemented by a comprehensive computation of accounting ratios (ratios of shadow prices to market prices) for about 130 commodities to arrive at an overview of economic pricing issues in the Egyptian economy. The structure of these accounting ratios demonstrates that the prices facing Egyptian consumers and producers are so much out of alignment with the true underlying values and relative economic costs that the result appears to be an almost random system, protecting some products and hurting others, without a systematic purpose, reflecting mainly 1/ See Chapter 1, pages 18 - 44 for a description of the various scenarios and sensitivity analysis. - vi - the accumulation of historic accidents. It is hard to detect a particular policy objective in this almost randomly distorted structure of incentives. The structure seems to have evolved not as the result of a particular set of broad policy objectives such as protection of "heavy" industry or "infant" industries, but more as the result of partial reactions to particular problems and cumulative interventions, sometimes reinforcing one another but sometimes cancelling out. As a result of these widespread price distortions economic rates of return are very different from financial rates of return, opening the way to misallocation of investment and waste in resource use. Under these circumstances, there is a crucial role for investment planning in overall economic management. A consistent and careful screening of projects based on the kind of shadow price analysis described in Chapter 2 could make an invaluable contribution by significantly augmenting the return Egypt gets on the large resources that should be devoted to investment. The Government is aware of the price distortions and is addressing the issue in the new 5-Year Plan. It is important to stress, however, that shadow pricing and government planning cannot bear the entire burden of improving resource allocation. In a mixed market economy actual market prices, financial incentives and financial profitability will have determining influence on resource allocation. As Long as financial rates of return are very different from economic rates of return, political and commercial pressures will tend to counteract the economic objectives cf investment planners. With existing price distortions there will continue to be dangerous opportunities for extremely wasteful projects in many areas, because projects with low or even negative economic rates of return can be financially quite profitable. Conversely, projects with high economic returns may not be undertaken because they would not lead to large financial profits. The difficulties and conflicts this situation creates should not be underestimated and one cannot expect a mixed market economy to function well under these circumstances. While careful economic pricing and project evaluation can help reduce misallocation and while planners may try to increase the productivity of investment, there is an urgent need to complement and support the process of investment planning with policies that adjust the pattern of domestic relative prices to reflect economic opportunity costs. This will permit greater concordance between commercial viability and economic efficiency, reduce the burden on the government, reduce the level of conflict in the system and help Egypt achieve an efficient allocation of investment so that the sacrifices made today can lead to greater and more rapid improvements in the future. In Parts II and III, the Report turns from economywide strategic and tactical issues to a detailed analysis of two major domestic commodity producing sectors: agriculture and industry. It is in these two sectors that most of the required import substitution and export expansion will have to take place and, in collaboration with officials of the responsible ministries, a lot of effort was spent assembling the information required for an analysis of past performance, future prospects and policy options in agriculture and industry. - vii - Chapters 3 to 6 in Part II of the Report provide a comprehensive analysis of trade strategy and investment planning in Egyptian agriculture. Chapter 3 provides an overview of the agricultural setting and discusses in detail recent trends and trade performance for the principal agricultural commodities. The objective is to provide an understanding of the underlying factors affecting agricultural trends including supply constraints and demand developments in domestic and export markets. The analysis has benefitted from various studies done on Egyptian agriculture coordinated by the Ministry of Agriculture and, in particular, the report of a special Presidential mission supported by USAID and USDA. From the review in Chapter 3 it is abundantly clear that, over the past decade, the growth of production could not keep pace with the growth of consumption, for virtually every agricultural product. Table B summarizes the impact of domestic demand and supply developments on trade performance in terms of self-sufficiency ratios, or the share of Table B Self-Sufficiency Ratios for Principal Agricultural Commodities (Domestic Supply as Percent of Domestic Consumption) 1960 1974 1981 Basic Food Commodities Wheat 69.8 36.8 24.8 Maize 94.0 86.6 71.1 Sugar 114.2 96.0 53.2 Beans 100.4 92.5 69.8 Lentils 92.3 81.2 5.6 Edible Oils 95.4 49.7 31.6 Exportable Field Crops Cotton 400.0 211.0 149.6 Rice 143.9 111.2 101.7 Onions (fresh only) 148.2 116.6 107e6 Groundnuts 121.6 138.9 138.6 Fruits and Vegetables Citrus 106.8 120.3 114e0 Potatoes 135.1 118.2 113.6 Tomatoes 100.4 100.1 100.1 Livestock Products Red Meat 94.5 99.7 73.3 Poultry 100.0 99.2 62.8 Fish 94.5 92.4 53.6 Milk 94.2 92.5 6202 - viii - domestic supply in total domestic consumption. Several factors were responsible for the cumulative trend including the more rapid growth of domestic demand and the inability to expand export markets for horticultural products. On the supply side, the principal limiting factors were a virtually fixed crop area, increasing problems of drainage, the adverse impact of past price policies on the level and structure of crop incentives, institutional deficiencies in extension, research and marketing and finally, increasing labor shortages due to emigration and insufficient domestic: incentives. The overall impact of these trends has been a sharply widening trade imbalance. The trade balance for the agricultural sector, which was in surplus until the early 1970's, showed a deficit of $800 million in 1977 and $2.5 billion in 1980/81. Given the limited possibilities for further expansion in the land base, a key factor in improving agricuLtural performance will be the adjust- ment of incentives to allow for a more efficient use of limited resources. Chapter 4 presents an analysis of the incentive issue at the sectoral and at the crop level, and examine comparative costs and returns for different crops and cropping patterns. The objective is to provide a good analytical description of comparative advantage and incentives in Egyptian agriculture so as to identify directions for policy change and to provide an empirical basis for project selection and investment planning within the sector. At the aggregate level, the results indicate that inspite of the progressive upward adjustment in agricultural crop price iD. recent years, the "net" tax resulting from intervention through taxes and controls remains substantial at about 14 percent of value added. In additicn, the sharp upward trend in real wages has adversely affected returns to other factors of production, most notably land. These trends have important ramifications for overall incentives and resource mobilization in the sector. Apart from the continued heavy implicit tax burden borne by the sector, what is also striking are the wide divergences between economic and private returns in Egyptian agriculture. Moreover, as the analysis in Chapter 3 indicates, the magnitude of this divergence has grown in recent years so that both the structure and level of economic returns is markedly different from the set of private incentives faced by the farmer. Table C summarizes the main results in terms of the alternate measures of private and economic returns to land for 1981. From these results one can draw several important conclusions related to economic efficiency and comparative advantage within the agricultural sector. In general, even within the limits of a multiple objective cropping system, there is considerable potential for a more efficient allocation of scarce land resources. The greatest economic returns are from the very high-value added export crops including a subset of fruits and vegetables (tomatoes, oranges, fresh vegetables) and export oriented crops such as - ix - Table C Private and Economic Returns to Land (1981) (LE feddan; percents refer to share of crop in total cultivated area) Ratio of Economic to Private Economic Private Return Return Return Winter Crops Wheat (12.6%) 84 105 1.25 Barley (0.8%) 43 56 1.30 Full Season Berseem (15.8%) 210 -16 -0.08 Beans (2.1%) 132 108 0.82 Lentils (0.1%) 104 47 0.46 Onions (0.2%) 97 1506 15.33 Summer Crops Rice (8.6%) 59 170 2.88 Maize (12.9%) 114 69 0.61 Sorghum (3.6%) 68 -2 -0.03 Cotton (10.6%) 155 421 2.72 Groundnuts (0.2%) 136 394 2.89 Sesame (0.4%) 126 92 0.73 Vegetables Winter Tomatoes (3.0%) 388 1193 3.07 Nili Potatoes (1.5%) 203 319 1.58 Perennials Oranges (1.5%) 295 668 2.27 Sugarcane (2.3%) 155 212 1.37 onions, garlic and peanuts. The potential for increased exports of these crops is, however, limited by market constraints and geographical specialization. At the next level in terms of economic returns are cotton and rice. In Chapter 4 the results also demonstrate that Egypt continues to have a comparative advantage in the production of extra-long staple cotton, although some switch to shorter staple varieties is justified for substitution in coarse yarn production. Among the import substituting crops, wheat and sugarcane have the highest economic returns, although lower than for export crops. Maize and beans have somewhat lower returns, and on the basis of present yields, lentils, sesame and sorghum are all marginal crops. Finally, from the point of view of economic returns, berseem has the lowest, in fact at the margin, negative economic returns, suggesting that a re!duction of the amount of land under berseem is very desirable. Given that. more than 25 percent of the crop area is under berseem, (15.8 percent for full season berseem) this is the most important alLocative issue with respect to land facing Egyptian policy makers. Chapter 5 turns to issues of investment allocation and investment planning in Egyptian agriculture. After a brief overview of investment alloction, we analyze a few selected projects in Egyptian agriculture using the methodology outlined in Chapters 1 and 2. The projects included are: (i) a "new lands" development project; (ii) rehabilitation of a. currently unproductive old new lands project; (iii) a fish farming project, and (iv) an agricultural development project in the old lands. The Chapter closes with a discussion of the investment requirements in the irrigation. and drainage system. While highly selective, this analysis of projects illustrates several important issues with respect to investment allocation and investment planning. It highlights the shortcomirngs of the internal rate of return methodology as a tool for investment planning, particularly in view of the need for longer-term structural adjustments which Egypt must achieve, The analysis of projects is thus based on the present value approach using a common set of economic prices. It is possible to obtain useful insights from this analysis about economic returns and the ordering of investment priorities as well as a better understanding of the key economic issues likely to affect the success of the projects. While it is not possible to summarize the detailed findings, we can note some of the principal conclusions. The analysis in Chapter 5 clearly indicates the potential for high economiic returns from additional public investments in Egyptian agriculture. T'his includes investments in new lands, although returns are likely to be lower than investments in old lands. Moreover, rehabilitation of lands already reclaimed but currently unproductive should be given greater priority than new reclamation of desert lands. Given the increasing population pressures on land, new land development includes benefits beyond just agricultural production, such as easing congestion in the old lands and preventing further loss of arable land. While it may thus be imperative to develop new land areas some important cautionary lessons emerge from Chapter 5: (i) new lands development should be spatially integrated to benefit from economies of scale; (ii) the cropping pattern should emphasize non-fodder crops; and (iii) the full energy costs of lifting water should be taken into account. Finally, it is worth stressing, particularly in the light of past experience, that a very careful assessment of soil conditions and water is required prior to development. The analysis in Chapter 5 also includes the evaluation of a fish farming project. Investments in fish farming, like poultry, are not land dependent and commercial investments in. both of these areas have been increasing. The evaluation of commercial fish farming indicates a fairly high - xi - economic rate of return. Increased fish (and poultry) production could thus provide a more economical source of animal protein than large livestock production. Another area where economic returns are very high, and where the scale of required investments is relatively small, is in the extension and research system which enables farmers to adopt improved technologies. This is the essential thrust of the Minya governorate based Agricultural Development Project included as the final project in our analysis. It is important to stress that adoption of such technologies are dependent on the maintenance of land productivity which in turn implies a properly functioning irrigation and drainage system. Thus, investments in extension and research, and investments in the water system are complementary and together constitute the key factors for augmenting productivity growth in the old lands. In the final chapter of Part II (Chapter 6), we focus on key issues of policy reform and growth prospects of the agricultural sector. While productivity growth in Egyptian agriculture is hampered by the important constraints we cited earlier, an international comparison under similar conditions as well as recent trial results from Egypt itself indicates a large gap between actual and potential yields under the uniquely favorable growing conditions in Egypt.- Thus, if the institutional, technical and pricing constraints can be addressed, several sources of agricultural growth can be identified. These include (i) yield increases for individual crops; (ii) more intensive cropping; (iii) shift towards higher value added crops, and (iv) increasing the productive base through additional land reclamation. To analyze the medium-term growth prospects for the agricultural sector as well as provide a framework for discussing key policy issues, we built a medium-term projection model (focussing on agricultural growth and trade) based on an earlier economywide framework -- the DRM Egypt model. Two alternate scenarios are developed, one with moderate policy reforms, or the Base Case Scenario and a High Growth Scenario based on an accelerated growth strategy. A major obstacle in formulating an effective policy package in the past has been the lack of a unifying institutional framework and the fragmentation of responsibility for the agricultural sector among several ministries and agencies. A breakthrough in addressing the problems of the agricultural sector would require a concerted and coordinated effort. Three mutually supporting and interrelated elements of such a comprehensive strategy are identified: (i) price rationalization; (ii) investment allocation and investment planning, and (iii) institutional reforms. The quantitative projections highlight the potential and need for major policy action in the agricultural sector. Under the assumptions of moderate policy reforms underlying the Base Case scenario the agricultural trade deficit is projected to almost double in constant terms by the end of the decade. Less resources would thus be available to other sectors and the agricultural sector would become an increasing bottleneck to overall economic growth. Moreover, the projected imbalance would be unsustainable in view of the central thesis of this report -- that Egypt will need to replace its oil - x:ii - earnings by other exports and import substitution in a major way during the 199O's if it is to sustain even a modest pace of economic growth. On the other hand, the high growth scenario suggests that on the basis of a concerted policy effort, the agricultural sector should be able to both increase exports substantially as well as limit the growth of additional imports. Much can be achieved in Egyptian agriculture by be!tter price policies, greater incentives and careful investment planning. Nevertheless it must be realized that agriculture cannot provide the export and employment growth on which the future of the economy ultimately depends. For that Egypt must look to industrial development. The Egypt of the year 2000 will have to be a diversified industrial economy, competing effectively in world markets and exporting about one third of domestic industrial output compared to less than 10 percent today. Given the likeLy size of Egypt's population, the tight constraint in usable land and the need to replace oil exports by alternative sources of foreign exchange, rapid and efficient industrial development is a challenge Egypt has to accept and meet. With Chapters 7 to 10, Part I:[I of the Report turns to an analysis of trade strategy and investment planning in Egyptian industry. The analysis is based on a study carried out jointly w:ith the Ministry of Industry and Mineral Wealth. We hope that this joint study is the first step in an ongoing collaborative work effort on issues of industrialization and industrial policy. After a brief description of the historical and institutional context in Chapter 7, Chapter 8 provides a quantitative analysis of growth and productivity change in the public industrial sector over the 1973-79 period. Table D summarizes some of the main results in terms of output growth, growth of factor inputs and an estimate of total factor productivity change where total factor productivity refers to the! "joint" productivity of capital, labor and material inputs. The conclusions cne can draw from these quantative estimates are quite interesting. First of all, it is clear that output growth was rapid during that period. In 7 of the 15 industrial sectors, rates of output growth for the representative firm exceeded 10 percent per year and total output of all firms grew at an average annual rate of 8.0 percent. Second, in more than half of the sectors it is not so much the growth of capital and labor inputs, but the very substantial increase in levels of total factor productivity that is the most important explanation of these high growth rates. While there are some sectors, notably cotton textiles, that experienced declines in total factor productivity, productivity change was an extremely important element of the rapid rates of industrial growth enjoyed by the Egyptian public sector between 1973 and 1979. Output in many industries grew far more rapidly than the effective contribution of factor inputs and, in particular, more rapidly than the effective contribution of capital and labor. - xiii - Table D Growth and Productivity Change in Egyptian Public Sector Industry (1973-1979) Average Annual Growth (%) Total Factor Output Capital Labor Materials Productivity Edible Oil 13.6 4.6 0.6 7.3 7.6 Beverage and Tobacco 11.7 7.8 2.4 5.9 6.0 Other Food 9.2 5.3 3.7 7.2 3.5 Cotton Textiles 0.5 3.8 0.6 3.2 -2.0 Other Textiles 3.2 1.4 2.3 1.8 1.4 Paper 9.3 8.2 2.3 9.4 2.3 Basic Chemicals 14.9 4.4 7.0 14.7 3.0 Fertilizer 23.8 3.5 8.1 17.7 13.2 Rubber and Plastic 12.9 4.9 2.8 15.3 -1.6 Light Consumer Goods -2.2 3.8 -0.2 -3.6 -1.3 Iron and Steel 5.8 7.2 5.7 3.9 0.7 Transport Equipment 12.1 1.5 1.6 10.0 4.5 Fabricated Metals 3.4 5.2 1.0 4.1 0.5 Electrical Machinery 17.0 5.2 4.2 16.4 3.8 China and Glass 3.4 3.5 -1.2 3.6 -0.2 TOTAL 1/ 8.0 4.8 2.4 7.3 1/ The total given in the last row aggregates the results over all 110 firms associated with the Ministry of Industry and Mineral Wealth. How are we to interpret these estimates of rapid total factor productivity growth? In measuring productivity change we define, via the production function, a relationship between measured inputs - capital, labor and materials - and output. There are many characteristics of these inputs, their quality, the rate of utilization, the manner in which they are coordinated and combined, which are difficult if not impossible to measure. In addition, there are important production inputs, for example management intensity and quality, which are almost universally excluded from the production function. Changes in the characteristics of inputs included in the production function or in the amount of characteristics of excluded inputs will be recorded empirically as an increase in the productivity of these inputs. For example, fuller utilization of capacity will be recorded - xiv - empirically as an increase in the output derived from a given stock of productive assets and, hence as posit-ive productivity change. A sudden disruption of input supplies may result in a fall in output for a given stock of labor and capital, and thus appear as a deterioration in productivity performance. Improvements by manageme!nt in using given techniques will also result in increased levels of total factor productivity. Thus, empirical results on total factor productivity change should not be interpreted simply as technical change in the sense of changes in the technologically feasible limits of production. Rather they represent a combination of changes in technique and changes in the productivity with which existing techniques are employed. Chapter 8 attempts to provide an analysis of these factors explaining total factor productivity change in Egypt. The following important findings emerge from the detailed analysis: (i) A substantial part of total factor productivity change is due to progress of the "best practice firms". This is particularly true in edible oils, paper, transportation equipment, fabricated metals and electricial machinery. Best practice firms in these industries appear to have been altering the existing structure of production, increasing capacity utilization, adjusting to changes in the production environment and innovating or adopting new techniques from abroad. Increased capacity utilization appears to be the single most important factor behind the rapid shift in the best practice production frontier. (ii) The rapid growth of best practice total fact:or productivity has as its counterpart a "falling behind" in levels of technical efficiency for the average or representative firm in Egypt's public sector. In 12 of the 15 subsectors analyzed, the representative firm was failing to maintain its level of productivity relative to the best practice firm. As a result, overall and intra-sector variations in technical efficiency increased during the 1970's. (iii) Cotton textiles, responsible for about 20 percent of total output, constitutes a very important exception to the generally high rates of observed total factor productivity change in Egyptian industry. It is the only sector in which we observe no perceptible movement of the best practive production frontier between 1973 and 1979. Moreover, the level of technical efficiency of the representative firm dleteriorated between 1973 and 1979 at an average rate of 2.0 percent per year. In an economy in which most enterprises were enjoying positive levels of productivity change, this deterioration in the productivity performance of a relat-ively large and mature sector is quite striking. While these results are very interesting, and a more detailed analysis is available in Chapter 8, it would be useful to follow up the present study by concentrating during the next stage on the precise reasons explaining the success of the best practice firms. If one could have a fuller understanding of the dynamics of their excellent performance, the industrial xv - sector as a whole probably could benefit from this experience. The Ministry of Industry and the World Bank are currently involved in such a follow-up study focussing on performance at the plant level over the last two decades. Several important conclusions can be drawn from the results of the present study. The period 1973-1979 in Egypt's public sector cannot in general be characterized as an era during which new lines of industrial activities or many new firms came on stream to add to the productive capacity of the sector. Much of the capacity in terms of technology, plants and equipment and labor force was in place prior to 1973. The period 1973-1979 was, however, an era of rapid growth in domestic aggregate demand and the period during which the policy reforms collectively known as "the opening" were implemented. These reforms coupled with increased availability of foreign exchange, reduced various supply-side constraints that had plagued the pubLic sector, increased to some extent the autonomy of firms, and led to increasing utilization of capacity in those sectors that were experiencing rapid growth in domestic demand. The results also indicate that the potential for very good performance exists in the public industrial sector. The increased dispersion of relative levels of efficiency which occurred in most sectors is probably an inevitable consequence of the movement from highly centralized direction of public sector enterprises to a somewhat more decentralized environment for production decisions. It is important to recall, however, that we are viewing a relatively short run process of adjustment here, with changes in capacity utilization explaining a substantial part of total growth. In the longer run, increased investment and efforts to adopt or create technical innovations will be necessary if industries are to continue experiencing rapid rates of output growth. Moreover, continued "falling behind" of average firms could have serious consequences for overall levels of total factor productivity. The analysis of output growth and productivity growth presented in Chapter 8, shows how economic performance changed over a particular time period. In Chapters 9 and 10, the Report turns to an analysis of the competitiveness of various subsectors and product lines at international prices, and to an examination of the incentives and policy regime faced by industrial firms in Egypt. In the long-run, industry is the sector that will have to be the driving force in the Egyptian economy, generating employment growth and growth in foreign exchange earnings. The objective of Chapter 9 is to provide an analytical description of comparative advantage and incentives in Egyptian industry which can form the empirical background and point of departure for further work on policy reforms as well as detailed sectoral investment plans. The analysis is based on the evidence from surveys that were conducted jointly with the Ministry of Industry and Mineral Wealth concerning the trade prospects, economic efficiency and international competitiveness of industrial producers in 10 sub-sectors of the Egyptian economy. We distinguish two subsectors in textiles, three in food products, two in chemical products and three metal products groups although some producers could be classified into more than one of these categories. For - xvi - each firm, domestic resource cost ratios were calculated under four different assumptions concerning the rental cost of capital. We selected accounting rates of interest at 6 and 10 percent, which bracket our estimates of the opportunity cost of capital derived from the optimal growth model described in Part I of this Report. Capital is valued at both its historic cost, the book value for depreciation, and at an estimate of replacement cost derived from the age of capital stock, assumed rateIs of inflation in captial goods prices, and rates of depreciation. The lowest rental cost is given by the pairing of a 6 percent rental rate with the historic cost of capital, and the highest by the pairing of a 10 percent interest rate with the replacement cost of capital. These values certainly bracket the "true" cost of the capital input in domestic resource costs. The primary purpose of this work is to test the sensitivity of the aggregate results to major assumptions regarding economic'prices and the use individual firm and product based domestic resource cost and effective protection calculations to provide additional insights into the sources of efficiency differentials among firms and industries. The results were compared wherever possible to previous work on the Egyptian industrial sector with the purpose of setting our findings in context and of following the historical development of a number of these industrial groups over the period since 1965. It would not really be feasible to try and summarize the detailed sectoral or product by product findings in this introduction to the Report. The results describing the competitiveness of the various subsectors and the impact of the policy regime are summarized at the end of Chiapter 9. What we would like to underline here are some of the basic messages that emerge from the analysis. The first message relates to the nature of the poLicy regime itself. There are three types of interventions that affect the structure of incentives: (a) import tariffs and trade restrictions, (b) subsidies on inputs, and (c) price controls. They are of roughly equal importance on average in determining the degree of positive or negative protection afforded to individual activities. But their impact differs widely not only by type of product but also by_type of ownership. In the public sector, the typical firm faces regulated prices on its output, coupled with substantial subsidies on its commodity inputs. The extent to which these two sets of implicit subsidies and taxes are offsetting determines the extent oi- effective protection. Most public enterprises in the competitive sectors would probably exchange the existing system of price controls and input subsidies for a system where they would pay the tariff inclusive price of inputs but would have the opportunity to charge the international price for their output. In the private sector in contrast, it is the tariff structure which delivers the bulk of effective protection. Price controls and subsidies play a less important role and contrary to the public sector, incentives are cumulative in the sense that implicit subsidies on inlputs, where applicable, raise effective protection above the levels which would prevail in their absence. - xvii - There are also very wide variations in both domestic resource costs and effective protection rates across sectors and products. The food and textile sectors show positive value added at economic prices in all firms in our sample. Chemicals and metals, on the other hand, each have a substantial percentage of firms, roughly 30 percent, which have DRC ratios less than zero. These establishments in the basic chemicals and metals sectors actually use more foreign exchange to purchase the intermediate materials which they use in production than they generate in foreign exchange earnings from the output produced. Much of this incidence of negative value added at world prices can be traced to the energy intensity of production processes in the two sectors. Because energy inputs in Egypt, fuel oil, natural gas, and electricity, represent potential export of petroleum foregone, setting domestic prices at levels well below international levels has resulted in a serious divergence between economic and market costs for this crucial input. Activities based on highly energy intensive processes may therefore appear profitable when evaluated at domestic market prices, but tend to be extremely wasteful of resources when examined in terms of economic prices. In all four sectors a substantial percentage of firms have resource cost ratios exceeding unity. These activities have higher economic opportunity costs in terms of output foregone at international prices than their net contribution to national income evaluated at world prices. They are therefore also inefficient, but unlike activities with negative value added at world prices, they do make some contribution to output valued at economic prices. The relative frequency of firm with DRC's exceeding one varies from a low of 21 percent in food manufacturing to a high of 46 percent in the chemnicals sector at a 6 percent rental cost of capital. When we raise the rental cost of capital to 10 percent, these percentages rise to 43 and 62 percent respectively. While there are differences when we compare broad aggregates, there are also very important variations when we consider several individual subsectors and even when examining individual producing units within a given subsector. This large variance is quite consistent with the picture that emerged from the dynamic analysis of productivity change undertaken in Chapter 9: some firms have been able to show impressive performance while others have been falling behind. This has happened in almost all sectors, increasing the variance in overall indicators of economic efficiency. Unfortunately, we do not, at this stage, fully understand the reasons for this process of increasing variance. Another very important message emerging from the analysis relates to the almost complete lack of concordance between financial and economic profitability. Table E below, summarizes the results in terms of single year estimates of financial and economic profitability, and parallels the return to land results presented in Table C. What is truly amazing is that financial and economic profitability point in opposite directions in almost all subsectors. In the textile sector, for example, financial profitability would suggest expanding woolen products, - xvill - Table E The Divergence between Economic and Financial Profitability Single Year Estimates FY1980/81 Economic Financial Rate of Return Rate of Return Cotton Textiles 13.6 5.9 Wool Textiles 14.1 15.5 Jute Products -5.1 17.5 Carpets 4.2 18.3 Oils, Soaps & Detergents 14.4 -6.6 Sugar 34.2 7.1 Processed Vegetables 12.3 2.2 Oils & Essences 78.1 17.6 Starch & Yeast 45.0 6.2 Artificial Fibres -9.5 1.9 Non-edible Oils -11.1 3.8 Coke -17.4 -20.7 Leather & Tanning 8.3 4.1 Iron & Steel 2.7 10.9 Aluminum -21.0 12.5 Non-ferrous Metals -3.1 15.5 Steel Pipes -2.0 18.9 Formed & Shaped Steel 6.4 11.7 Ferrous Castings -46.2 -6.7 Road Motor Vehicles -32.7 -13.4 Railway Carriages 17.3 12.1 Bicycles & Motorcycles -3.2 1.5 Industrial Electrical Products 52.6 24.4 Electric Consumer Durables 20.0 15.8 Consumer Electronics -3.6 20.5 Ceramics -12.8 2.4 China & Glass -16.4 20.6 jute products and carpets, whereas economic profitability suggests that it is cotton textiles that deserve expansion. In oils, soaps and detergents, the economic rate of return is a very respectable 14.4 percent, but financial profitability is negative. On the contrary, in sectors such as non-edible - xix - oils, consumer electronics or aluminum, financial profitability is positive, but profitability at economic prices is significantly negative. These wide discrepancies underline, in our view, the pressing need for: (i) a gradual but resolute movement towards price flexiblity and greater uniformity in incentive structures particularly during the transition period and, (ii) careful investment planning using economic prices. It is only with these preconditions that greater decentralization and autonomy of producers can generate the desired economic results. Present incentives are such that greater decentralization of economic decision making is effectively not feasible. Finally, it is worth stressing that the results of the study do not support any sweeping generalizations regarding the relative efficiency of the public and private sectors. The private sector, of course, shows much greater financial profitability, but in terms of economic profitability the results are mixed. Against the background and on the basis of the quantitative results described in Chapter 9, Chapter 10 takes a close look at the key issues of policy reform related to industry and industrial performance. We identify: (i) price policy and public sector organization, (ii) export promotion and exchange rate management, and (iii) employment, wage and human resource policies as critical areas in need of wide ranging and comprehensive policy reforms. The Report attempts to suggest concrete and graduated reform measures in these areas all designed to enhance the productive efficiency of the Egyptian economy. There is a common theme running through the recommendations: gradually, the fragmentation and the extreme forms of dualism in the economy should be reduced. While financial profitability should be brought much closer to economic profitability, a common set of incentives and objectives should characterize all productive activity, whether in the public, private or "'mixed" sectors. Of course, this cannot be achieved overnight. It would not only be unrealistic but even harmful if the same set of pricing, employment and management rules were to be imposed suddenly on to what are at present quite different sectors. A start should be made, however, because the dualism and fragmentation of the economy is growing and with it the price and incentive distortions that reduce the efficiency of the economy, hamper the country's saving and investment capability and make economic management an ever more difficult task. The challenge, of course, is to achieve this more "unified" economy, attain greater efficiency and mobilize the required domestic resources within a framework that preserves social stability and remains, at every step, politically feasible and implementable. Chapter 10 discusses policy reform within this framework. It should be recognized, however, that there is a difficult trade-off between short-run expediency and long-run viability. In the short-run it may appear easier to preserve existing mechanisms and to postpone difficult decisions. Political constraints may seem to forbid bold and wide ranging reforms. But as time passes the problems will become more difficult to solve and the magnitude of the required changes will become even - xx - greater. What may appear to strengthen short-run stability could very well lead to major social and political difficulties in the longer run. This trade-off is at the center of Egypt's search for optimal economic policies. Nowhere is it more obvious than in the debate on price reform and the causes of inflation. Allowing public sector enterprises to set their product prices at economic levels would not only improve resource allocation but also reduce the public sector deficit, reduce Central Bank financing and reduce, not increase, inflationary pressure in the economy. Of course, the measured price index would rise as public sector prices are adjusted and there would be short-term costs. But one has to distinguish between a once and for all change and a process of inflation. Raising public sector prices to reduce the public sector resource gap is not an inflationary policy: on the contrary, it will have to be an essential ingredient of any macroeconomic stabilization package. This point deserves greater emphasis in the debate on economic strategy in Egypt. Inflation takes away income from people just as surely as price increases decided on and implemented by the government. If government expenditure is higher than government revenue the difference must come from somewhere. Holding down the prices of one set of products by subsidies or price controls financed through Central Bank credit forces up other prices elsewhere in the economy. It is incorrect therefore to argue that the price controls financed by Central Bank credit can in the long run control overall inflation in the economy. On the contrary, they constitute one of the driving forces behind the inflationary process. In concluding this summary, it may be worth focussing once more on the nature of the structural transformation that appears to be required. Table F below presents a decomposition of Egypt's trade baLance, as it was in 1980 and as it may have to be in 1990 and the year 2000. Of course the scenario for 1990 and the year 2000 is illustrative only. But these estimates Table F The Structural Transformation of the Egyptian Economy seen through its Trade Balance Trade Balance as 1980 1990 2000 Percent % of GDP for: - Agriculture -10.3 -6.9 -5.1 - Industry -13.4 -15.9 -4.2 - Energy 9.5 11.3 0.4 - Services 1/ 8.5 5.7 3.7 - Current Account -5.7 -5.8 -5.2 1/ Including remittances, Suez Canal and interest payments. - xxi - again underline the magnitude of the task that lies ahead. In agriculture, moderation of the trend towards larger and larger deficits by resolute policy reform and investment efforts of the type outlined in Part II of this Report; in industry, efficient import substitution and efficient generation of a large exportable surplus of manufactured goods so that Egypt by the end of the century, can join the ranks of the more successful newly industrialized nations of the world. 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I 4 ,L , LLiz) d Ji L.....................I JSL._W1l Jf ty5 MLL 0L0 L,~ rt-~-' U1t§ 6_) C . Jqi I EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING PART I AN ECONOMY-WIDE PERSPECTIVE CHAPTER 1 Economic Growth and Structural Change in the Long-Run: A Macroeconomic Framework 1.1 A Long-Run View The objective of the first chapter of this study is to put the problem of trade strategy and investment planning in Egypt into a long-term macroeconomic perspective. It is often difficult for policy makers to think about the long-term. There are always immediate and pressing problems that require prompt actions and undivided attention. Moreover, the long-run is full of uncertainties and as one tries to reach forward in time, it becomes more difficult to grasp the fundamental economic, technological and social factors that will shape the future. And yet, without a sense of direction based on a consistent long-term strategy, development policies cannot be effective. Development is a long-term process and formulating a development strategy naturally requires a long-term approach. If economic policy is to reflect more than just a sequence of crisis management measures, a long-term framework of thought appears indispensible. Such a long-term framework can provide an overview and a general direction. Individual policies can then be formulated within such a general framework and the progress of the economy can be evaluated against a better understanding of long-term trends and objectives. Below we describe a model of the Egyptian economy designed to provide such a long-term perspective. The analysis focuses on the next three decades; the period from 1981/82 to 2011/12. During this period Egypt faces a tremendous challenge. The labor force is likely to increase by about 15 million from 11.5 million in 1981/82 to 26 or 27 million people who will require productive employment by the year 2012. Assuming a modest 2 percent per annum increase in real per capita food consumption and population growth averaging 2.2 percent during the period under consideration, total food consumption would increase 3.5 times. As population growth, industrialization and urbanization continue, domestic energy requirements will grow rapidly. A 6 percent annual growth in demand for electric power would require multiplying generation capacity by six over the thirty year planning horizon. Imports of food, capital equipment and many intermediate goods will have to increase steadily if development and employment growth is to proceed. On the other hand, it will be very difficult to sustain rapid growth in remittances, oil revenues and foreign aid which have financed Egypt's imports in the recent past. There is, therefore, the need for a process of structural adjustment that will have to lead to the emergence of non-oil merchandize exports as a new and major source of foreign exchange. This chapter presents a model of the Egyptian economy that focuses on the most essential aspects of this structural adjustment process. To emphasize the essentials, we have to discard many details, aggregate and oversimplify. But simplification is useful if it can make reality more transparent and if it clarifies the most important features of the complex 2- policy choices that must be made. Once the most basic choices are brought into focus, the aggregate model can be used as a unifying framework for more detailed studies of selected economy-wide and sectoral issues. The economic model that will support the analysis is an aggregative, optimizing, long-term growth model that distinguishes three sectors: (i) a sector producing tradables (exportable commodities and import substitutes); (ii) a sector producing non-tradables (commodities that canlot normally be exported or imported); and (iii) the oil and gas sector. The basic objective of the policy-makers is assumed to be the maximization of a discounted stream of domestic consumption over time. There is the usual trade-off: restraining consumption in the short-run allows more saving and, provided there are positive real returns on saving, more consumption in the loing-run. There is a balance of payments constraint: in any given period the value of imports cannot exceed the sum of tradable commodity exports, oil exlports, foreign transfers and net borrowings from abroad. There are also phlysical and technological constraints: increases in domestic production are limited by the amount of physical capital that can be installed, the size of the productive labor force and the technological improvements that can be achieved. Finally, there is an exhaustible resource constraint: the cummulative production of oil and gas cannot exceed available reserves. Within this framework, the key strategic policy choices facing Egypt over the next 20 to 30 years can be summarized as follows: (a) How much should Egypt save? Should the savings effort increase over time, decrease or remain constant? (b) In what form should Egypt save and invest? The country's total wealth can be decomposed into: (i) real capital assets (factories; infrastructure, etc. 1/); (ii) wealth in the form of oil and gas underground; and (iii) financial claims on the outside world (reserves in the Central Bank, net claims on foreigners). The process of saving and investing can add or substract to these three types of wealth. In view of the alternatives, what constitutes an optimal distribution of saving.? Note in this context that oil and gas extraction "decumulates" the second type of wealth. (c) Given a certain overall rate of "physical" investment (alternative (i) in (b) above), how should capital accumulation be allocated between the tradable, the non-tradable and the oil and gas producing sectors? What factors determine an optimal allocation? While we shall discuss specific "optimal" growth paths, the primary objective is to analyze the interdepenclence between the various decisions that must be made and the sensitivity of optimal policy rules to key parameters such as the degree to which Egypt is willing to take a "long-run view", the estimated magnitude of oil and gas reserves, and the return Egypt can hope to get on physical investment. I/ It is best, in this context, to think of human resources as part of Egypt's real capital assets. Human capital can be increased by real investment, in a manner similar to physical capital formation. - 3 - A second important objective of the modelling work is to provide insights into the price and incentive structure that should accompany an optimal savings and investment strategy. With a three sector model not much can be said, of course, on the microeconomic structure of economic (shadow) prices. But some of the aggregate parameters that are usually given exogenously to project planners can be analyzed in a dynamic general equilibrium framework with the kind of optimizing model presented below. In particular, the following questions arise: (d) What is a reasonable time path for the social rate of discount? The degree of time preference and risk aversion remain fundamental value judgements that cannot be avoided, but the sensitivity of the social discount rate to long-run macroeconomic trends can be explored systematically with an applied optimal growth model. (e) How should the "real" exchange rate behave to support an optimal growth path? This important relative price is crucial for investment planning and project appraisal procedures for it determines, loosely speaking, how costs and benefits that can easily be expressed in terms of foreign exchange availability to purchase imports should be valued in comparison to costs and benefits that are essentially of a domestic nature. The key question here is to what extent, projected structural changes in the economy require accompanying changes in shadow prices and to what extent one needs to take into account these "future" changes when making "today's" investment decisions. These are the fundamental, strategic questions that can be analyzed quite naturally with a numerical optimal growth. While finding correct answers is difficult and will always contain a large dose of "arbitrary" judgement, it is perhaps worth stressing that, as any practical policy maker knows, decisions must be made even with very imperfect knowledge. In one way or another decisions have to, and are being made, on all these issues. When a project is rejected on the grounds that it does not yield an internal rate of return of, say, 10 percent, this decision reflects a judgement on the appropriate discount rate. When any particular exchange rate is used to convert, say, projected domestic construction costs to a dollar accounting unit, there is implicit in the calculation a judgement on the future path of the real exchange rate. Implicitly or explicitly, in consistent or inconsistent fashion, these judgements are made during the process of policy formulation and implementation. What this chapter attempts to do is to analyze these issues in an explicit dynamic and optimizing framework to bring out the interdependence of the key variables that affect the process of investment planning and to clarify the strategic choices that must be made. 1.2. The Initial Conditions: Egypt at the Beginning of the 1980's Total Resources and "Exogenous" Resources The 1970's witnessed a radical transformation of the structure of Egypt's resource base. In terms of overall growth in resources available to the economy, the last decade has been a period of rapid expansion. Defining total resources as the sum of gross domestic product and net imports (domestic resources plus net resources from abroad), we get an average annual growth rate of about 12 percent over the 1974-1981 period. This means that real resources available to the economy more than doubled in seven years. While total resources increased at a remarkable rate, the composition of those resources underwent a radical change. Four major developments led both to the rapid growth in Egypt's resources and to the change in their composition: (i) The petroleum (and gas) sector emerged as the financially dominant sector of the economy with production rising from less than 8 million tons in 1974 (worth then about $800 million at world prices) to more than 32 million tons (worth almost $8 billion) in 1981. In constant dollars, this represents an average annual growth rate of about 27 percent. (ii) Remittances from workers, abroad increased from $190 million to $2,800 million in 1981, a dramatic increase averaging about 32 percent a year in constant do:Llars. (iii) The Suez Canal was re-opened and enlarged and Canal earnings reached about $900 million in 1981. (iv) Finally, direct foreign investment and net MLT lending increased significantly, part:icularly if one distinguishes between the pure balance of payments supporting grants and loans of the mid 1970s and the more autonomous development project directed capital inflows of the 1978-1981 period. It is useful to define "exogenous resources", RE, as the sum of Egypt's share of petroleum output valued at world prices (deducting the foreign companies share), workers' remittances, Suez Canal earnings and net foreign capital inflows: Egypt's Share Workers' Suez Net Foreign RE of Petroleum + Remittances + Canal + Capital & Gas Output Earnings Inflows By calling these resources "exogenous" we do not m,ean to imply that their magnitude is totally unresponsive to domestic economic policy. There is also no doubt that these resources are of great value to the national economy. They are "exogenous" more in the sense of having very little to do with the productivity of Egypt's domeslic labor force that is overwhelmingly employed in agriculture, industry and services. It is alsco true that their magnitude is very much dependent on factors beyond the policy makers control (world oil prices, the political situation in the countries hosting Egyptian workers, etc.). Finally it must be stressed that oil and g,as extraction, leading to a current income stream, depletes a stock of wealth so that the income generated in that sector should not be treated in the same way as income from other, renewable assets. - 5 - Figure 1.1 below plots the ratio of RE to total resources available to the Egyptian economy for the 1974-1982 period, where the 1982 values represent fairly reliable preliminary estimates. FIGURE 1 1 EGYPT: 1974-1982 SHARE OF EXOGENOUS RESOURCES IN TOTAL RESOURCES 0- V) -J SI~~~~~~~ER o1 C,J 01 The picture tells a striking story. The ratio of exogenous to total resources went from about 6 percent in 1974 to 45 percent in the early 1980's. The most dramatic part of the increase occurred between. 1976 and 1980. After 1980 the ratio starts showing a slow decline. Crucial questions facing Egyptian policy makers and planners relate to the impact RE has on the domestic economy and its most likely behavior in the future. Will RE continue to grow in absolute terms? Will it grow or decline as a percentage of total resources? What implications does an alternative growth path of RE have for overall economic growth? For investment allocation? For exchange rate policy? For project selection? These are some of the difficult questions that lie behind the policy debate in Egypt. An important challenge is to try to derive from the macroeconomic analysis operational implications for investment planning and project appraisal. -62 Tradables, Non-Tradables and the Real Exchante Rate While there are some sianificant differences between oil revenues, remittances, Suez Canal earniigs and foreign aid flows, they all basically represent a transfer the magnitude of which bears very litle direct relationship to productivity, wages and resource growth i.n the non-oil domestic economy. Moreover, the transfer accrues in the fosrm of foreign exchange and, therefore, implies immediate command over resources that are tradable on the world market. An increase in exogenous foreign exchange resources implies an immediate incr-ease in the capacity of a country to consume easily traded coeLmodities aFWd services, There are some commodities and services, however, that are not easily traded, For such commodities, availability of foreign exchange does Rot signify an immediate increase in potential consumption. Housing is one example of such relatively non-tradable commodities. In contrast to tradables such as clothing or food, it is not possible to increase dome.stic coesumption of housing by increasing imports or reducing exports: housing is non-tradable in rhe sense that transport costs are simply too high to make significant trade a viable alternative. Substantial portions of an economy's outp._t have this characteristic of non-tradability (many servtices, construction, electricity, transport and communication networks are all relatively .onptranable). A rapid increase in exogenous foreign exchange flows does not allow an equally rapid increase in the consumption of such items, since their ,4upply can only be increased by raising domestic production. In constrast, thae supply of a tradable commodity can be increased quickly by importing more or exporting less. The impact of a sudden increase of e-ogenous foreign exchange flows on the structure of at economy has traditionally been described with the help of a simple two sector model. The economy is viewed as consisting of two sectors, (i) tradables and. (ii) non-tradables, I' the abseace of any other resources, the production possiblity ftontier is also the consunumption possibility frontier and imports mTnJst e,x.ctly epqal exports in value. Now assume that this economy all of a sudden rece:Lves anl exogenous resource transfer that is equal in value to, say, 30 percent of the value at world prices of its tradable output. The production possibility frontier does not change since tlhe capacity to produce tradnbles or nart-radables is not (immediately) affected by this transfer, But given any level of domestic production, the economy can now -onsume wore tr?dables by simply importing them from abroad and running a bFlence of trade defi citi O(n the other hand, the economy's ability to consume nomt dabees :emnains constrai:ned by domestic productive capacity. It is easy to see, therefore, that consupiption possibilities expand: as income has risen, the economy can consume more of both tradables and non-tradables. To achieve this, more non-tradab½es ilust ke produced. This implies shifting resources Qut of tradables into the nn-oitradable sector. This shift, in turn, requires a rise in the relative price of non-tradables so that the initial imbalance is correc teJ by PA a..incre ase in. lth supply of non-tradables and a reduction in Ie.l.3nd foi t hem, both br2olght albout by an increase in their relative price. - 7 - While the model is usually discussed with reference to a positive transfer of resources, the same analysis, in reverse, applies when a country loses foreign resources. The loss of foreign resources will necessitate a shift of resources into tradables and a rise in their relative price. It will also, of course, imply a loss in real income and consumption. This is the short run impact. Population growth and accummulation of physical capital shifts production capabilities over time. In a forward looking model the change in relative prices due to the transfer, as well as all future changes will affect the magnitude and allocation of investment, as we will discuss below. It is this simple theoretical model of an economy that provides the starting point for our analysis and the basis for a disaggregation of the Egyptian economy into three sectors: (i) a sector producing tradables, (ii) a sector producing non-tradables, (iii) oil and gas and other exogenous resources. The base period is fiscal year 1981/1982 and the disaggregation is based on the following grouping of sectors and production levels; Table 1.1 Tradables, Non-Tradables and "Exogenous Resources" 1 Tradables (a) Tradable Agriculture (b) Industry (c) Tradable Services 2. Non-Tradables (a) Construction (b) Housing (c) Electricity (d) Other Infrastructure (e) Non-Tradable Services 3. Exogenous (a) Oil and Gas Resources (b) Workers' Remittances (c) Suez Canal (d) Net Foreign Capital Inflows Figure 1.2 below gives an overview of the Egyptian economy in the early 1980's by comparing the share of the three "kinds" of sectors in gross value-added output and employment. A striking fact is the contrast between the importance of RE in total resources (output or value-added) and the insignificant share of employment in the "exogenous resource" sector. The big challenge that faces Egypt arises from the need to gradually shift the structure of growth, from "natural resource" and "foreign resource" based growth to growth based on the rapid expansion of the domestic economy accompanied by growth of productive domestic employment. To underline the importance of the challenge, it is worth looking a little more closely at the four basic components of what we have defined as exogenous resources. Figure 1. 2 The Shares of the Three "Sectors" in Value-Added, Gross Output and Employment a. Sbares in Value-Added b. Shares in Gross Output c. Shares in Employment T T NT ~ ~ ~ ~ ~ ~ ~ ~~~~~N T a Traded Sector NT : Non-Traded Sector RE :Exogenous Resources - 9 - Workers' remittances have grown at spectacular rates during the last decade characterised by rapidly rising outmigration. Looking into the future, it is very difficult to project continuous substantial outmigration of the typel that occurred in the 1970's. The host countries, mainly in the Gulf, have reached their absorptive capacity limits. Of course, real incomes in the Gulf are likely to continue to rise, although probably at a slower pace, and as long as migrants send home a constant fraction of their incomes, one should expect remittances to continue to grow in real terms. Unfortunately, there is a good chance that both the savings rate and the proportion of savings sent home in the form of remittances will decline over time. As migrants get used to their income levels and as they get more established in their new environments, their consumption standards are likely to go up. Moreover, while for Egyptian workers in particular, the attachment to the Nile Valley will. remain strong, the passage of time is bound to have some effects and an increasing portion of their savings may be directed to purchasing assets (houses, cars, etc.) in the host countries. This has been the pattern elsewhere and something similar is likely to characterize the behavior of Egyptian migrants. Much, of course, will depend on political conditions, and investment opportunities in Egypt compared to investment opportunities abroad. The most likely scenario is one of continuous but moderate and gradually slower growth, going in real terms from about 3 to 4 percent per annum in the 1980's, to maybe 1 or 2 percent after 1990. If overall economic growth in the Egyptian economy can proceed at 6 or 7 percent per annum, one should expect the share of remittances in total resources to gradually decrease over the next decades. Net foreign assistance flows have been important for Egypt throughout the 1970's. The existing pipeline and the commitments already made by major countries and international lending institutions are sufficient to allow some real growth of gross resource transfers over the next few years. But the level of new commitments is showing only a slow increase so that eventually the growth in disbursements may slow down and the level of gross resource transfers may stabilize. Debt service payments, on the other hand, are due to increase substantially after 1982. This could lead to a situation where the level of net foreign assistance flows remains essentially constant. There is, of course, direct foreign investment but profit repatriations are likely to limit any net balance of payments contribution to very modest levels. Turning to the Suez Canal, further rapid growth in the volume of traffic is unlikely. Tariffs have already been raised and the possibility of traffic diversion puts an upper limit on the level of tariffs. Changes in the composition of traffic may also affect the magnitude of revenues. The most likely scenario is one of moderate growth, more or less in line with world trade, at 4 or 5 percent per annum, but the experience of spectacular expansion that has characterized the 1970's cannot be repeated. Finally, and most importantly, there is oil and gas. Recoverable reserves from established fields are currently estimated around 500 million tonnes (3.4 billion barrels). Given vigorous exploration activity and the fact that proven reserve estimates do not take into account future new discoveries in as yet unexplored areas, a reserve estimate of 900 million tons Lo - (about 6.5 billion barrels) would seem to constitute a reasonable, base case scenario. At 1981 output rates, this constitutes 29 years worth of production. On the other hands if oil productior- were to grow at the same rate as the economy, say 6 or 7 percent every year, these reserves would be completely exhausted in less than 20 years. Fortunately gas can, to some extent at least, come to the rescue. Proven reserves did not exceed 10 Tcf in 1980 (equivalent to 240 million tons of oil) but given the rapid increase in reserve estimates and using a proven + 1/2 possible formulas total reserves may be close to 25 Tcf or about 600 million tonnes of oil equivalent. Adding oil and gas one can arrive at a base case estimate of total recoverable oil and gas reserves of about 1500 million tonnes. At present production levels and assuming, ror the moment, perfect substitutability in use, this represents 47 years of production. On the other hand, with 6.5 percent growth in annua:L production, reserves would be exhausted in about 30 years. Of course:, the exportable surplus of hydrocarbons would dissappear well before reserves reach this total exhaustion limit. The combination of these factor-s constitutes an iirportant challenge to the Egyptian economy. It seems thai: before the end of this century, Egypt will have to effectuate the transition from an economy where natural and foreign based resources account for almost half of total resources to an economy where the role of these resources is much more modest, where growth is based on the expansion of domestic tradables and non-tradable production and where foreign exchange must come primarily from industrial exports. The next century may seem far away but what distinguishes good development planning from a succession of crisis management policies is precisely the presence of a long-term perspective. Policies cannot be elaborated overnight, time is required for projects to be carried out, for resources to shift and for economic structure to change. A long-run perspective, even if it is filled with uncertainties and involves only rough estimates of the future environment, seems essential if development policy is to be formulated with a sense of direct-ion and long-term purpose. 1.3 An Optimal Growth Model This section provides a verbal description of the specific optimizing growth model that was built to analyse the kind of fundamental policy problems referred to above. While our starting point is the three sector framework discussed in Section 2 (tradables, non-tradables and exogenous resources) the model has some extensions and special features reflecting important aspects of reality that we wanted to introduce in:o the analysis. These features are the following: (i) There is an explicit input-output structure and commodities are required as inputs in production as well as for final use. (ii) Domestically produced tradables and tradables produced in the rest of the world are imperfect substitutes. While the world price of imports is exogenously given to the Egyptian economy, the proportion of imports ni7n cocait doIr,aLC 'L_-CL cX rad1able :intermediate and consi-r..ar go,s roe c1latie price of imports in Lerms of doaieSLci aILy rad ' 'i7 s. (iii) There is ho such Latrtiuri Silit; fr investifent goods; imported c.ruita^l goc&da reial-.`.r. a tixed propoirtion of total investment. (iv) Do-Lmestically produced edusias ca-n be used i, the domestic economy or they can be exporioed, The wi,rorld price of Egyptian exports (excluding oil, Sue.z, dcmiances. 3k d cpenl however, on their volume. The price of exports wili faIl 1 with iacreases in volume, although we assume a high dearana aiasticity so that large increases in exports can occur vi to relati-vely -iiiaor declines in price. (v) We distinguish oil from ocatural gas. Gas caa suibstitute for oil as a source of energy o1riiv up t-o a certain point. Also gas is treated as non-trada`le-, For Egypt, !.PC exports are not considered a viable alternative even -ith optimisLic reserve estimates, given market condit-'Lons in the Middle East and the Mediterranean. (vi) The production of oil in any period is endogenous. However, production costs depead on the rati-;i of the flow of extraction to the stock of proven reserves, Since production costs are to a very large extent borne by foreign oil companies who " recover" their costs by getting a share of total production, rising production costs in the oil sector are reflected by- a rising share of the foreign oil companies. Mor-eover, proven reaerves are updated every time period by adding new discoveries and subtracting current production levels. New discoveries are exogenously projected so thtat total reserves are also exogenously given to the mnodel. (vii) The productioni of gas is treated soariewliat d:ifferently in that investment costs are borne by Egypt, rather than foreign companies and per unit production costs are constant. There is therefore a standard capital output ratio reflecting the need for domestic investment in the gas sector. (viii) The marginal efficiez.cy of total econc mywide investment declines if investment grows too rapidly. While there may not be an "absolute" absorptive capacity constraint that constittutes a rigid upper bound for investment in any period, the productivity of investment falls if it exceeds a certain critical level determined for every period by the rate of technical progress, the rate of growth of the labor force and the level of investment in previous periods. The model can be sumUnarized as follows; - 12 - Production Constraints Domestic (Capital Stock Employment technical ) Productio", ( in Tradable a in Tradable , Efficiency in ) of Tradables 4 ( Sector Sector Tradable Sector) Domestic ( Capital Stock Employment Technical ) Production of (in Non-Tradable , in Non-Tradable , Efficiency in) Non-Tradables ( Sector Sector Non-Tradable ) Sector ) Domestic (Capital Stock Proven Technical ) Production ( in the , Oil , Efficiency in) of Petroleum ( Oil Sector Reserves the Oil Sector) Domestic (Capital Stock Proven Technical ) Production , ( in the Gas Efficiency in) of Gas ( Gas Sector Reserves the Gas Sector) In the tradable and non-tradable sectors, domestic production is constrained by production functions linking output to capital stock installed in the sectors, employment, and an index of technical efficiency that grows over time. Production can be increased by accumulating more capital, by increasing employment or through technical progress. The time period distinguished in the model is twoLears.3 In any given period, there is a certain amount of capital installed in each sector and it is not possible to shift or augment capital within the two year period. An expansion of sectoral capital stock can be achieved only through new investment a,nd investment is assumed, on average, to take two years before it results in new productive capital. The labor force, on the othe:r hand, is assumed to be mobile between tradables and non-tradables and it is possible to achieve an irmmediate increase in the outDut of say, tradables, by shifting labor from non-tradables into tradable otltpUt producing activities. Production constraints in the oil and gas sectors are of a different nature. For oils the cost of production depends critically on the relationship betweert the stock of reserves and the flow of extraction. Given a certain number of fields and certain levels of reserves, there is an upper limit on how rmuch oil or gas can be produced without endangering the long-term productiveness of the fields. Nevertheless, with the aid of secondary and tertiary recovery techniques, oil production can be maintained at high levels for some time even in old fields with small reserve to production ratios. The model captures this relationship by linking the cost recovery share of the foreign oil companies to the production-reserve constellation. Capital expenditures in the oil sector are overwhelmingly financed by the oil companies. The companies then recover their costs "in kind" by getting a certain amount of cost recovery oil in addition to their contractual share in profit oil. Attempts to push production beyond "normal" lIevels will run into diminishing returns to the Egyptian economy reflected in a steeply increasing cost recovery share. - 13 - In the gas sector, the same kind of relationship does in fact exist between reserve levels and production flows but there is somewhat greater flexibility. There are also important institutional differences. The foreign companies role is not as important and domestic investment is required to expand productive capacity. These considerations as well as computational constraints have led us to drop the variable production costs specification for gas and use a simple capital output ratio specification. Material Balances The second group of constraints reflect the intermediate input requirements of production and are arranged in the form of material balance equations setting total use of a commodity equal or below total available supply from production and trade. We have: Exports of Domestic use Total Domestic Domestically Produced + of Domestically - Production of Tradables Produced Tradables Tradables Domestic Use of Total Domestic Domestically Produced ~ Production of Non-Tradables Non-Tradables Exports of Petroleum Domestic Total Domestic (Foreign and + Use of & Production of Egyptian Share) Petroleum & Gas Petroleum & Gas Imports and domestically produced tradables are viewed as imperfect substitutes and there is a material balance equating total domestic demand for tradables to total supply, domestically produced and imported: Total Domestic 6 Total Supply of Tradables Use of Tradables - from Domestic Production (Net of Exports) and from Imports. Imperfect substitutability means that while import substitution is possible and may be desirable, there are increasing domestic resource costs to pushing it further and further. Similarly significant increases in Egypt's share of the world market, implied by very rapid growth in exports, can be achieved at the cost of some decline in export prices. This decline can be interpreted to include increased transport and distribution margins as Egypt attempts to capture a share in more distant and difficult markets. In the oil and gas sector, we distinguish between two kinds of (intermediate) demands: (i) a demand that can only be met by petroleum, and (ii) a demand that can be met by petroleum or gas. For example, electricity can be generated by gas or oil; on the other hand, we assume that cars and trucks will continue to require petroleum products. The third material balance equation above states that the total supply of petroleum must be - 14 - greater than total demand composed of exports and domestic demand, where the latter decomposes into a portion that :is petroleum specific: and a portion that could be met partially or entirely by gas. To the extent that the latter demand is in fact covered by gas output, domestic demand for petroleum declines. For example, if gas has totally replaced oil wherever it can, the demand for oil would consist only of exports and non-substitutable uses. Of course, oil exports could turn negative if domestic use outruns domestic production, in which case Egypt would become a net importer of oil. In addition to the material balance constaint on oil and gas t:here is also, therefore, a special constraint on the use of gas. Domestic Production Domestic Demand for of Gas Energy that can be met by Gas The output of gas is constrained not only by capacity and reserves as reflected in the production function, but also by domestic demand: given the probable range of Egypt's reserves and the market conditions in the region, we do not consider exports of LNG to be a viable alternative, so that domestic demand in the sense described above (all possible uses where gas can replace oil), acts as a constraint on the total production of gas. Gas output is constrained, therefore, both from the supply side (existing fields, proven reserves, etc.) and from the demand side. As we shall discuss below, this has important implications for the economic valuation of natural gas. The Balance of Payments Apart from these sector specific limits, the economy's ability to produce, consume and grow is, of course, constrained by the balance of payments. The balance of payments reflects society's budget constraint: the value of imports cannot exceed the sum of export earnings, factor receipts and net foreign capital inflows: Foreign Cither Exports Value Petroleum Oil of Tradable Workers Net Foreign of Exports - Companies' + Goods and + Remittances + Capital Imports Share Services Inflows By choice of units all prices except the oil price equal unity in the base period. Oil is expressed in million tonnes so that the base year price is the overall 1981/82 price of a ton of Egyptian crude oil ($216). Import prices are exogenous and remain at unity throughout the planning horizon. This simply reflects the fact that we are dealing with a real model (everything is expressed in terms of constant dollars), and that relative price changes will be measured with respect to the exogenous import prices. For example, if the price of oil is assumed to grow at one percent per annum, this means that Egypt can buy one percent more imports per annum with a given physical quantity of oil exports. - 15 - Capital Accumulation Capital is accumulated through investment and there is on average a two year lag between the time investment takes place and the time new capital becomes productive. Clearly some investment takes much longer to mature; but some also matures more quickly so that a two-year average gestation lag is a reasonable approximation: Sectoral Sector Capital Investment Capital Stock = Stock - Depreciation + in in Period t in Period t-l Period t-1 In a first set of experiments, total capital accumulation (the sum of sectoral investments) will be projected to grow exogenously. With exogenous total investment, the problem for the optimizing procedure is to allocate investment to the individual sectors. In a second set of experiments, total investment will itself become an endogenous variable so that the model will attempt to optimize not only the sectoral pattern of investment but also its total volume and growth over time. Moreover, the model includes a kind of absorptive capacity constraint that introduces diminishing returns to aggregate investment beyond what is already implicit in the production functions. There is a critical investment level, itself a function of time, beyond which a fraction of the "excess" investment is wasted and does not yield effective new capacity. The specification is designed to capture the difficulties inherent in trying to raise investment very rapidly beyond customary levels. These difficulties have been observed in many countries and are due to a multitude of causes ranging from limited port and transport capacity to lack of specific complementary factors such as sufficient management or specially skilled labor. To try and capture all this with a single absorptive capacity constraint is, of course, an imperfect solution. But the formulation adopted reflects an important aspect of reality that is central to the problems of investment planning and that should not be neglected. Natural Resource Exhaustion Constraints The last set of constraints describe the fact that petroleum and gas production over the years is ultimately limited by total recoverable reserves. It is this limit on cumulative production that distinguishes oil and gas from other industrial and agricultural commodities. Oil and gas are exhaustible resources that cannot be reproduced forever. In this context it is important to distinguish between "proven" or "discovered" reserves and reserves that will be discovered in the future. The distinction is important because production costs and therefore, indirectly, production flows, are determined not by total reserves that will eventually be discovered, but by reserves in existing, known oil and gas fields. We have: Petroleum Petroleum Extraction New Oil Reserves in = Reserves in - in + Discoveries Period t Period t-l Period t-l in Period t-l - 16 - Initial reserves and discovery flows are exogenous. The magnitude of future discoveries is, of course, subject to great uncertainty. But it is precisely by exploring the impact of different reserve scenarios that we can hope to gain a better understanding of the role of exhaustible resources in the determination of optimal levels and allocations of investment and in the determination of shadow prices that would support optimal strategies. Social Objectives The constraints described above are the fundamental limits that economic policy must operate within. Subject to these constraints, the model maximizes a social welfare function which attempts to reflect the long-term development objectives of Egyptian society. The planners' long-term economic goal is taken to be to reach a growth path that results in the highest possible level of material well-being to the average Egyptian. This can be achieved by maximizing the cumulative stream of per capita consumption over time. In defining the social welfare function that is being maximized, several factors are taken into account. First, when there is a choice between an additional unit of consumption today and the same additional unit some time in the future, the first option is preferable. In technical terms the pure rate of time preference is positive. This is taken into account by discounting the contribution to well-being of consumption by a discount factor for each period in the future. Suppose for example that we want to compare the social value of LE 10 million of food consumption today to LE 12 million of food consumption in the year 1990, or 8 years from the base year of the plan. If we had the choice, what is more valuable: to consume another LE 1 million worth of food today or consume LE 1.2 million worth more of the same food in the year 1990?. All other things equal, the answer depends on the social rate of time preference which uLtimately reflects a society's attitude to risk and its valuation of the welfare of future generations. If time preference was zero, then we should chose LE 12 million in the year 1990 over LE 10 million now simply because it is a greater amount. But suppose that the social rate of time preference is 4 percent per annum, meaning the weight society puts on future consumption dec'Lines at the rate of 4 percent per year. We would then make the following comparison: Value of LE 10 Million Worth of Food Consumption Today = LE 10 Million Value of LE 12 Million worth of food consumption 12 million = 12 million = 8.8 million 8 years from now (1.04)d 1.3686 This calculation shows that with a time preference rate of 4 percent, LE 12 million worth of consumption in the year 1990 is wort:h only 8.8 million of consumption today, so that society prefers LE 10 million worth of consumption today to LE 12 million worth of consumption in the year 1990. How much consumption in the year 1990 would we need to compensate society for the loss of LE 10 million worth of consumption today? The answer is given by LE 10 million x (1.04)8 = LE 13.7 million, more than the 12 million actually - 17 - at stake. On the other hand, if we could gain 15 million in the year 1990 by giving up 10 million today, the calculation shows that this would be worthwhile. A second important consideration relates to the distribution of social welfare across generations. Suppose the model projects that the average Egyptian in a particular year X will have 50 percent more income than the average Egyptian in another year Y and suppose we could choose between providing an additional LE 1000 to each person in year X and providing the same LE 1000 to each person in year Y. Assume for the moment that time preference is zero so that the timing in itself does not matter. If, as individuals become richer, the social value of an additional unit of consumption declines, total social welfare would increase more if we could provide the additional income in year Y, when the average individual is poorer than in year X. We take this consideration into account by assuming that marginal social welfare is a declining function of per capita income: as per capita income rises, the additional welfare that can be achieved by a given increment in consumption gradually declines. More specifically, we shall assume that a 100 percent increase in per capita consumption leads to a ELS (consumption elasticity of marginal utility) percent increase in social welfare, where ELS will be less than 100 percent. The combination of time preference considerations and income distribution considerations implicit in a value of ELS below unity, lead to the need to discount future benefits and costs of any investment program. More precisely, it can be shown that in an economy where investment is allowed to proceed at an optimal pace, future economic benefits and costs should be discounted by an interest rate, CRI, given in the formula below: CRI = TP + (g x ELS) where CRI is the "consumption rate of interest", TP is the pure rate of time preference, g is the growth rate of per capita consumption and ELS is the consumption elasticity of marginal utility. Suppose for example, that we assume the pure rate of time preference TP to be 4.5 percent, that ELS is 0.5 and that we project consumption per capita to grow at 2 percent per annum. The consumption rate of interest would then be: CRI = 0.045 + (0.02 x 0.50) = 0.055 Future costs and benefits would have to be discounted at 5.5 percent to calculate the net present value of an investment program or of a particular investment project. An optimal investment plan is always the outcome of confronting the "objective" constraints faced by an economy (resource availabilities, balance of payments, productivity etc.) with the unavoidably more "subjective" social objectives of planners and policy makers. To formulate an optimal investment plan or even just to apply consistent procedures for project appraisal, it is necessary to make explicit judgements about social time preference and income distribution across time periods. These judgements, as well as the projected rate of growth of consumption and population, will be reflected in what economists call the "consumption rate of interest" or CRI. For simplicity and - 18B - perhaps wider appeal, we shall sometimes call this crucial decision parameter the social rate of interest. It matters a great deal whether the social rate of interest in Egypt is zero, 4 percent or 8 percent. To anticipate some of the subsequent analysis, a 9 percent social interest rate makes the development of new desert lands difficult to justify. But with a CRI of 5 percent, the same investment becomes part of an optimal plan. Unfortunately, one can neither avoid value judgements, nor derive them from some objective facts. But formal modelling can help in establishing the logical consequences of a particular set of value judgements and can help achieve overall consistency so that the required political judgements can be made with a much better understanding of their consequences and implications for growth and development policies. 1.4 Experiments with Fixed Total Investment Once an economic model has been constructed and can be operated, it becomes a kind of laboratory with the help of which alternat:ive scenarios can be explored, different views of the future can be contrasted and the implications of different political decisions can be evaluai:ed. The experiments reported below try to contribute to a better understanding of some of the basic characteristics of Egypt's future growth and are designed to help evaluate the most important policy options. For the first set of experiments the growth of physical investment is kept approximately constant and the trade balance is fixed exogenously. This assumes that total investment escapes the control of the policy maker, that Egypt cannot or will not use net foreign borrowing as a significant policy variable and that workers' remittances and Suez Canal earnings grow at some exogenous predetermined rate. Given these constraints, there are two major issues that the optimizing model can explore: the allocation of investment between tradables and non-tradables and the optimal pace of oil and gas extraction. Note that in so far as oil and gas extraction require investment in the oil and gas sector, investment allocation also deternmines the pace of extraction so that can be viewed as focusing on resource allocation given exogenously fixed total streams of investment and foreign capital and an exogenously given profile of oil and gas reserves. A Base-Case Scenario To give us a basis against which to test the sensitivity of the model to variations in exogenous variables and parameter estimates, it is useful to start by exploring a base case scenario which can then be used as a kind of reference path. The base case scenaric should not be regarded as a projection but only as a reference path to facilitate sensitivity analysis and comparison of different possibilities. There is too much uncertainty to make meaningful projections but it is possible to improve our understanding of the range of the possible and of the sensitivity of the important economic variables to alternative assumptions. A key factor determining the characteristics of any optimal growth path derived from the model is, of course, the view one takes about oil and gas reserves. Clearly, there is a tremendous amount of uncertainty relating to the magnitude of hydrocarbon reserves. Proven reserves in Egypt are low - 19 - compared to annual production levels and projected growth of domestic use. For oil, a comprehensive recent study estimates proven reserves to be between 2.6 and 3.6 billion barrels in 1980 (360 and 500 million tons). 1/ This amounts to no more than 10-14 years worth of production at current rates. Prospects for new discoveries are good, however, and there is a great deal of investment in exploration. Over the past few years this search for oil has produced a steady stream of small but significant discoveries, adding between 20 and 40 million tons on average to proven reserves every year. For natural gas, the situation is similar. The point estimate in 1980 for total proven reserves from established fields and one well finds was 8.3 trillion cubic feet, equivalent to about 200 million tons of oil equivalent. On the other hand, most analysts are quite optimistic about reassessments of existing fields and new discoveries. The PEIDA consortium puts probabilistic and possible "guesstimated" undiscovered gas at 23 Tcf or 550 million tons of oil equivalent. Note that PEIDA considers this as a kind of upper bound for the next twenty years. The study in fact works with a "proven reserves + half probable + one quarter possible" formula that yields 15.5 Tcf as the most likely reserve scenario for natural gas. There are, however, more optimistic estimates, ranging up to 35 Tcf or 840 million tons of oil equivalent and it is also worth stressing that the PEIDA study is not concerned with the post-2000 period so that small discoveries that might still be made in the outer years are discounted. In light of the above, we start by focusing on a base-case scenario with the following characteristics: Table 1.2 Assumptions Characterizing the Base Case Scenario Proven Reserves Projected New Total 1981/1982 Discoveries 1982-2011 Reserves Petroleum Reserves 500 m.t 400 m.t. 900 m.t. Gas Reserves 250 m.toe. 300 m.toe. 550 m.toe. WorLd Price of Crude Oil 2.7 percent real annual growth 1983/84-1989/90 1.8 " " " 1989/90-2000/01 0.5 " " " " 2001/02-2011/12 Suez Canal, Remittances 2/ 3.5 percent real annual growth 1981/82-2011/12 and Net Foreign Capital Economy-wide Investment 5.5 percent real annual growth 1981/82-2011/12 Economy-wide Labor Force 2.7 percent real annual growth 1981/82-2011/12 Total Factor Productivity 3.0 percent real annual growth 1981/82 -2011/12 1/ See the Pearce-Whitman-PEIDA report entitled "Gas Utilization Study" financed under IBRD Loan 1732-EGT (Gulf of Suez Gas Project) 2/ The components grow at different rates, with Suez Canal earnings growing faster and net foreign capital growing at only one percent in real terms. - 20 - As described above, oil extraction costs are endogenous and depend on the relationship between the rate of extraction and the stock of "already discovered" reserves. While a similar relationship exists for gas, it is weaker and given the relatively more plentiful supply, we are ignoring it in the range of variation explored with these experiments. Production costs in the gas sector are assumed constant and do not depend on the reserve to extraction ratio. Based on these assumptions about hydrocarbon reserves and other parameter values described more fully in Appendix A, the model has been solved numerically to generate a base case optimal growth path and associated shadow prices. We shall first describe in sorae detail the characteristics of the base case optimal growth path and then test the sensitivity of the most important variables to variations in reserve scenarios, oil prices and foreign exchange inflows. The Base Case The most important underlying factor explaining the characteristics of the optimal growth path is the behavior of what we have called "exogenous resources", RE, composed of Egypt's share of petroleum output, workers' remittances, Suez Canal earnings and net foreign capital inflows. Figure 1.3 below describes the ratio of exogenous resources to total resources for the base case scenario. It is clear from Figure 1.3 that under base case assumptions Egypt will have to adjust to a very substantial transformation in its resource base. The RE ratio declines from about 47 percent in the initial period to about 30 percent around the year 2010. The decline does not really start until the latter half of the 1980's and the transformation takes place gradually but its cumulative impact is very important. Figure 1.3 The Ratio of Exogenous to Total Resources: The Base Case 98- I H ?XSTC,7AL ' MODL. 'ESUL7S DATA U -709 6I. 1079 1I7G MO a i03 1"S Z 2995 2913 2315 YERS - 21 - Developments in the oil and gas sector are the most important determinant of the behavior of the RE ratio. Figure 1.4 below summarizes output and export paths for oil and gas, given the base case discovery and reserve assumptions. In the base case scenario total oil production (the sum of Egypt's and the foreign companies' share) continues to grow throughout the 1980's, peaks at the end of the decade at about 47 million tons a year (a little less than one million barrels a day) and then declines quite rapidly. By the year 2010, oil reserves are nearly exhausted. Figure 1.4 depicts Egypt's share of oil production which broadly follows this pattern with the decline accentuated by the decrease of the ratio of Egypt's share to total production, reflecting higher production costs and therefore higher cost recovery transfers to foreign oil companies as the extraction to reserve ratio falls over time. Figure 1.4 Developments in the Oil and Gas Sector: Production Levels (Egypt's Share) and Exports t, L I3AS iA-~~ ,- - GAS :S~~~ -- *- _~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~C- L . - .- --L cCRT5 4.9 ¶ `3 I i I Z-I 3 2*31 -<31 ~ ~ ~ ~ ~ ' g - 22 - While oil production follows this pattern, natural gas production increases steadily between 1981/1982 and the year 2000. It then levels off at a rate of 20 million tons of oil equivalent. The uppermost unbroken line in Figure 1.4 describes the total of Egypt's share of oil and gas and is the sum of the first two broken lines. Finally, the last line describes the behavior of Egypt's oil exports derived as the difference between oil and gas production (net of the foreign companies' share) and domestic consumption. Egyptian energy exports, caught between a levelling off and then gradual decline in production of oil and gas, increased extraction costs and steady growth in domestic demand, start declining after 1988/89 and, by 2001/2002, the base case projects net energy imports, growing rapidly thereafter. Two points are worth stressing in this context: (i) The behavior of net exports (or imports) of energy often appears to be the crucial variable. In fact, what matters is the magnitude and rate of change of total oil and gas production. For example, consider adjustment problems in two hypothetical countries. Country A initially produces 80 million tons of oil and gas, exports 40 million and consumes 40 million domestically. Country B produces 40 million, consumes the same 40 million and has no net trade. Five years later, Country A still produces 80 million tons, consumes 60 million and exports 20 million tons. On the other hand, Country B produces 50 million, consumes 60 million tons and has, therefore, become a net importer. Nevertheless, other things equal, it is Country A that will have suffered from a greater adjustment problem. (ii) The model projects net oil imports after 2002. These imports can also be interpreted as imports of "alternative energy" in the form, for example, of foreign exchange expenditures on nuclear power plants, nuclear fuels and nuclear technology. Egypt is, in fact, planning to generate nulcear power starting around 1990 and this interpretation of the projected "oil" imports is not inconsistent with the view of the future of Egyptian energy planners, although the base case scenario seems to suggest that these expenditures should not occur before the end of the century. Of course, nuclear power requires bulky investments so that the path of foreign exchange expenditures would be much more irregular than that depicted in Figure 1.4. 1/ Given exogenous overall investment and an exogenous trade balance, there are only two possible adjustments to the decline in exogenous foreign exchange receipts described above: export expansion or import substitution. Figure 1.5 below depicts both processes at work on the base case optimal growth path. 1/ The small macro model is too aggregated to be able to address fully the issue relating to the optimal choice of primary energy for the power sector. - 23 - Export expansion occurs in the form of a greater share of tradables having to be exported. From Figure 1.5 it is apparent that the late 1980's and early 1990's would have to be a period of dramatic export expansion under base case assumptions. Real annual export growth of non-oil merchandize would average 7.7 percent from 1981/82-1985, 11.6 percent from 1986 to 1991, 11.8 percent from 1992 to 1995 and then decline gradually to 8.6 percent from 1996 to 2001 before stabilizing around 8.2 percent thereafter. The share of exports in domestic production of tradable commodities would rise from about 13 percent in the first half of the 1980's, to 35 percent at the end of the planning horizon. While this is a very large increase over a relatively short period of time, it would bring Egypt's share of exports in tradable output to a level only a little bit above the average 25-30 percent characterizing most semi-industrial economies. Nonetheless, given the severe land limitations constraining agriculture, such an increase requires sustained and very rapid growth in manufactured exports over a period of 10 to 15 years. Figure 1.5 Export Expansion and Import Substitution Base Case with Fixed Investment EXPORT EXPANSION IMPORT SUBSTITUTION THE SHARE OF EXPORTS IN THE SHARE OF IMPORTS IN DCCMESTIC PRODUCTION OF TRADEABLES INTERMEDIATE AND CONSUMLR DEMAND M -~~~~~~~~~~~~~~~~~3 40- 48- 2s ~ ~~- ~23 q_ _ 13- ..~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~...... 1V.S IRSS 1-18 Ig$S 208 22S 2 22t8 213 lass las5 Iwol 12s a3O 233S 2131 .2313 Y!ARS Y!MS Parallel to the process of export expansion, the share of imports in domestic intermediate and final consumption would have to decline from 37 percent in the early 1980's to 28 percent at the end of the planning horizon. All this amounts to a substantial increase in the share of the tradables producing sector in the economy. Figure 1.6 describes the base case results in terms of the share the tradable sector has in investment, capital stock, employment and output in the domestic non-oil and gas economy. 24 - Figure 1.6 The Share of Tradables in the Domestic Non-Oil Economy INVESTMENT CAPITAL STOCK 76-L 73- 78- 78- 65- 65 Oso 45 ~~~~~~~~~~~~~~~45 lo lziS 10Q 1CQ6 L_C9 2B =; 0 2StS tOOs IcM 1 1C= lQ=S 19 2= 281tS YEARS YESJS ESPLOYMENT OUTPUT 72- --75 70_ 78- '1- -l l I Vs Os2 45- 45 t" IQ low ItI; wl 22l I26t" t" lM I;, 0 09 = YVZM Y - Y The structural adjustment depicted in Figure 1.6 is necessary to allow the required degree of export expansion and import substitution. Note that Figure 1.6 only describes the supply side of the economy. The demand side also adjusts, but given the limited substitutability that is possible between the broad groups of tradable and non-tradable commodities, the adjustment is very mild, as described in Figure 1.7. - 25 - Figure 1.7 The Share of Tradable Consumption in Total Consumption ALL TRACEAELES 3. SS1 3. -L-3i~~~TALYP~O._ 1 ,4.S a ss ~~~~ c;0-10TCLY F.-UG. TRAiDE:AEe I - . - .0 '' t~d3 11 S 13 23V3 I. a 31' 3 II The structural adjustment characterizing the optimal growth path can also be described in terms of growth rates. Table 1.3 below summarizes the growth pattern for the four sectors distinguished by the model. Table 1.3 Average Annual Sectoral Growth Rates : The Base Case Tradables Non-Tradables Oil Gas 1982-1985 7.0 6.2 6.0 30.0 1986-1991 6.8 5.4 0.2 10.0 1992-1995 6.9 4.7 -5.3 5.5 1996-2001 6.7 4.5 -7.1 2.1 2002-2011 6.4 4.6 -14.5 -0.6 Over the entire planning horizon, domestic production of tradables has to grow more rapidly than domestic production of non-tradables. The deviation from balanced growth is most pronounced in the 1992-2001 period during which the structural adjustment process is particularly pronounced. 26 - After the end of the century, the difference between the growth rates tends to narrow somewhat as the economy gradually adjusts to the near-exhaustion of oil reserves and the levelling off in the gas sector. At this stage, it may be useful to remember that throughout, by assumption, investment grows at an arnual rate of 5.5 percent. This clearly constrains the nature of the adjustment process. Table 1.4 below summarizes the behavior of the main macroeconomic aggregates. Table 1.4 Growth of Macroeconomic Aggregates : The Base Case (% annual growth in constant base year prices) GDP Imports Consumption Investment 1982-1985 7.2 6.6 6.7 5.5 1986-1991 4.9 5.2 5.0 5.5 1992-1995 3.7 3.8 3.6 5.5 1996-2001 4.0 3.9 3.2 5.5 2002-2011 4.6 7.2 3.2 5.5 With investment growth fixed and constant and the difference between imports and exports also fixed and growing at an approximately constant rate (between 3.2 and 4.1 percent) it would seem that the growth path of consumption must closely follow the growth path of GDP. Two factors, however, account for the differences between consumption growth and growth of GDP. First, while investment growth is constant, the share of investment in GDP changes, affecting the "residual" growth of consumption. Second, there are terms of trade effects, favorable in the beginning when the real price of oil increases, unfavorable later as export. expansion requires a decline in non-oil export prices. The behavior of total exports constitutes an interesting feature of the growth path. Total exports first grow very rapidly, then the growth rate becomes very small, before rising again. Figure 1.8 below separates the growth path of exports into its two components : oil exports and non-oil, tradable exports. As can be seen from the figure, the uneven growth of total exports reflects their changing composition. The period of slow growth in total export earnings results from the very rapid growth in non-oil exports being counterbalanced by a decline in the volume of petroleum exports. After the year 2000, Egypt becomes an importer of petroleum and the path of total exports merges with the path of non-oil exports. The combination of slow GDP growth and slow export growth during the 1992-2000 period, leads to a slow import and even slower consumption growth rate. Given that population growth is likely to remain above 2.0 percent per annum, in the early 1990's, 3 to 4 percent growth in total consumption implies - 27 - only very slowly increasing per capita consumption during the difficult structural adjustment process in the 1990's. Nevertheless, the base case scenario is always characterized by growing per capita consumption: the growth rate declines, but there is continued progress despite the loss of oil exports after the year 2000. All this is of course based on a constant investment rate. As we shall discuss, below, it is possible to achieve higher consumption growth in the 1990's if the investment rate could be raised in the 1980's. Figure 1.8 The Composition of Exports 40- TOTAL EXPCRTS ---- OIL EXPORTS i - --EXPORTS CF TRADAELES cx z 0, - I S - - ., z -29, 1880 1985 199a 199S 2229 2225 2919 231S YEARS Sensitivity to Oil and Gas Reserves It is clear that oil and gas reserve estimates have a determining influence on the nature of the optimal growth path. It is particularly useful, therefore to test the sensitivity of the projected "structural adjustment path" to variations in oil and gas reserves, keeping all other exogenous variables constant. Table 1.5 describes the alternative reserve scenarios that have been explored with the optimizing model: - 28 - Table 1.5 Alternative Scenarios for Oil and Gas Reserves (million tons of oil equivalent) Base Case High Oil & Gas Low Oil & Gas A-1 A-2 Proven Oil Reserves 500 500 500 New Oil Discoveries over the Planning 400 655 100 Horizon. Proven Gas Reserves 250 250 250 New Gas Discoveries over the Planning 300 590 150 Horizon These various reserve scenarios ranging from the very optimstic (A-1) to the very pessimistic (A-2) are all based on a fairly non-controversial estimate of initial proven reserves (500 m.t. for oil and 250 m.t.e for gas) and projected new discoveries the magnitude of which is, of course, much more uncertain. It would be a fundamental mistake, however, to attach zero probability to new discoveries given: (i) the large investiment effort in exploration that is underway, and (ii) past performance which has produced a steady stream of small discoveries of both oil and gas. There is little doubt that new oil and gas will be discovered in Egypt. The question only relates to the magnitude and time pattern of these discoveries. T]he scenarios described below span the range of the possible. Outcomes outside this range are very unlikely. Regarding oil, the base case assumes annual discovery flows starting at 25 million tons in the mid-1980's and then declining gradually to 10 million tons in the mid-1990's before ending in the year 2000. The optimistic scenario assumes higher initial discovery rates, again dec:Lining but with discoveries continuing throughout the planning horizon. The pessimistic scenario, on the contrary, projects only very small discoveries ending after the early 1990's. For gas, the situation is somewhat different. Exploration in the very promising Nile Delta region has only recently got underway and the next 10 to 15 years are likely to be characterized by steady rather than declining discovery rates. Figure 1.9 below describes the production schedules (Egypt's share of oil and gas) for three scenarios explored : the Base Case and the high and low reserves scenarios. Figure 1.9 also summarizes the impact of alternative - 29 - reserve assumptions on the behavior of Egypt's exports over the planning horizon. Figure 1.9 Alternative Scenarios for the Oil and Gas Sector 60- 48- 4a- ==-___ - e ' / '~~~~~~~*.* ~~PRODUCTION ........ 1 - \ _ -4a-- - -l -S8-~~~~~~~~~~~~~~~~~- 0a ,l k. 0 C: 0 EXPORTS H-30 BASE CASE --A-1 -458 -62-A- 1989 1985 1990 199l 20880 205 2810 2815 YEARS Perhaps the most important message that one can derive from these output and export scenarios is that some time between the mid-1990's and the year 2010 Egypt will become a net importer of energy. With pessimistic assumptions this could happen as early as the mid-1990's. With good oil discoveries and a sustained rapid growth in gas output, Egypt could enjoy an exportable surplus until about 2010. But even assuming the most optimistic developments for oil and gas, oil exports would peak around 1990 and decline thereafter. The need for structural adjustment is there, no matter what one assumes (within reasonable limits) about oil and gas reserves. With large oil - 30 - and gas discoveries in the 1980's and 1990's, it will be possible to spread the adjustment over a longer period and therefore make it easier to achieve. But even very optimistic scenarios about oil and gas cannot significantly reduce the adjustment problem: around the year 2000 Egypt's population, the sheer size of the economy and its import requirements will simply be too large in relation to the revenues that can be obtained from the oil and gas sector. The persistence of this need for ad'.ustment is reflected in Figure 1.10 describing the share of exports in tradable production for the three alternative reserve scenarios. This share has to rise from 13.3 percent in 1981/82 to 36.5 percent for the pessimistic scenario, 34.5 percent for the base case and 29.8 percent for the very optimistic scenario. The average annual growth rate for non-oil merchandize exports over the next three decades, would be 10.4 percent for the pessimistic scenario, 10.1 percent for the base case and 9.4 percent for the optimistic oil and gas reserves scenario. Achieving such targets will require a relentless effort to strengthen the existing and develop new export industries. Parallel to this effort, there should of course be a significant process of import substitution. In all three experiments the share of imports in domestic absorption decreases and the aggregate import elasticity of the economy is below unity, in the range between 0.80 and 0.95. The challenge is not, therefore, on exports alone, but on the tradable commodity producing sectors as a whole. T GURE 1. 1 EXPORTS AS A SHARE CF TRADEABLE_:S 40 -- BA_E CASE --- A-1 - ---- A-2 20-~~~~~~~~~~~~~~~~7 rS~~~~~~~~- 7' -Y,-' 1~~~~ ~ ~ ~ ~ - ,/ _ ~~~~~~~~~~~~// a-~- , l3sS lisS 19Se 99Sg 2aaX 2as5 2010 za X5 YEARS - 31 - Table 1.6 describes the sensitivity of GDP and consumption to alternative reserves and energy production scenarios. Table 1.6 The Impact of Alternative Oil & Gas Reserve Scenarios on GDP and Consumption Growth GDP (percent growth) Consumption (percent growth) Base High Low Base High Low Case Reserves Reserves Case Reserves Reserves 1982-1985 7.2 7.2 7.2 6.7 6.7 6.7 1986-1991 4.9 5.6 2.8 5.0 5.5 3.7 1992-1995 3.7 3.8 2.7 3.6 3.6 2.7 1996-2001 4.0 4.4 3.5 3.2 3.6 3.0 2002-2011 4.5 5.6 4.0 3.2 4.2 3.8 1982-2011 4.8 5.4 4.3 4.1 4.7 3.2 GDP growth ranges from 5.4 percent with the most optimistic oil and gas assumptions to 4.3 percent in the case of low reserves. In all cases, it is the mid-1990's that constitute the most difficult period while there is an improving trend after the year 2000 as the economy is projected by the optimizing model to adjust to a much reduced role of the oil and gas sector. Sensitivity to the Real Price of Oil So far the growth path of the real price of oil was kept constant throughout the experiments. The price scenario adopted is the World Bank's "oEficial" scenario of close to 3 percent real growth starting in 1985 until the early 1990's and a gradually declining price growth thereafter. According to this scenario, the average price of a barrel of Egyptian crude in constant 1981/82 prices would be $35.8 in 1990, $48.7 in the year 2000 and $57.0 in the year 2010. 1/ Any public or private economic decision maker has to project the real price of oil : unfortunately there is no escape from this despite the obviously massive uncertainty attached to future oil prices. The path of world oil prices will depend on a multitude of factors such as worldwide discovery rates, worldwide economic growth, technological developments 1/ The "average" price is a weighted mean of the three types of Egyptian crude: Suez Blend (31 API, 1.4 percent sulphur), Belayim Blend (29 API, 2.1 percent sulphur) and Ras Gharib (76 API, 3 percent sulphur). - 32 - affecting other forms of energy (solar, nuclear, biomass, etc.), conservation and domestic price policies and, last but not least, political developments of various sorts affecting the production and worldwide trade of hydrocarbons. All these factors could combine to drive the barrel of oil steadily up in value. On the other hand, the combination of a series of technological breakthroughs, major new discoveries and slow economic growth in the major consuming nations eventually could lead to constant or even declining oil prices. To explore the sensitivity of the optimal growth path to variations in oil price assumptions, we compare the base case to three alternative scenarios derived from different assumptions about the future behavior of oil prices. Figure 1.11 below describes the nature of the comparison: Figure 1.11 Alternative Scenarios Eor the Real Price of Oil 7-4 f ~ ~ ~ ~ ~~~~~,A-1 HISTORICAL IMODEL PROJECTIONS - Ease <~~~~~~~~~~~~~~~~- fi | < ~~~~~-A-2 2B-S s.1 ~ ~I .- __ - 1970 1975 tQ80 1985 199G 199S 2O33 2825 21110 231S 2020 YEARS At one extreme, Scenario A-1 assumes exponential growth in the real price of oil at 3 percent over the entire planning horizon - in our view a very unlikely event. At the other extreme, Scenarios A-2 and A-3 assume that the real price of oil reaches an upper limit of about $44 per barrel in the late 1990's, marking the advent of "back-stop" alternative technologies. A-2 has the oil price first stagnant and then growing at a declining rate to the - 33 - "back-stop" level, while A-3 has the oil price decline for a few years before resuming faster growth to eventually reach the same back-stop value. The base case, which reflects the World Bank's "best estimates" as of June 1982, is a kind of intermediate scenario, with around 3 percent growth in the second half of the 1980's, as the world economy slowly pulls out of the deep recession characterizing the 1980-1983 period, but then growth in the relative price of oil slows down gradually, as new technologies and alternative energy sources manage to moderate what would otherwise be an "explosive" growth path. The impact of an increase in the price of oil depends, of course, on whether the economy is a net importer or exporter of oil. If the economy is a net exporter, a higher price leads to a favorable terms of trade effect. If the economy is a net importer, the terms of trade effect would be negative. It is clear, therefore, that a high price of oil during the 1980's and 1990's would favorably affect the Egyptian economy. On the contrary, high oil prices after the year 2000, when Egypt is or is about to become a net importer, would have a negative impact. This is illustrated in Table 1.7 below. Scenario A-2 and A-3 (early back-stop at $44/barrel) is "good" for the post-2000 period, but "bad" for the 1990's. On the contrary, in Scenario A-1 (continuous exponential growth of oil prices), the post-2000 period is negatively affected and growth would be unable to recover, because a continuous terms of trade deterioration would magnify the problem created by the loss of oil exports. Table 1.7 The Impact of Alternative Oil Price Scenarios on GDP and Consumption Growth GDP (percent growth) Consumption (percent growth) Base A-1 A-2 A-3 Base A-1 A-2 A-3 1982-1985 7.2 7.2 7.2 6.4 6.7 6.7 6.7 5.9 1986-1991 4.9 4.5 5.5 5.9 5.0 4.7 5.4 5.4 1992-1995 3.7 3.2 3.2 3.5 3.6 3.8 3.4 3.7 1996-2001 4.0 2.9 3.5 3.7 3.2 3.0 3.0 3.3 2002-2011 4.5 2.6 5.0 5.1 3.2 2.8 3.8 4.2 Alternative oil price scenarios also have a significant impact on the optimal rate of oil extraction. With an early back-stop putting an upper limit on the price of oil it pays to extract as much as is technically feasible as quickly as possible. But with continuous exponential growth, it is worth slowing down the extraction rate somewhat to conserve oil for the later years when its price will be much higher. Sensitivity to Domestic Energy Efficiency While varying projected reserves and oil prices, we have so far not varied the relationship between output growth and growth in domestic use of energy. Specifically, we assumed that starting in 1986/87, energy input - 34 - coefficients would slowly decline, reflecting more energy efficient investments and the response of the economy to a gradual increase in domestic energy prices. Domestic energy prices in Egypt in the base period are extremely low, less than 20 percent, on average, of the corresponding wor].d price levels. These low prices, combined with rapid economic growth in the 1970's and rapid urbanization, have led to extraordinarily high domestic demand growth in the late 1970's and early 1980's. In the recent past, total demand for hydrocarbons increased at rates averaging about 12 percent per annum. It is extremely unlikely that such rapid growth will be sustained beyond the mid-1980's. It is true, of course, that economywide growth was exceptionally high during the 1977-1980/81 period. One sometimes hears the argument that such rapid growth of domestic energy demand is "normal" for a developing country. In fact domestic energy demand growth in Egypt has been abnormally high: the average growth of domestic demand for primary energy in developing countries during the late 1970's has been around 6 percent, close to the rate of growth of GDP, whereas in Egypt demand for energy has grown about 50 percent faster than GDP. It is important in this context, to stress the link to price policies and there is growing awareness of this link in Egypt. The Government wants to move gradually towards higher domestic prices and is also contemplating major efforts to improve the energy efficiency of the domestic economy. There are some very large and very inefficient energy-users in domestic industry. 1/ There is, therefore, the potential for considerably reducing energy coefficients as higher prices and efficiency-improving investments show their effect. To explore the impact of different assumptions about domestic energy efficiency on the nature of the optimal growth path, we have compared the base case to two different scenarios derived from the following assumptions: Table 1.8 Alternative Scenarios for Domestic Energy Efficiency Index of High Energy Low Energy Unit Energy Base Case Efficiency Efficiency Requirements 1985 100.0 100.0 102.0 1990 96.3 93.8 106.2 2000 86.9 78.7 115.0 2010 77.5 62.5 122.5 1/ The Kima fertilizer plant and the Nag Hammadi Aluminum smelter jointly consumed almost 30 percent of the electric power generated in Egypt in the late 1970's. - 35 - We take, here, the per unit input coefficients of oil and gas in the tradable and non-tradable sectors to reflect the per unit "energy" requirement, treating power as "embodied" oil and gas. More efficient use of electric power will lead, indirectly, to a lower requirement of oil and gas per unit of tradable or non-tradable output. 1/ The base case reflects moderately optimistic assumptions about what can be achieved by a planning and pricing policy designed to increase energy efficiency. The effect would be very gradual, but their cummulative impact quite important. Table 1.9 summarizes the impact of the alternative energy efficiency scenarios on the growth rate of domestic demand and the growth of GDP and consumption. Table 1.9 The Impact of Different Energy Efficiency Scenarios (Rates of Growth) Domestic Use of Oil and Gas GDP Consumption High Low High Low High Low Base Eff. Eff. Base Eff. Eff. Base Eff. Eff. 1982-1985 6.5 6.5 7.2 7.2 7.2 6.6 6.7 6.7 6.4 1986-1991 4.9 4.3 7.1 4.9 5.1 4.2 5.0 5.1 4.0 1992-1995 4.5 3.8 6.9 3.7 3.8 3.4 3.6 3.6 3.1 1996-2001 4.3 3.5 6.6 4.0 4.3 2.8 3.2 3.6 3.0 2002-2011 4.2 3.2 6.4 4.5 4.9 1.9 3.2 3.8 1.5 The results demonstrate that an increasing trend in the energy intensity of domestic production would have very serious long-term macroeconomic consequences. Egypt cannot afford continuous high growth of domestic energy use and efforts to increase the energy efficiency of the economy deserve high priority. They are likely to be one of the most important means of facilitating the required structural adjustment process and of maintaining continuous growth in the standard of living during the difficult transformations that lie ahead. 1/ The issue of energy efficiency is, of course, much more complex, with important questions relating to the least cost expansion program of the power sector and the optimal use of gas in need of careful consideration. But for the present, macroeconomic analysis the treatment of power as "embodied" oil and gas is adequate. -36- 1.5 Experiments with Endogenous Investment A Fundamental Optimality Condition Throughout the analysis in the preceding sections, the rate of growth of investment, and therefore the pace of capital accummulation was fixed at 5.5 percent per annum. This specific growth rate was chosen because it appears reasonable as a long-run average, in light of Egypt's development objectives as well as the experience of other developing or semi-industrial economies. The growth of investment was kept constant, however, only as a first step in the analysis of the growth and structural adjustment process. In fact, one of the key questions facing the investment planner is precisely how to determine the optimal investment rate. This section attempts to contribute to a better understanding of the issues involved. How should investment behave on an optimal growth path? Should it be a rising, constant or declining fraction of total resources? If more oil and gas is discovered, should the economy-wide investment rate rise or decline? What is the sensitivity of the optimal investment rate to different oil price scenarios? To alternative assumptions about social time preference or the pace of technical progress? These questions are, of course, linked to the issue of optimal foreign borrowing. In this section we analyze optimal investment behavior keeping the current account fixed exogenously before, in a later section, allowing capital flows to become, at least partly, endogenous. Full endogeneity of capital flows is not a very realistic assumption in Egypt's case, since both domestic and international political factors are very important in determining their possible range of variation., Before turning to the numeric;al results derived from experiments with the model, it is worth discussing in a qualitative way the important factors that will influence the behavior of the optimal savings and investment rate: (i) Traditional national accounting treats income derived from the extraction of a natural resource just like any other kind of income generated in the economy. This similarity is quite misleading. The income derived from a textile plant or from a cotton field is different from the income derived by operating an oil well. In the former case, the generation of net income (after taking account of capital depreciation) does in no way subtract from the stock of wealth available to the economy. But in the case of an exhaustible resource, to put it bluntly, the generation of current income is accomplished by running down the country's wealth. It is intuitively clear, therefore, that the optimal proportion of savings in national "income" depends on the nature of that "income". To the extent that income generation implies natural resource decummulation, it would appear that this decrease in national wealth should be compensated by a higher investment rate that builds up alternate forms of wealth. (ii) With investment able to vary endogenously, the economic return of investment will always be equated to the consumption rate of interest on an optimal growth path. The economic return of investment is measured by the increased consumption stream made possible by the - 37 - additional investment and/or any increase in the value of capital goods. As long as that economic return exceeds the CRI, it is worth increasing the investment effort until the marginal return on investment inclusive of capital gains equals the marginal cost of postponing consumption. (iii) In a country with exhaustible resources, the required equality between the consumption rate of interest and the marginal productivity of investment extends to the return on "investment" achieved by keeping the natural resource in the ground. The net economic return on the natural resource must also equal the consumption rate of interest. The time path projected for the world price of oil is, of course, an important determinant of the economic rate of return on holding reserves in the ground. With higher expected real prices, it is worth keeping more oil and gas in the ground. Two important points need to be stressed in this context, however. First, oil production costs depend on the extraction to reserve ratio. The rate of return of limiting extraction reflects, therefore, both the expected price appreciation and the decrease in production costs achieved by reducing the future output to reserve ratio. Second, while the income derived from extraction could be consumed, a large fraction of it will or should in fact be invested in acquiring alternative forms of wealth in the form of capital goods, either through imports or domestic production. This brings us back to the factors discussed in (i) and (ii) above. In fact, on an optimal path, investment and saving must be such that at every point in time, the following equality is satisfied: The Economic Rate of The Social The Economic Return on Return of Investment = Rate of = Holding Natural in Capital Goods Interest Resource Reserves This equality reflects the essential efficiency condition characterizing an optimal growth path. While the basic concepts are quite clear, in practice one has to be very careful when interpreting this optimality condition. It strictly holds only if each of the three "rates of return" is expressed in terms of a common unit of account and is defined to include any "capital gains" or "capital losses" that may arise because of relative price changes. The model used for the endogenous investment experiments is similar to the one used in the previous section, with two differences: first, we do not distinguish between oil and gas, as that distinction does not seem particularly relevant for the issues discussed in this section; second, we incorporate the real world fact of absorptive capacity constraints on capital accumulation in the form of a diminishing marginal efficiency of investment. We assume that capacity constraints apply only to aggregate investment, on an economy wide level, reflecting shortages in such crucial factors as management capability, special skills, port capacity and the transportation network. As explicit and detailed modelling of these factors is outside the scope of the aggregated model, we have adopted a shortcut to incorporate them. Up to a - 38 - cut-off level XLIM no absorptive capacity constraints are operative; XLIM is set at 10 percent above the actual increase in capital generated by last year's investment. After that, the extent to which resources devoted to investment actually generate usable capital goods declines exponentially on the margin. The existence of such a constraint does not affect the basic optimality condition equating economic rates of return but care should be taken in defining the marginal productivity of devoting one unit of income to capital formation when such constraints are binding: resources devoted to investment will not generate capital on a one for one basis when the constraint is binding, so their margitnal productivity should be adjusted downwards. For example, the costs of a steel mill or a land reclamation project are of two kinds. First, there are the energy, labor, capital and raw material costs that are traditionally taken into account in project evaluation. Second, there are the more subtle and indirect costs imposed on the economy by projects that use the particular scarce factors that are responsible for the overall absorptive! capacity limits on the economy. The declining marginal efficiency of investment schedule is an attempt to capture in the model these very real yet often neglected costs of rapid capital accumulation. On the other hand, this treatment also implies that projects that lead to a relaxation of such constraints should carry a premium over the value of capital if only future outputs of the project itself are considered. The Base Case with an Optimal Investment Rate The Investment Rate Table 1.10 below compares the rate of investment as a share of total resources in the fixed-investment growth base case scenario, to what would be an optimal investment rate, with the same reserve, technology and world price assumptions. Table 1.10 The Share of Investment in Total Resources (Percentage of Total) 5.5% Annual Optimal growth in Inivestment Investment 1982-1985 20.5 27.3 1986-1991 19.8 35.2 1992-1995 22.7 33.4 1996-2001 25.1 31.0 2002-2011 28.8 30.6 - 39 - These results confirm the intuitively plausible view that a very high investment rate is justified as long as oil and gas revenues constitute a substantial feature of national resources. A simple calculation can help clarify the key issue. In 1981/82 Egypt extracted about 35.3 million tons of oil and gas, which, at an average of $216 per ton, have a value close to $7.6 billion. During the same year the net increase in productive assets due to investment was about $4 billion. This shows that the economy's real saving rate is much lower than what it appears to be because part of what is treated as income in the national accounts is not current income, but decumulation of wealth. It should not be surprising that an optimal investment strategy will attempt to avoid periods of overall wealth decumulation. Table 1.11 below summarizes the behaviour of national wealth (capital stock and natural resource reserves) in the two cases considered. The optimal investment case leads to much faster accumulation of physical capital until the year 2000 to compensate for oil and gas depletion. Table 1.11 Asset Accumulation with Fixed and Optimal Investment Rates -------------Fixed livestnent Growth--------------- -----------------Optimal Investmen…------ --------- Growth Rate of Growth Rate of Growtn Rate of Growth Rate of Growth Rate of Growth Rate of Physical Capital Oil & Gas Wealth Oil & Gas Wealth Physical CapitaL oil & Gas 'iealth Oil & Gas Wealth Scock Ln in Constant IncLuding Stock in in Constant Inc l,ding Constant Prices Prices Appreciati.n of Constant Prices Prices Apprecintion of Reserves Reserves 196Z-lY.S9 7.7 -1.3 4.6 8.9 -2.8 2.6 198b-1991 t.7 -3.8 0.Z 11.3 -4.6 -1.3 l6Z-i?s) t.2 -5.1 3.4 9.2 -5.5 -4.6 195o-.001 5.v -6.8 -4.6 5.5 -7.1 -7.1 0u0-'oii0 5.h -13.7 -9.0 4.0 -14.5 -12.4 Note that high investment rates are optimal even though there are absorptive capacity constraints. Of course, without absorptive capacity constraints, the optimal investment rate would be even higher, close to 40 percent in the mid-1980s. But despite absorptive capacity problems, it is worth pushing the investment rate up, even to levels which generate some losses in efficiency. There is a trade-off: high investment rates are very desirable in an economy that enjoys large but temporary "exogenous resource" -- 40 - flows; on the other hand there is waste and loss of efficiency if the investment rate is pushed too much, too fast. The optimal solution will be a compromise that pushes investment up, accepts some losses in efficiency but ensures that the gains achieved by more rapid investment growth are not dissipated by these losses of efficiency and lack of absorptive capacity. Table 1.12 below describes some of the macroeconomic characteristics of the optimal investment solution, in contrast to the base-case scenario with fixed investment growth. Table 1.12 Growth of Macroeconomic Aggregates : with Fixed and Optimal Investment Behaviour Fixed Investment Growth Optimal Investment GDP Consumption Inveastment GDP Consumption Investment 1982-1985 7.2 6.7 5.5 7.9 4.0 14.7 1986-1991 4.9 5.0 5.5 8.0 5.7 10.3 1992-1995 3.7 3.6 5.5 4.2 6.0 0.3 1996-2001 4.0 3.2 5.5 3.8 3.8 2.3 2002-2011 4.5 3.2 5.5 3.7 3.3 3.0 1982-2011 5.0 4.2 5.5 5.2 4.4 5.6 The choice of an optimal investment rate allows not only a somewhat higher overall growth of GDP and consumption, but more importantly it leads to a more even growth rate of consumption over time. While large resources are available from the decumulation of oil and gas reserves, a large portion of these resources should be converted into productive capital assets so that at the time oil and gas revenues decline, these capital goods can sustain the economy and allow more steady growth in consumption to continue, despite the depletion of hydrocarbon resources. Accelerated Structural Change With higher investment rates in the earlier years of the planning period, it becomes possible and desirable to accelerate the pace of structural change. Given the present stage of development of the capital goods industries in Egypt, a high investment rate implies rapid growth in the imports of capital goods. This in turn implies the need for larger foreign exchange revenues leading to (i) accelerated extraction of oil and gas, subject of course to the extraction cost constraints and (ii) accelerated export growth and import substitution. Figure 1.12 below illustrates the structural transformation of the economy in terms of the share of tradables in the domestic non-oil economy. A comparison with Figure 1.6 above indicates that the endogenous investment - 41 - rate leads to a magnified and accelerated increase in the share of the tradable sector, producing exportables and import substitutes. Figure 1.12 The Share of Tradables in the Domestic Non-Oil Economy (The Base Case with Endogenous Investment) INVESTMENT CAPITAL STCCK es-i~~~~~~~~~~~~~9 ,,1 W.1 .~15 i2~2121 48 74 103 1055 is" 1; 2=*S 23# 281t 2515 1tt loi 1000 IO= 2SIW ZM 2318 0 231 YVRS YWI:S EMPLOYMENfT OUTPUT 4J- 78- IjsI * : to" lo"i 10l 11Gs twol 2;N1 =18 2B1r IQ o O te 2t =1 2gtt =16 Another, quite dramatic way of describing the transformation is to depict the shares of the three forms of wealth in the economy. As shown in Figure 1.12, the value of hydrocarbon reserves (including anticipated future discoveries) currently accounts for about 60 percent of total wealth while the value of the capital stock in the tradables goods producing sector represents less than 22 percent of total wealth. By the end of the planning period, however, the share of oil and gas wealth will have declined to only 5 percent of the total while capital in the tradable goods sector will have increased its share to about 75 percent. - 42 - THE COMPOSITION OF NATIO?.A' WEALTH (THE BASE CASE WITH ENDOGENO'S ThVESTKiNT) Percent of l&a- Total ea -. . - * Capital Stock in W3- ~ ~ ~ - .^ ~~Non-Tradeabie Sector 7o- 53- \ ~~~~~~~~Capital Stock in Tradeable Sector 30- Oil and Gas Reserves 1S33 198s 1899 I9SS5 2$83 Z25 a t 22lS YEARS Sensitivity Analysis The "base case scenario" is, of course, only one of the possible scenarios and the precise characteristics of the optimal growth path depend on the exogenous variables such as the projected rate of oil and gas discoveries, world oil prices, energy efficiency levels reached by the economy, etc. An extensive set of sensitivity analysis has been conducted, similar to the one described in Section 1.4 above. The basic story does not change as long as the variations in the exogenous variables are kept within reasonable bounds. Consider for example, the behavior of the "optimal" investment rate with optimistic and pessimistic reserve assumptions. Table 1.13 below summarizes the results and compares them to the base case with enclogenous investment. - 43 - Table 1.13 The Impact of Alternative Oil and G.s_Roserve Scenarios on. the OptiL,sil Invertmer.c Rtce Optimistic Scetiario Base Case Pessimist_c Scenario Projected New Discoveries Projected Projected 1245 M. toe 700 X. toe 250 M. toe kR- as % Investment as R>' as /. Investment as RL as .' InvestmeaC dS of Total ° of Total of Total A of Total of Total % of Total 1982-1985 46.4 27.0 46.1 27.3 46.1 27.8 1986-1991 47.0 34.1 46.0 35.2 43.7 36.3 1992-1995 43.0 32.0 41.5 33.4 36.9 34.4 1996-2001 39.1 30.3 36.6 31.0 31.9 31.8 2002-2011 34.0 30.3 29.6 30.6 26.4 31.4 RE: Exogenous Resources The first thing to note about the results in Table 1.13 is that despite quite large variations in projected discoveries ranging from 1245 million tons of oil equivalent in the optimistic scenario to only 250 million tons of oil equivalent in the pessimistic case, the "optimal investment story" holds. A very high investment rate is required particularly during the 1986-1991 period to build up capital stock in the tradable sector, compensating Egypt for the declining share of exogenous resources in total resources. While the essentials remain the same across scenarios, the intensity of the required investment effort varies with anticipated oil and gas discoveries. When these discoveries are very large, the RE ratio declines more slowly and the optimal investment rate remains somewhat lower than when small discoveries lead to a very rapid decline in the RE ratio. Another set of important parameters that do, of course, affect the optimal growth path and the optimal investment rate are the intertemporal choice parameters of the social welfare function. Table 1.14 below summarizes the impact of varying the social rate of time preference and/or the consumption elasticity of marginal utility on the optimal investment rate: -. 44 - Table 1.14 The Impact of the Time Preference and Utility Elasticity Parameters on the Optimal Investment Rate Base Case Variant 1 Variant 2 Variant 3 TP = 4.5% TP = 3.0% TP = 6.0% TP = 4.5% ELS = 0.5% ELS = 0.5% ELS = 0.5% ELS = 1.0% Investment Investment Investment Investment CRI Rate CRI Rate CRI Rate CRI Rate 1982-1985 6.3 27.3 3.7 30.0 7.4 24.8 7.2 25.5 1986-1991 6.8 35.2 4.6 40.6 7.8 31.0 7.6 32.1 1992-1995 5.4 33.4 4.4 39.5 6.9 28.2 6.4 31.8 1996-2001 4.9 31.0 3.8 36.1 6.2 27.0 5.5 30.2 2002-2011 5.0 30.6 3.6 35.4 6.3 26.5 5.5 28.7 Varying TP and ELS does have a significant impact on the optimal investment rate by leading to important variations in the consumption rate of interest and other social discount rates. The behavior of optimal investment over time remains similar, however, across the different variations explored, with the optimal investment rate always peaking in the 1986-1991 period and then gradually declining thereafter. It may be worth stressing in conclusion that the investment rates discussed in this section are those that would characterize an optimal growth path where optimality is essentially defined by the time preference and social utility parameters adopted for a particular run. They are not projections of what: is most likely to happen but recommendations as to what should happen if the basic assumptions and constraints of the growth model are taken as adequate representations of economic reality as it is likely to unfold over the next three decades. Foreign Borrowing In the experiments described above the growth of other "exogenous resources" (RE - Oil - Gas) has kept constant. It was assumed throughout that the sum of workers remittances, Suez Canal earnings and net foreign capital inflows would grow at a rate averaging about 3.5 percent per annum in real terms over the planning horizon. This treatment does not address the problem of optimal foreign borrowing or lending. Not only remittances and Suez Canal earnings but also foreign capital inflows were treated as exogenous and we did not allow endogenous variation in foreign assistance or borrowing. The ability to freely borrow and lend in international capital markets would of course greatly increase the range of options available to the policymakers. In particular it would allow delinking income and expenditure flows over a particular period and make it much easier to smooth consumption over time. It would also permit an increase in economic welfare (the discounted stream of - 45 - consumption over time), if Egypt could increase borrowings from abroad over the assumed levels, at real interest rates below the relevant social discount rate on the optimal growth path. Suppose for example that Egypt at present was able to borrow additional funds for investment at a nominal interest rate of 13 percent, with international inflation expected to average 7 percent over a 15 year period of amortization. This would imply a 5.6 percent real rate of interest which would have to be compared to the social discount rate and marginal productivity of capital applicable in that period. If the relevant social discount rate is higher than the real rate at which Egypt can borrow, it is possible to increase welfare by borrowing. In Egypt's case it would be quite unreasonable, however, to assume endogenous foreign borrowing that would be adjusted to the requirements of an optimal growth path. Capital flows to Egypt are largely determined by politidal factors and the government does not really have the freedom to vary in substantial ways the magnitude of net foreign capital inflows. Nevertheless, there is some variability. As time passes, an increasing portion of net capital inflows could take the form of commercial lending. This would in time lead to greater debt servicing requirements and change the nature of of Egypt's capital account. We shall come back to an analysis of the problem in Chapter 2, within the context of discussing social discount rates and the economic price of capital. 1.6 Conclusion The long-run optimal growth model developed in this Chapter was used to analyse some of the fundamental macroeconomic challenges implicit in Egypt's economic structure. While there is a great deal of uncertainty relating to oil and gas discoveries, world prices and other exogenous variables, such as long term growth of remittances, it is nonetheless possible to derive some robust conclusions that can serve as guidelines to development strategy in Egypt: (i) Revenues from oil and gas are a very special kind of income. They imply decumulation of wealth unless they are converted into other productive assets. It is misleading not to differentiate GDP in the non-oil economy from this "income" derived from resource depletion. (ii) Workers' Remittances, Suez Canal earnings and foreign aid are "lexogenous" resources that should be viewed as a "transfer" to the economy not based on domestic production. It is very unlikely that the growth in this "transfer" can keep pace with the growth of the economy that is required to maintain a steady increase in the standard of living of the Egyptian people. (iii) An optimal growth strategy, therefore, will require very high investment rates during the 1980s. The analysis suggests that investment rates between 30 and 35 percent of total resources are desirable targets for economic policy. - 46 - (iv) A high proportion of this investment shouLd be directed into export expanding and import-substituting activitjies. Over the next two decades the growth of non-oil merchandise exports will have to be in the 9 to 13 percent range and imports will have to grow more slowly than domestic production. These are difficult targets to achieve and sustain over an extended period. They imply the need for a very substantial structural transformation of the economy that must begin very soon and will reac-h its most difficult stage some time during the 1990s. (v) While Egypt may experience short term macroeconomic difficulties of a "cyclical" nature in the mid-1980s, the contribution of the oil and gas sector to total resources will continue to be large for the next 5 to 8 years. The big challenge lies further in the future, wqhen the share of "exogenous resources" will start showing sustained decline as Egypt adjusts to a new type of economy where growth comes mainly not from increases in oil and gas production but from productivity growth and factor accumulation in the domestic non-oil economy. (vi) An inadequately anticipating investment effort or a lack of sufficient productivity growth could lead to very serious economic difficulties. However, with a large investment effort and steady improvements in efficiency and total factor productivity throughout the economy, it can be possible for Egypt to maintain significant growth in per capita consumption throughout the planning period despite the magnitude of the structural change and the need for generating a large exportable surplus of domestically produced tradables. - 47 - CHAPTER 2 Shadow Prices for Trade Strategy and Investment Planning 2.1 Prices and Planning: Some Fundamental Macroeconomic Indicators The analysis presented in Chapter 1 suggests the need for a very substantial structural change in the Egyptian economy. The most important macroeconomic policy objectives were seen to be: (i) a very high investment rate during the 1980's, while there are still large oil revenues; (ii) a shift of resources into the production of exports and import substitutes; (iii) rapid development of Egypt's substantial natural gas resources as substitutes for petroleum products, and (iv) improved energy efficiency and conservation in the domestic economy. The implementation of these macroeconomic goals requires a selection of investment projects that could gradually lead to the required structural change. In practice, it is the process of project selection and the priorities adopted during this process that can translate a set of macroeconomic objectives into an operational investment plan. Good project selection depends very much on a correct evaluation of the benefits and costs of a project, given the overall economic environment and the social objectives adopted by the planning authorities. Since a project uses up many different types of inputs and usually produces more than one output, some "weights" must be used to compute the social profitability of a project by comparing the beniefits it generates to what it costs to obtain these benefits. For a private profit-maximizing firm, these "weights" are clearly the prices attached to the commodities and the services it buys or sells. For the Egyptian government, however, these prices can only be acceptable weights if they accurately reflect the full economic and social costs and/or benefits of the inputs and outputs of a project. Take, for example, wheat. The benefits of an agricultural project increasing the supply of wheat must be measured by what this wheat is "worth" to the Egyptian economy as a whole. This may or may not be what the farmer producing the wheat will actually get paid for his product. Consider, as a second example, a steel mill that uses electricity. When the planner looks at the economic and social profitability of the steel mill, the price that the steel company will actually pay the electricity authority may not reflect the real economic cost of producing electricity. It is this real economic cost that should be used when computing the economic profitability of the steel project. It is not always easy, however, to determine the correct "shadow" or "economic" prices that should be used in project evaluation and investment planning. Shadow prices may differ from prices observed in the market because of non-competitive behavior, externalities and distortions introduced by government policy. Tariffs, subsidies and price controls introduce distortions into the pricing system that can lead to substantial differences between market prices (what consumers and producers actually pay) and shadow or economic prices that reflect the true costs and benefits to the economy of - 48 - a particular commodity or service. The problem is further complicated when an economy has to undergo rapid structural change of the type discussed in Chapter 1. For example, an economy that tries to rapidly expand exports should choose a different set of projects than an economy where export expansion has no particular priority. Similarly, the shadow prices appropriate to a "low investment" economy presumably are different from those needed in a "high investment" economy. What procedures could Egypt follow to select the most desirable projects? ]:n particular, how can Egypt encourage a high investment rate and a shift of resources into the efficient production of exports and import substitutes? In this and the following section we shall discuss some of the key "economy-wide"' and "dynamic" issues that affect investment planning procedures. In Section 2.3, we shall turn to a more micro-economic approach and estimate shadow prices for a large set of commodities and services. Whenever it was possible, we have drawn on the optimizing model developed in Chapter 1. But the approach taken here is much broader. In presenting the shadow price estimates and discussing the issues involved in this estimation, this chapter draws on all kinds of available macroeconomic and microeconomic information and tries to give a fairly comprehensive overview of the relationship between economic (shadow) and market prices in the Egyptian economy. The Social Discount Rate and the Unit of Account A typical investment project costs society real resources when it is undertaken and generates net benefits in the future. The rmost central question facing the investment planner is, therefore, how to value and compare costs and benefits that accrue at different points in time,, The problem was already discussed in Chapter 1 and we stressed the important role of value judgements. How much a society values the future and the well-being of future generations is a fundamental political judgement. Economic analysis can help clarify the implications of different political decisions. It cannot, however, make these decisions. Consider first the consumption rate of interest. As explained in Chapter 1, it is given by the following formula: 1/ CRI = TP + (g x ELS) The Consumption The Rate of The Rate of The Consumption Rate of Interest = Pure Time + Growth of Per x Elasticity of Preference Capita Consumption M!arginal Utility The parameters TP and ELS refLect pure value judgements. If TP is 4.5 percent, society values consumption 2 years from now at 1/(1 + 0.045)2 91.5 percent of consumption today. If ELS is 0.5, a doubling of per capita consumption (100 percent increase) wiliL lead to a 50 percent increase in social welfare. Assuming TP to be 4.5 percent, g to be 3 percent and ELS to be 0.5 percent, we would get CRI = 6 percent. 1/ This is the "continuous time" formula. In a discrete time treatment the exact formula is 1 + CRIt = (l+TPt)(Ct+l)ELS ct - 49 - In a world of optimal investment where there are no technical or institutional bottlenecks restraining the investment effort, any project yielding a positive return when future costs and benefits are discounted at a 6 percent social discount rate should be undertaken. Suppose, for example, that: in FY83 there were 1600 projects under consideration at the Ministry of Plarning, amounting to a total investment of LE 9 billion. Suppose that calculating their net present values with a 6 percent discount rate led to the result that 1200 projects amounting to LE 7 billion of investment in FY83 had positive returns (positive net present values). It would follow from this calculation that these 1200 projects should be included in the investment plan and that total investment should be LE 7 billion. When such a calculation is made, most planners will find, however, that their total investment budget is not large enough for all these projects to be included in the plan. Instead of LE 7 billion, total savings available might be only LE 5 billion. Some projects will, therefore, have to be excluded from the plan. What this example suggests is that in most economies the marginal return to investment is in fact higher, sometimes substantially higher, than the consumption rate of interest. If enough savings could be mobilized to finance the "additional" 400 projects, the return that this would generate in the future would be more than enough to compensate for the additional sacrifice that has to be made today to mobilize these resources. For various reasons, the additional savings cannot be mobilized and/or specific bottlenecks arise that impose "absorptive capacity" limits on the amount of investment that can actually be implemented. As a result, total investment remains below what it should optimally be. In Egypt, the constraint on total investment is both an institutional savings constraint and an absorptive capacity constraint. Private savings are constrained by weak capital markets and risks associated with past shifts in the policy environment. Public savings are constrained by the budget process and political obstacles. But even when savings are mobilized there are absorptive capacity constraints due to skilled labor shortages, management and institutional bottlenecks and specific weaknesses in basic infrastructure including transport. An important implication of such situations for project evaluation and investment planning is that projects that generate savings or that help overcome the absorptive capacity constraint are socially more valuable than projects generating income that is consumed. Consider, for example, two projects that generate exactly the same stream of income (or value-added). The kind of income generated by project A will largely be saved, while the kind of income generated by project B will mostly be consumed. In an economy where the marginal productivity of investment is close to the consumption rate of interest, the two projects would be equally worthwhile. But in an economy where the marginal productivity of investment is substantially higher than the consumption rate of interest, project A should be chosen over project B, because project A will help the economy overcome its savings constraint. There is, therefore, a need for systematic investment planning procedures that ensure the selection of savings generating projects, or projects that specifically help overcome the economy-wide absorptive capacity constraint. - 50 - When LE 100 saved is no longer equivalent, from the planner's viewpoint, to LE 100 consumed, it becomes important to select either consumption or savings as the basic unit of account for investment planning. It does not really matter which unit of account is selected, but investment planning procedures must be consistent once the choice is made. Suppose, for example, that income consumed is the unit of account. Then there should be a premium on income saved. Conversely, if savings are the basic unit of account, consumption should be valued at less than parity t:o take into account that it is less valuable than savings. How much more valuable savings is when compared to consumption depends on how large a gap there iS between the marginal productivity of investment and the consumption rate of interest. In an economy where there are investment projects yielding 20 percent returns that cannot be undertaken for lack of investment funds, it is clear that savings should be valued at a high premnium over consumption. On the other hand, if most projects that are under consideration for inclusion in the plan yield 7 or 8 percent and the consumption rate of interest is 6 percent, the savings constraint is not really binding and the planner need not worry much about valuing savings generating projects at a premium. A second important question that arises in "savings or investment constrained" economies relates to the permanent or transitory nature of the savings constraint. Suppose, for example, that it is expected that the savings constraint will gradually disappear over a five year period. This implies that the relative value of savings vis-a-vis consumption will gradually decline during that period. If income available for investment is the unit of account, then savings that become available early in the planning period are more valuable than savings which become available later, for three reasons: (i) Because there is time preference (ii) Because there is diminishing marginal utility to increases of per capita consumption (iii) Because the economy is expected to be less savings constrained in the future than it is today. Points (i) and (ii) above are the two factors which, together with a projected rate of growth of consumption, determine the value of the consumption rate of interest (CRI). But if savings rather than consumption are the unit of account and if the relative social value of savings compared to consumption is expected to change over time, it is necessary to define a social discount rate that takes into account factor (iii) above. Economists have called this discount rate applicabLe to a savings denominated project evaluation procedure the accounting rate of interest, ARI. It must satisfy the following relationship: PC = -PCt ARt = Rt PCt - 51 - where PCt is the relative value of consumption in terms of savings. If PCt+l = PCt, there is no change in the relative value of income consumed compared to income saved and we would have the ARI equal to the CRI. But if the gap between the marginal productivity of investment and the consumption rate of interest gradually declines, then PCt+l is greater than PCt because the premium attached to savings becomes relatively smaller over time (the relative value of consumption increases). For example, if the growth rate of PCt is 3 percent per annum and the CRI is 6 percent, the ARI equals 6 + 3 = 9 percent. The return on a project for which all benefits and costs have been expressed in terms of "savings available for investment" should be reduced to a present value calculated by discounting net future benefits by the accounting rate of interest, which in this case would be 9 percent. The value of PCt as well as its rate of change over time is important for project evaluation and investment planning. While this is generally accepted by economists, it is rarely taken into account formally in applied project analysis because it is difficult to estimate the level and dynamic time path of PCt. Moreover, projects produce goods and services, not "savings" or "consumption" and there is often no immediate link between the kinds of goods and services produced by a project and the "savings" stream it generates. One way of dealing with the problem is to look at the income stream generated by a project. Using savings as the unit of account, total benefits derived from the project can then be decomposed into income that will be saved and income that will be consumed. The latter, consumed portion of income, is valuled at a discount, as long as we believe the economy to be savings constrained. Moreover, if the magnitude of that discount diminishes over time, the social discount rate in terms of investment as the unit of account will fall over time, reflecting the gradual relaxation of the savings constraint. While this procedure seems clear enough, it still leaves the planner with the problem of projecting what part of income will be saved and what part will be consumed. The most commonly made assumption is that wages generate much more consumption than profits. This implies that the "social" cost of labor should include the "extra" consumption that is due to the employment generated by the project. We shall come back to this below, when discussing the shadow wage rate. It is sufficient here to note that it is usually the "shadow" wage rate that will be the key variable allowing the planner to put a premium on savings. Assuming for the moment that it is possible to encourage savings oriented projects by using a higher shadow wage, there still remains the problem of comparing savings "today" to savings in the future i.e. of choosing values for the accounting rate of interest. The growth model developed in Chapter 1 can throw some light on these issues. Table 2.1 below describes the ARI's, the CRI's and the price of consumption in terms of saving, PC, implicit in various runs of the model. -52 - Table 2.1 Social Discount Rates and the Consumption Discount: Results from the Optimizing Model Base Case with Base Case with Base Case with Fixed Investment Optimal Investment Optimal Investment Real Investment Projects Relaxing Projects Which Do Growth at Future Absorbtive Not Affect Future at 5.5 Percent Capacity Constraint Absorptive Capacity ARI CRI PC ARI CRI PC ARI CRI PC 1982-1985 6.5 6.7 0.70 17.9 5.9 0.62 9.5 5.9 0.70 1986-1991 6.5 5.5 0.76 7.9 6.3 0.91 7.2 6.3 0.91 1991-1995 6.5 5.0 0.83 5.6 5.7 1.00 5.6 5.7 1.00 1996-2001 5.9 4.9 0.85 4.9 4.9 1.00 4.9 4.9 1.00 2002-2011 5.7 4.9 0.90 5.0 5.0 1.00 5.0 5.0 1.00 In almost all cases the consumption rate of interest, CRI, declines over time. The decline is more immediate in the exogenous investment case than it is in the endogenous investment runs where the CRI starts declining only after 1990. A declining trend is also present in the ARI and it is particularly strong with endogenous investment. The ARI tends to be significantly above the CRI with a particularly large difference in the 1982-85 period for the endogenous investment with absorptive capacity use. The savings premium or consumption discount is highest in the second column because savings and investment there are not only valuable because they allow more capital accumulation "today" but also because investment "today" relaxes the absorptive capacity constraint "tomorrow". Several factors are reflected in the time paths of these social discount rates: (i) The rate of growth of per capita consumption is high in the 1980s but lower thereafter, whlich tends to reduce both the ARI and the CRI. (ii) The relative value of "savings" compared to consumption is higher at the beginning of the planning period thatn it is at the end. This is so for two reasons: investment is particularly desirable when there are large oil and gas revenues and when it can help relax the absorptive capacity constraint. Bcth factors are present in the early 1980s in Egypt, leading to a high value for the ARI. - 53 - When using the numbers generated by the aggregate model to evaluate investment projects one must be careful, however, in ascertaining the way in which a particular project is likely to tighten or relax the savings/ investment constraint now and in the future. All investment does not contribute to relaxing the absorptive capacity constraint so that the high value of the ARI in the endogenous investment with absorptive capacity case exaggerates the magnitude of the savings premium and therefore also its rate of decline. Investments in human capital, infrastructure or activities that lead to a lot of learning by doing, are likely to deserve a much higher premium than investment in candy factories or soft drinks. It is impossible to capture those factors in a macromodel and economists tend to ignore them because they are too difficult to quantify. And yet most policymakers in developing countries are aware of the problem and "prefer" a power plant, or a new highway to a candy factory even though the candy factory appears to be a project with higher economic return. In many cases the policymakers might be quite right because the apparently lower returns of "bottleneck breaking" investments have not been adequately calculated. On the other hand it is clear that one can also overdo it and there are many cases of huge investments that are supposed to have all kinds of indirect or unquantified benefits which in fact amount to a disastrous waste of scarce investment resources. Given the various underlying considerations discussed above and in Chapter 1 it appears reasonable to use the following values for social discount rates and the price of consumption in Egypt: Table 2.2 Recommended Values for Social Discount Rates and the Price of Consumption in Terms of Saving ARI CRI PC 1982-1985 9.0 6.5 0.67 1985-1990 7.5 6.0 0.75 After 1990 5.5 5.0 0.90 Note that as long as "foreign exchange available for investment" is the unit of account, it is the ARI that should be used to discount future costs and benefits of a project. It is also worth stressing that the discount factor applicable to a particular period is the product of the discount factors preceding it. For example, the discount factor for 1992 is: SDF 1 1 5 1 2 =043 1992 = (1.090) (1.075) 01.0553 which implies an annual average ARI of 7.6 percent over the 1982-1992 period. - 54 - The Economic Price of Labor The appropriate pricing of labor is another important issue that arises in investment planning and project evaluation procedures. Labor is at the "base" of the whole productive system: it is the most fundamental primary input and it has been argued that one can usefully view all economic costs as ultimately decomposable into labor and time. The price of time is the price of "waiting" and we have seen above how it is intimately linked to the price of capital in terms of consumption. "Time" and "capital" can usefully be treated in an aggregate way because new investment is essentially fungible. It is very difficult, however, to talk about labor as a single factor. Much depends on skill levels and types of labor and a more disaggregated approach is required. The crucial question for the investment planner is to what extent wage costs that a project will incur adequately reflect the true economic cost of labor to the Egyptian economy. The most immediate and obviouts cost of hiring an additional worker for a particular project is the amount of output the same worker would have produced had he or she not been hired for the project in question. If labor markets were competitive and functioned well, marginal productivities would be close across sectors and the wage of the worker could be taken to measure the output he/she would have produced without the project under consideration. Three basic issues arise in this context: (i) In economies with significant unemployment, the employment of an additional worker may not imply any loss of output if that worker was previously unemployed. In that case, the wage that a new employer has to pay is only a financial not an economic cost. Making the same point in a less extreme form it is possible to argue that by hiring a worker into a modern, high productivity firm, the economy will be losing less than the wage the worker will receive as long as his productivity in his old occupation was below his new wage. This is an argument for using a lower shadow wage and more labor intensive techniques than tlhose that would be chosen at market prices. (ii) While the Egyptian economy may achieve a net gain in output by transferring workers from low productivity to higher productivity activities, this may also lead to an increase in consumption compared to the "no project" situation. If the economy is savings constrained (there is a consumption discount and PC is less than one), this is an economic cost in addition to the output foregone and contrary to (i) above, constitutes an argument for a higher shadow wage using less labor intensive techniques than those that would be chosen at market prices. (iii) Finally, the planner may care about the distribution of income in itself (irrespective of its influence on the savings/investment balance) or employment as such may be considered a politically desirable target. Special adjustments must then be made to reflect these objectives. In general, the adoption of such objectives will lead to lower shadow wages and more labor intensive production techniques. - 55 - All three considerations are relevant to the Egyptian economy in the 1980's. The picture that emerges from analysing the labor market is very complex and often full of contradictory evidence. 1/ Egypt traditionally was considered to be a typical example of a labor surplus economy. Recently however, largely due to massive outmigration, many sectors of the economy appear to suffer from serious labor shortages. And yet there still is considerable unemployment and underemployment, and the population continues to grow at almost 3 percent per annum, suggesting that the relative tightness of the labor market is likely to be a short-lived, transitory phenomenon. Tables 2.3 and 2.4 present the available information on the distribution of employment by sector. Over the past 30 years the sectoral structure of employment in Egypt has changed significantly. Agriculture's share in total employment declined from 58.4 percent in 1947 to 43.8 percent in 1976. Prior to 1970, although agriculture's share declined, the absolute size of the agricultural labor force continued to grow slowly. There is now, however, evidence to suggest that the agricultural labor force has begun to decline in absolute size. Indeed labor force surveys show a rapid decline in male agricultural employment between 1972 and 1979. It is uncertain, however, to what extent this represents a permanent reduction in the agricultural labor force, since little is known about the permanence of the migration or its effect on the participation of women and children in the agricultural labor market. The ILO has suggested that there is apparent tightening of the rural labor market and some evidence of an emerging scarcity of agricultural labor. In the non-agricultural sectors of the economy government and construction stand out as leading sectors in terms of employment growth, with manufacturing in third place. The leading role of government as an employer in Egypt has important implications for the structure and functioning of labor markets in the formal sector of the economy. The most important employment generating government policies have been the expansion of and overstaffing in the public sector, both in public administration and the public sector enterprises. From 1966 to 1973 government employment - excluding the armed forces - grew at 6.7 percent per annum. From 1973 to 1978 the rate of increase was 7.0 percent. In the public industrial enterprises managers were compelled to hire labor in excess of their requirements and prohibited from making labor, once engaged, redundant. In addition, the public enterprises were at various times compelled to hire all university graduates and returned conscripts from the armed forces. The result of these employment policies has been to leave the public sector overstaffed with unskilled workers of two very different types, largely illiterate former conscripts and highly educated graduates with few specific industrial skills. Recent innovations have released public enterprises from the requirement to guarantee employment to conscripts and have increased the scope for managerial discretion in hiring and firing of labor, but there remains a substantial hangover of redundancies from the time of the employment drive. In some enterprises, the size of the labor force is sufficiently large to introduce the possibility that the marginal product of 1/ The ILO has recently completed an excellent report focusing on labor market and employment issues in collaboration with a large team of Egyptian economists. See "Employment Opportunities and Equity in Egypt", Bent Hansen and Samir Radwan, coordinating authors, ILO (1982). - 56 - Table 2.3 Labor Force by Industry, 1960-76 Annual Number of Persons Rates of Shares of Shares of Increase Industry thousands Growth, total, % 1960-76 Compound Number, 1960 1976 X 1960 1976 Thousands 1. Agriculture, fishery, etc. 4,406 4,881 0.6 65.3 43.8 475 14.4 2. Mining, quarries 21 34 3.0 0.3 0.3 13 0.4 J. Manufacturing 647 1,369 4.7 8.3 12.3 722 21.9 4. Electricity, gas, etc. 17 62 8.3 0.2 0.6 45 1.4 5. Canstruction 159 425 6.3 2.0 3.8 266 8.1 6. Trade, etc. 691 861 1.4 8.8 7.7 170 5.2 7. Tranisportation, communication, etc. 260 482 3.9 3.3 4.3 222 6.7 8. Financing, ecc. 72 88 1.2 0.9 0.8 16 0.5 9. Services 1,333 1,868 2.1 17.0 16.8 535 16.2 1U. Not adequately described I/ 225 1,060 10.1 2.9 9.5 835 25.3 Total 7/ 7,832.0 11,131.6 2.2 100.0 100.0 3,299.6 100.0 of which (288.9)3/ 1,779.0 (12.9)5/ (3.7)3/ 16.0 (1,490.1)5/ (45.2) Government 2/ (932.9)4/ (6.3)6/ (846.1)6/ (25.6) 1/ Including unemployed. 2/ Not including military conscripts and public enterprise employment both of which are reported in industries 1 to 10. 3/ 1961; comparability with the 1976 figures is uncertain. 4/ 1965/66; comparable. 5/ 1961-76. 6/ 19b5/66-75. 7/ Includinig military conscripts. Source: ILO Report (1982) - 57 - Table 2.4 Labor Force in Egypt by Industry, 1971-79 (Ages 12 to 65) Annual Number of Persons Rates of Shares of Shares of Increase Shares of Increase Industry thousands Growth, total, Z 1960-76 in Employment Compound Number, Outside Agriculture 1971 1979 Z 1971 1979 Thousands X X 1. Agriculture, fishery, etc. 4,469 4,002 -1.4 54.2 41.8 -467.5 -35.6 - 2. Mining,quarries 7 23 15.5 0.1 0.3 15.6 1.9 0.9 3. kianufacturing 1,030 1,532 5.0 12.5 16.0 501.7 38.2 28.2 4. Electricity, - gas 26 66 12.4 0.3 0.7 39.9 3.0 2.2 5. Construction 193 448 11.1 2.3 4.7 255.3 19.4 14.3 6. Trade, etc. 797 918 1.8 9.7 9.6 121.0 9.2 6.8 7. Transportation, communications 323 488 5.3 3.9 5.1 165.3 12.6 9.3 8. Finance, etc. 83 117 4.3 1.0 1.2 33.6 2.6 1.9 9. Services, etc. 1,269 1,820 4.b 15.4 19.0 551.7 42.0 31.0 10. Unspecified 54 150 13.6 0.7 1.6 95.2 7.3 5.4 Total employed 1/ 8,252 9,565 1.8 100.0 100.0 1,312.8 100.0 - of which in Government 1/ 2/ 1,270 2,065 3/ 7.2 15.4 21.9 3/ 794.8 3/ 60.5 3/ 47.1 3/ Total labor force i/ 8,406 10,023 2.2 100.0 100.0 1,617.9 100.0 - of which unemployed 153 400 12.7 1.8 4.6 307.1 19.0 - 1/ Not including military conscripts. 2/ Not including public enterprises. 3/ 1978 or 197i-78. Source: ILO Report (1982) 58 - labor is in fact negative, since workcers require supervision and administration without contributing to output. The extent of overstaffing in the public sector and government is not easy to quantify, but the ILO has estimated that between 1960 and 1976 perhaps as many as 750,000 jobs were created in excess of employment requirements. 1/ The market for skilled labor in contrast has been characterized by growing shortages of workers particularly in construction trades and some skilled industrial occupations. In recent years, Eygpt has experienced a tremendous increase in the scale of external migration of its labor force. The number of Egyptians working abroad in 1965 was estimated to be approximately 100,000, while in 1980 the figure had reached at least one million, perhaps more. Out-migration has reduced the rate of growth of the labor force from approximately 3 percent per year to 2 percent, and has led to tightening in at least some segments of the labor market. Thus, the picture of employment trends which emerges is one of increasing scarcity of labor in parts of the agricultural sector, largely as a result of pull factors from external migration, government employment and military conscription. Surplus labor appears to be concentrated in the public sector, certain types of small-scale agriculture and perhaps in the urban informal sector. Among skilled workers there is increasing tightening of the labor market. The construction industry is one area of acute labor shortage, particularly in skilled trades. Recent wage trends appear to reflect this tightening of the labor market. Wage formation processes in Egypt range from the salary structure in the government and public enterprises with their rigid pay scales and grades which exhibit little if any response to market forces, to the market for hired agricultural labor with its apparently highly flexible wages which adjust to clear markets in a reasonably efficient fashion. In between are the private industrial enterprises which are subject to minimum wage legislation and unionization and the small scale and casual sectors, about: which very little is known. The available information on money wages by sector is summarized in Table 2.5. The data are subject to substantial error but they are indicative of broad trends. Between 1966 and 1972 both agricultural wages and government wages were largely static and therefore declining in real terms. After 1972 agricultural wages experienced rapid increases while the government wage levels increased at more moderate nom:inal rates. The tightening of the labor market in construction is not readily apparent from Table 2.5, but an alternative wage series reported in Table 2.6 reveals the extent of wage increases in the construction sector. 1/ Chapter 9 in Part III of this study presents an analysis of the overstaffing issue in public industry based on firm level data. The microeconomic data confirm the existence of large amounts of excess labor in public industry. Table 2.5 Money Wages in Agriculture, Establishments and Public Administration, 1966-76 (Indexes, 1966 = 100) Agriculture Goverrnment Av. Daily Wages Establishments 10 Employees, Average Weekly Administration Men Women & Total Manufacturing Construction Annual Salary Children Private Public Private Public Private Public Per Employee (1) (2) (3) (4) (5) (6) (7) (8) (9) 1966 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 W 1967 iO0.0 100.0 103.5 100.0 103.2 98.8 91.5 106.2 97.0 1968 96.0 95.8 110.3 101.7 109.6 103.5 107.4 117.5 94.2 1969 99.1 102.5 110.0 113.3 109.3 119.2 107.6 118.3 98.6 Y970 99.9 105.0 113.5 111.2 113.6 118.2 108.4 115.5 101.9 1971 99.9 101.7 122.4 112.9 128.2 116.6 102.3 116.8 \100.6 i972 103.4 105.8 145.3 118.0 118.6 124.8 105.7 117.5 103.5 1973 111.6 114.7 137.7 125.8 139.6 134.5 (89.0) 130.4 110.2 1974 138.9 136.7 107.8 1975 182.2 171.7 176.2 144.9 187.9 149.2 125.2 162.9 115.0 1976 239.2 230.2 212.1 164.0 225.0 174.7 156.0 188.4 129.4 1977 298.2 296.1 147.8 1978 345.4 343.3 159.6 1979 411.7 171.8 1966 25 PT 12 PT 340 PT 466 PT 280 PT 432 PT 527 PT 388 PT LE 333.77 1975 46.5 PT 21 PT 599 PT 675 PT 526 PT 631 PT 660 PT 632 PT LE 383.76 Sources: IL0 Report (1982) Table 2.6 Average Wages in Construction and Agriculture Construction -Occupation--------------------- Index of Year Establishments Excavation Concrete Concrete Mason Plumber labor Agriculture, 10 Employees Carrier Carpenter costs Men 1970 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1971 100.7 - - - - - - 100.2 1972 101.6 - - - - - - 110.6 1973 111.7 200.0 160.0 138.9 i66.7 187.5 153.0 137.6 1974 138.6 - - - - - - - 165.8 1975 139.5 333.3 350.0 222.2 233.3 500.0 301.0 190.1 1976 162.5 - - - - - - 226.2 1Y77 - 500.0 550.0 361.0 380.0 625.0 473.0 263.9 1978 - - - - - - 290.2 1979 - - - - - 334.5 Daily Wage, 1970 0.75 0.30 0.50 0.90 1.50 0.80 - 0.26 1975 LE L;05 1.0 1.75 2.00 3.50 -.u - 0.465 Soures: .L Report (1982)...._ . .. . 0 'Sources: ILO Report'( 1982) - 61 - Wage differentials in Egypt are large as is the case in most developing economies. Table 2.7 shows wage rates on a daily basis for selected major sectors in 1966 and 1976. There has been some narrowing of the differential between agriculture and public employment in both manufacturing and government, and a major widening of the differential between agriculture and construction, reflecting the influence of emigration on the wage structure. The average differential between agricultural employment and manufacturing remains large, approximately 100 percent. We lack reliable comparisons for unskilled labor, however, a problem which complicates the estimate of shadow wages. Table 2.7 Sectoral Wages, 1966 and 1975 Average Daily Wages 1966 1975 PT Index PT Index Agriculture, men 25 100 46.5 100 Construction, excavators, men 25 100 100.0 215 Manufacturing industry Public 70.5 282 105.1 226 Private 46.5 186 85.9 185 Government 103.3 413 127.9 275 Source: ILO(1982). It is assumed that employees in the manufacturing industry work 6 days per week and government employees 300 days per year. It is apparent from this brief overview of developments in the Egyptian labor market, that wages actually paid in a particular project may often not be a reliable guide to the economic value of output foregone elsewhere in the economy. Whenever the labor for a project is drawn from sectors characterized by unemployment or underemployment, or whenever the worker shifts from a low productivity job to a high productivity activity, there is an argument for a shadow wage lower than the prevailing market wage. This may not always be the case, however. It is quite possible that for skilled categories of labor there are situations where the wage offered in a new project is below the true social productivity of a worker in his old occupation. Consider for example, a skilled and hard working administrator working for the Ministry of Planning or Industry or an experienced engineer whose skills are crucial to the efficiency of an "old" textile plant in the public sector, who is offered a job in a new private sector firm. The new wage may be three times as high as the old salary in the public sector. But the contribution he makes in his old job may be worth more to the economy than the new wage reflects. - 62 - The situation in Egypt is further complicated by the existence of large outmigration and the role of Egyptians in the economies of the rich oil surplus countries. If there were no restrictions to migration and no limit to the Gulf countries' absorptive capacity, it could be argued that the opportunity cost of a worker or technician is given by the remittances he would send to Egypt if he migrated. Even though remittances are only a fraction of a migrants total income, given the huge wage differentials existing between Egypt and the host countries, this kind of reasoning would lead to a very high shadow price for Egyptian labor, perhaps two or three times as high as the market wage. In fact, while potential remittance income should be taken into account when computing the shadow price of labor, there are absorptive capacity constraints inl the host countries and there are also certain costs to migration, including the uncertainties associated with living in a foreign country, that must be included in the calculation. In general, it is possible to define the "efficiency" wage as a weighted average of the economic costs implicit in hiring Labor, where the appropriate weights are the probabilities that the labor hired by a new project is drawn from certain "alternative" occupations. Consider for example, a new modern "joint-venture" project in the basic metals sector. Let us assume that portions of the labor force would have migrated if not employed by the project, some would have been openly unemployed, sorae drawn from agriculture, some from more traditional industrial activiti'es, some from similar industrial activities and some from government services. The analysis should not stop here, however, because the vacancies created by the project in the sectors it draws labor from will, to some extent at least, lead to further adjustments and labor movement. For example, the labor hired from small-scale firms is likely to be replaced in these small-scale firms by labor coming from agriculture or labor previously unemployed. In this case, withdrawing a worker from the "informal" small-scale sector is equivalent in economic impact to directly drawing his replacement from agriculture or unemployment into the formal sector. What matters is not the direct origin of the labor hired in a new project but the ultimate effect of such hiring on the labor market. Viewed in this way, it seeems reasonable to assume that additional formal employment in modern projects will, directly or indirectly, come from: (i) unemployed labor; (ii) agricultura:L labor; (iii) labor that would otherwise have migrated, and (iv) underemployed public sector labor. An appropriate formula for computing output foregone (the efficiency wage) is therefore: (Z 2oLabrgl Productivity (Economic ) (Yarginal Productivity ) ( ) + p(Marginal Agriculture) 3(Value of + P4(of UJnderemployed Labor) (Remittances) (in the Public Sector where the Pi's are the relative weights assigned to these ultimate sources of labor supply and EW is the efficiency wage. The efficiency wage computed in this way does not, however, reflect the full economic cost of hiring labor. In a savings constrained economy there are additional costs if the employment generated by a project leads to increased consumption at the expense of savings. On the other hand, the - 63 - investment planner may consider employment in itself to be a valuable objective for social and political reasons or because it will help achieve a more desirable distribution of real income. Finally, it should be stressed that the economic price of labor is going to be very different depending on the particular skill category that is being considered. Each category should ideally be treated separately to arrive at the appropriate shadow prices. In practice, this is usually not possible. It is useful, therefore, to have "average'" estimates that can be used to form some broad categories, although more specific estimates should be used whenever the available information permits it. Tables 2.8 and 2.9 below present estimates of accounting ratios for wages of unskilled and skilled labor (ratios of shadow wages to market wages) for some broad categories of labor based on an analysis that integrates and quantifies the various considerations discussed above. The Tables include the "'probabilities" needed to weight the individual accounting ratios in order to arrive at an overall accounting ratio for a particular category of labor. We estimate, for example, that 75 percent usuable labor hired for urban public sector projects "ultimately" (after labor market adjustments) comes out of the rural labor pose, whereas 10 percent and 15 percent respectively is drawn from unemployed labor and labor that is under-employed elsewhere in the public sector. The estimates include "efficiency wages" and "extended efficiency wages", where the latter include the "consumption cost" of extra employment whereas the former only measure output foregone elsewhere in the economy. We do not present estimates that attempt to include the "pure" distribution or political benefits of increasing employment. The calculations are based on a small model of the Egyptian labor market, some key assumptions about supply and demand elasticities in various sectors and a detailed analysis of labor productivity in agriculture that will be presented in Chapter 4 of this Report.l/ In the absence of more detailed project specific or skill specific information, it is possible to break down a project's total labor costs into the categories distinguished above and multiply the subtotals by the relevant accounting ratios to calculate the economic cost of labor. If one believes that the economy is and will remain savings constrained, it is the accounting ratios at extended efficiency prices that must be used. The difference between the efficiency price and the extended efficiency price based accounting ratio is largest for urban unskilled labor because it is when agricultural or unemployed labor is drawn into formal urban employment that the largest increase in consumption is likely to occur. The estimates above reflect calculations done with 1979-1981 data. As we saw in Chapter 1, Egypt is likely to go through major structural adjustments and these will affect shadow wage calculations. While we did not attempt to build a full dynamic model of the labor market, the following considerations are relevant: 1/ See J. Page (1982) "Shadow Prices for Trade Strategy and Investment Planning in Egypt" for a detailed overview of what alternative assumptions may be plausible and a more technical exposition of the issues involved. - 64 - Table 2.8 Accounting Ratios for Wages of Unskilled Labor (1979-1981) _ Unemployed including Public Sector Rural Labor Employed in Household Underenployed Overall Extended Extended Extended Extended Efficiency Efficiency Efficiency Efficiency Efficiency Efficiency Efficie"cy Efficiency C. 75Z [j°-% U T15% Urban Public sector U.54 0.84 0.15 0.65 0.00 0.00 0.42 0.70 Projects 0.7U% ~ox 0 Urban Private Sector 0.72 0.95 0.25 0.60 n.a. n.a. 0.58 0.85 Przojects ~~~~~ ~ ~ ~ %0% Projects in Apricuiture 1.40 1.40 0.00 1 0.24 n.a. n.a. 1.33 1.35 Table 2.9 Accounting Ratios for Wages of Skilled Labor (1979-1981) Kif.rant Labor Other Domestic Employment J Overall Extended | Exter.ded | Extended Efticiency Efficiency Efficiency Efficicncy Efficiency Efficiency Wa;es Wages )dges Wages Wages Wages -o7Z - 33% UrDan Projects in P2utic 1.10 1.10 0.97 0.97 1.06 1.06 Sect or i67X % 7 33% i Urban Projects In irivate 1.10 1.10 0.73 0.88 0.98 1 03 Se_ tor - - Projects in Agriculture 1.10 1.10 | 1.0 1.40 1.25 1.25 - 65 - (i) The importance of migration is likely to diminish relative to the size of the labor force. In the 1970's, one out of three new entrants into the labor force appears to have migrated. In the 1980's and 1990's, this ratio is more likely to be between one in six and one in eight. (ii) With the kind of large investment effort directed at export expansion and import substitution recommended in Chapter 1, Egyptian goods will have to become more competitive both in the domestic and in foreign markets. This implies that domestic factor prices, including the price of labor will be constrained by the need to expand exports and effectively compete with imports. (iii) The savings constraint is likely to remain binding throughout the 1980's, but gradually diminish in intensity. If it can be overcome not only through project selection procedures but also through appropriate macroeconomic policies, the difference between extended efficiency prices and efficiency prices will narrow. (iv) Rural-urban wage differentials are likely to diminish and this may lead to an increase in the accounting ratio of urban unskilled labor. These considerations should be taken into account when evaluating projects of a long-term nature. The Real Exchange Rate There are essentially two sets of reasons why there is an exchange rate "issue" that affects project evaluation and why project analysts should not always use the exchange rate that one can actually observe during foreign exchange transactions. One set of reasons relates to the tariffs, subsidies, export taxes, quantity restrictions and other policy interventions that generate differences between world prices and domestic prices and also affect the relative price of tradable goods and services compared to non-tradables. These distortions and their effect on investment planning will be discussed in section 2.3 below. The second set of reasons necessitating a closer look at the "exchange rate" are more macroeconomic in nature and relate to prospective structural changes in the economy. In Egypt's case, the structural change referred to is the gradual transformation of the economy from a situation where "exogenous resources" finance almost 50 percent of consumption and investment to an economy where the share of oil, remittances, foreign aid and Suez Canal earnings decline to less than a third of total absorption. This transformation requires export growth to average about 10 percent per annum complemented by continuous progress in import substitution. It necessitates a gradual shift of Egypt's entire production structure and resource allocation towards export-oriented and import substituting agricultural and industrial activities. The question then is: can project selection procedures facilitate this process? After all, it is only through the selection of enough export-oriented and import-substituting projects that the required structural transformation can take place. - 66 - The first point that needs to be made in this context is that the structural transformation that Egypt must achieve over the next few decades will necessitate a real devaluation, over and above any nominal exchange rate adjustments required to compensate for an excess of domestic over world inflation. Suppose, for example, that inflation in Egypt averages 15 percent per annum over the next 10 years, while world inflation averages 6 percent. The average annual adjustment in the nominal exchange rate that would keep the "real" exchange rate constant would be 8.5 percent. But tie expansion of the tradable sector and the increase in Egypt's world market share described in Chapter 1 will require a change in the real exchange rate so that enough resources can be attracted into the production of tradables and so that sufficient export expansion and import substitution can be achieved. The magnitude of the real exchange rate change that is necessary depends essentially on the following factors: (i) The "ease" with which resources can be shifted into export expanding and import substituting activities. The easier it is to shift resources, the smaller will be the required change in the real exchange rate. (ii) The degree to which increasing import substitution will require higher domestic resource cost per unit of "dollar" saved. (iii) The degree to which increasing export volume will require higher domestic resource cost per unit of "dollar" earned, including higher transport and marketing costs, reducing the "net-back" to Egypt per unit of an exportable commodity. (iv) The degree to which Egypt has to lower its export prices to increase its market share. The macromodel developed in Chapter 1 tries to capture these elements by specifying different production functions in the tradable and non-tradable sectors, imperfect substitutability between imported goods and domestically produced substitutes and less than infinitely elastic export demand curves. As a result, there is a real decline in the value of domestic goods compared to imports in all the various runs that were explored. Table 2.10 below describes the relative price change for the base case with exogenous and endogenous investment. Table 2.10 The Real Exchange Rate Index Over Time (1982 = 1.00) Base Case with Base Case with Exogenous Investment Endogenouis Investment 1982-1985 1.00 0 98 1986-1991 0.98 0.92 1992-1995 0.96 0.87 1996-2001 0.91 0.84 2002-2011 0.87 0.83 - 67 - The real exchange rate index described in Table 2.10 is the price of a basket of Egyptian goods (tradables and non-tradables) in terms of imported goods. The basket is defined in terms of the weights that characterize the GDP deflator, so that movements of the exchange rate index indicate to what extent Egypt would have to adjust the exchange rate beyond the inflation differential given by a simple "purchasing power parity" rule. Note that the particular index chosen does not have compelling significance or virtues but it is the kind of index that is often used when trying to determine whether a nominal exchange rate adjustment is called for. .The optimal (endogenous) investment case leads to accelerated exchange rate adjustment because the structural transformation is more rapid and larger than in the exogenous investment case. The adjustment implicit in these figures may not appear very large but it must be remembered that these adjustments give an indication of what is required in addition to any inflation differential compensating adjustments that may have to be achieved. The pace of export expansion and import substitution that is necessary requires an increase in competitiveness, not just the prevention of a decline in competitiveness. This projected decline in the relative value of domestic goods compared to the value of imports also implies, of course, that the value of domestic factors of production in terms of imports declines compared to a constant real exchange rate scenario. Technical progress may still ensure increasing total factor productivity and increasing real wages. But the returns to both capital and labor will be affected negatively by the real exchange rate adjustment that is required for successful structural adjustment. The analysis presented above has obvious implications for macroeconomic managment and exchange rate policy. Its implications for project evaluation procedures are more indirect. When analyzing a particular project, the by now well accepted procedure is to decompose cost and benefits into tradable, non-tradable and primary input components. Tradables, whether actually imported, exported or domestically produced and used, are valued at their projected world price, adjusted for transport and marketing margins. Non-tradable inputs are often dealt with by valuing them at domestic prices. The correct procedure, however, is to decompose them into their tradable, non-tradable and primary factor content. By moving through several rounds of analysis in this fashion, it is usually possible to reduce the social cost of most commodities to their equivalent cost in terms of foreign exchange and primary inputs. While there remains the important problem of estimating the shadow prices of primary inputs, the exchange rate issue as such seldom need arise in the analysis of an individual project. What is important is that transport and marketing cost-adjusted world prices and primary factor prices are estimated adequately. For example, the "net-back" to Egypt from exporting a certain commodity to China may be significantly lower than the "net-back" from exporting the same commodity to Italy. If the macroeconomic situation five years from now warrants incurring the extra marketing and transport costs of exporting to China, or the increased domestic resource costs of further import substitution in electrical machinery, this will reflect the real exchange rate adjustment. But as long as the project analyst has correctly estimated the prices associated with a particular project including the - 68 - opportunity cost of capital and labor and succeeded in assigning world price derived weights to the output and input streams, there is nio need for the appearance of an "average" exchange rate of the type discussed in the context of macroeconomic management. Foreign Borrowing and Social Discounting An issue that is of considerable importance for investment planning and that is intimately related to the macroeconomic paramet:ers discussed above relates to foreign borrowing. It was noted in Chapter 1 that for various political and economic reasons it is probably not possible for Egypt to borrow or lend very large amounts in the international commercial money market. Nonetheless it may be possible for Egypt to supplement available investment resources by additional foreign borrowing in moderate amounts and it is therefore useful to ask under what conditions such lending would be desirable. Consider for example, the possibility of a ten year loan (1982-1992) at a 13 percent fixed nominal interest rate that Egypt could draw on. Let us also assume that international inflation (measured in the same currency or currency-basket as the foreign loan's denomination) is expected to average 7 percent over the same period. This implies that Egypt would be paying a 5.6 percent real interest rate for the loan. If all investment goods were viewed as consisting of imports (a large fraction of them are), it would be appropriate to compare 5.6 percent to the accounting rate of interest (ARI) applicable to the same period, which averages 7.6 percent (see page 71 above). However, to the extent that investment goods contain a non-tradable component, it is necessary to adjust the ARI to take into account any real price changes of the non-tradable in terms of imports. When there is a real devaluation, foreign exchange in terms of domestic non-tradables is more valuable in the future than it is today. In the base run with fixed investment this relative price changes by about 2.5 percent over the 1982-1992 period, while it changes by almost 9.0 percent in the base run with optimal investment. This translates into annual price change rates of 0.25 and 0.87 percent. Accepting 0.50 as a compromise and adjusting the ARI taking into account the share of domestic non-tradables in investment, one arrives at an average adjusted ARI of 7.3 percent to be compared with the 5.6 percent real interest cost of the loan. This would show that the returns that Egypt can expect from borrowing the money at 13 percent and investing it all at home are more than sufficient to compensate for the interest charge. Suppose on the contrary, that Egypt expects world inflation to average only 4 percent instead of the 7 percent assumed above, the real cost of funds would then become 8.5 percent which is higher than the 7.3 percent average adjusted ARI and Egypt should not borrow money on such terms. On the contrary, if Egypt could safely lend money at 13 percent and really believed world inflation would not average more than 4 percent, it would be beneficial to the economy to lend abroad. The crucial role played by the expected inflation rate in the example described above, explains why international capital market transactions are increasingly based on variable interest rates. With variable interest rates, it is reasonable to expect that nominal rates will fall and rise with - 69 - inflation and that real interest rates will be more stable. Since it is real interest rates that matter for economic policy, variable rates can in fact stabilize the system by reducing uncertainty about real rates. Whether interest rates are variable or fixed, it is the real interest rate (nominal rate - inflation rate) that should be compared to adjusted ARI values when considering additional foreign borrowing. Note that this should in principle be quite independent of the particular project to which the loan may formally be attached. What counts in determining the ARI is the marginal economic return to investment. An ARI of 7 or 8 percent is quite consistent with intra-marginal projects with much higher economic returns. If the economy-wide adjusted ARI is 7.3 percent, the fact that there is a 25 percent rate of return project does not justify borrowing at a 9 percent real interest rate for that project, unless the project would not otherwise be undertaken. On the other hand if it is possible to borrow below the ARI in real terms Egypt can increase economic welfare by doing so. 2.2 The Economic Price of Energy The social discount rate, the real exchange rate and shadow wages together constitute the standard set of macroeconomic parameters for investment planning. In Egypt's case, the economic price of energy, notably of petroleum products, natural gas and electricity, is close in importance to these macroeconomic parameters since energy is one of the key inputs in most activities and constitutes at present the country's most valuable natural resource. Petroleum Egypt is a "small" country on the world oil market. Export and import prices of petroleum products are exogenously given to the Egyptian economy and the shadow prices of crude oil and refined products are, therefore, the prices determined on the world market. The economic value of a barrel of oil to Egypt is whatever Egypt can earn by exporting tha barrel. It does not matter in principle how that export price is determined. If OPEC somehow succeeds in raising the world price of oil to $50 a barrel, then that is the economic price of Egypt's oil. On the other hand, if market forces and technological developments keep the price of oil around $30 a barrel, it is this lower price that measures the value of oil to the Egyptian economy. While it does not matter what forces determine the world price of oil, it is, of course, very important for Egyptian planners to estimate how real oil prices are likely to behave. If, for example, a war in the Gulf leads to shortages and a sudden increase in world oil prices that is expected to be temporary, it is the long-term price forecast that should enter project evaluation procedures, not temporary spot prices based on transitory events, How successful one can be in projecting crude and petroleum product prices remains, of course, an open question but, in principle, the situation is quite clear. The shadow price of petroleum and petroleum product prices are whatever one projects world prices to be, fob for exported products, cif for imported products. The difficulty here is not in calculating shadow prices that are different from observable market prices but in predicting what world market conditions are likely to be. - 70 - Natural Gas The problem of adequately shadow pricing natural gas is much more difficult than that of determining the economic value of petroleum products. Natural gas is not an easily tradable product. In fact, except in very large quantities, it is basically non-tradable. Natural gas is, however, a valuable input into the production of tradable commodities such as fertilizers, cement and steel. It is also a near perfeci: substitute for fuel oil in the generation of electricity. Within a certain range of available supply it is therefore possible to calculate the shadow price of natural gas as the net marginal value product of gas in the production of a tradable commodity. Consider, for example, the economic value of natural gas in the domestic production of fertilizer. For example, a 560,000 tons per year nitrogenous fertilizer (urea) plant would allow Egypt gross foreign exchange savings of $100 million, at 90% capacity use and at a cif import price of $300. The plant would use about 14.8 million Mcf of gas per year. The net economic benefits of the plant, however, assuming efficient operation and after taking into account all direct and indirect costs except the use of natural gas, would be about $100 million. One can conclude therefore that the economic value of gas in the production of fertilizers for import substitution is about $6.75 per Mcf of gas. 1/ FIGURE 2.1 THE MARGINAL PRODUCTIVITY OF GAS IN THE DOMESTIC ECONOMY 8 7 FERrILIZER £0 ~ _ 'a. CEMENT & STEEL POWER_____ QJ4 _ QUANTITY OF GAS AVAILABLE- OVER A PARTICULAR PERIOD l/ Taking annual averages can only give a rough approximation. The numbers given in the text are in fact derived from a discounted. cash flow analysis of the Taklha II fertilizer (amonium and urea) project. - 71 - By far the largest potential use of gas in the domestic Egyptian economy is as a substitute for fuel-oil to generate electricity. The substitution process is an easy one and many dual-fired power plants are already capable of using either gas or fuel-oil. At a fob fuel-oil price of $175, the "fuel-oil equivalent" shadow price of gas is about $4.20 per Mcf in 1982 dollars. At any given point in time one can, therefore, visualize a downward sloping marginal productivity of gas curve and an intersection point with available supply determining the shadow price or economic value of natural gas. Implicit in the way the marginal product curve is drawn on Figure 2.1 is a "no exports" assumption. Consider, however, an export oriented fertilizer project. The "net-back" to Egypt from using gas as an input into, for example, an export oriented urea plant will be lower than the "net-back" from the same plant designed for import substitution. The difference will largely consist of: (i) transport costs and, (ii) marketing costs. Transport costs are likely to range between 15 and 20 percent of the price of fertilizer. Marketing costs may add another 10 to 20 percent to the price differential. Taking mid-range values, the marginal productivity of natural gas in an export oriented fertilizer plant may be around $4.00 per Mcf in 1982 prices compared to the $6.75 per Mcf in import substitution. Marketing costs usually include a substantial compensation for risk by a foreign partner willing to assume the marketing and price risk. Often the foreign partner guarantees to market the product but asks for risk compensation indirectly, by insisting on a "low" price for the natural gas input. For example, if a foreign partner asks for a natural gas price of $3.00 per Mcf and if the marginal productivity of gas in the venture is $5.00 per Mcf with present price projections and excluding marketing costs, the foreign partner is in effect asking for ($2.00)x(quantity of gas used)x(partners share in equity) as compensation for marketing costs and price risk. Finally, there is the possibility of exporting gas directly in the form of LNG. The capital cost of producing LNG plants are very large and there are major economies of scale. An optimum scaled plant should be able to use about 200 billion cubic feet (0.2 Tcf) per year for not less than 15 years. The net-back on such a plant at present prices would be between $2.50 and $2.00 per MCF and this last value can be viewed as a floor below which estimates of the economic price of gas cannot fall. The analysis so far has remained in a very "static" framework. Unfortunately, the problem is complicated by its essentially dynamic nature. Both demand and supply curves can be expected to shift over time and the correct economic valuation of gas "today" should reflect these projected shifts. The value of gas "today" should be determined not only by its immediate usefulness but also, with proper discounting, by the usefulness it may have in the future. The intertemporal model developed in Chapter 1 provides an "imacroeconomic" estimate of the economic value of gas that is quite useful. Within the simplified and aggregate framework of the model, the following relationships must hold: - 72 - The Shadow The Shadow Marginal Price of Gas Price of Gas x Production (Extraction) "In the Ground" Costs The shadow price of gas in the ground is usually referred to as the depletion premium or resource rent and it measures the opportunity cost of using gas today rather than "saving" it for future use. In the optimizing model, it is possible to substitute gas for petroleum products or petroleum derived energy in the production of tradables and non-tradables. Specifically, gas can satisfy up to 60 percent of the total demand for hydrocarbons (50 percent at first rising to 60 percent). Beyond that point, the production of gas becomes demand constrained rather than supply constrained; at a particular point in time there may be more gas than can be absorbed in the domestic economy. Within the framework oi- the model there are two possibilities: (i) The shadow price of gas equals the value of its thermal fuel-oil equivalent whenever the 60 percent substitution limit has not been reached. (ii) The shadow price of gas is below the value of its thermal fuel- oil equivalent whenever there is more gas than the domestic economy can absorb at that particular time. Note that in both cases the (economic value of gas will equal production costs augmented by a depletion premium or resource rent. In the first case, the depletion premium is a residual rent derived by subtracting production costs from the fuel-oil equivalent value, and in the second case the depletion premium is again such a rent but this time derived from the "future" fuel oil equivalent value of gas, discounted over time. Which of the two cases applies at a particular time depends crucially on the supply demand balance projectecd for that period. To illustrate what is involved, Figure 2.2 below summarizes results derived from the optimizing model for three scenarios: These estimates span the realm of what appears possible over the next three decades. All other exogenous variables such as oil prices, oil reserves, energy efficiency etc., were kept at their base case values, so that the model could explore the sensitivity of the growth to variations in gas reserves. As can be seen from Figure 2.2, the economic price of gas remains equal to its thermal fuel-oil equivalent up to the year 1989 for all three scenarios. With pessimistic assumptions about gas reserves, the fuel-oil parity holds throughout the planning period. With moderatiely optimistic assumptions, the shadow price of gas drops significantly bielow its fuel-oil equivalent in the period from 1989 to 2000. During that period, the shadow price rises gradually because the depletion premium rises over time. By the year 2000, demand again catches up with supply and the shadow price reverts to the fuel-oil equivalent value. Finally, with very optimisltic assumptions, the same story holds with a more pronounced and durable difference between the - 73 - FSGURE 2.2 THE ECONOMIC PRICE OF GAS UNDER DIFFERENT RESERVE SCENARIOS 7- 2N, 4- tees 18eS l98 1995 20-8 2235 2220 2015 - YEARS Scenario 1: 23 Tcf of cumulatis production fer 1982-2012 (the Base Case). Scenario 2: 37 Tcf of cumulati; production for 1982-2012. Scenario 3: 16 Tcf of cumulati% production for 1982-2012. economic price of gas and the value of its thermal fuel-oil equivalent. While the economic price of gas rises with a rising depletion premium, it remains below fuel-oil parity throughout the period considered. - Table 2.11 The Model-Derived Economic Price of Gas: Shadow Production Cost and Resource Rent ($/Mcf, 1982 Prices) (Base Case Scenario) Economic Price Price of Thermal Production Cost of Gas Fuel Oil at Economic Resource Rent Equivalent Prices 1/ 1985/1986 4.50 4.50 0.70 3.80 1991/1992 3.80 5.35 0.65 3.15 1995/1996 4.25 5.80 0.62 3.67 2001/2002 6.80 6.80 0.60 6.20 TT These production costs are based on capital-output ratio estimates. While they are actually derived from cost calculations for gas from the Abu Qir field, the magnitudes should be taken as illustrative only. Actual production cost will vary by field and location. -- 74 - It is interesting to decompose the shadow price of gas projected by the model into its two components: production costs and the resource rent or depletion premium. Table 2.11 provides this decomposition for the base case scenario in selected years. These experiments are particularly useful in that they demonstrate that the depletion premium itself puts a floor on the value of gas that is significantly higher than the LNG net-back value. The prDduction costs plus resource rent values derived from the model may also be higher than what Egypt can expect from export oriented fertilizer projects, except perhaps for the very optimistic (37 Tcf of reserves) scenario. Figure 2.3 below contrasts the base case, model derived shadow price, to estimated LNG net-back and exportable fertilizer net-back derived shadow prices. LNG exports can be clearly ruled out as an economically attractive use of Egypt's natural gas resources. Figure 2.3 The Value of Gas as Et Substitute for Fuel-Oil Compared to the Value of Gas Derived from LNG and Fertilizer Exports * - - M IGT 3£ZX | - ?L. nfl aRYf YM4. W p%MWL PC /" 'J MM E 7~~~ EA"- - s- _ _ ~~~~~~~~ ~~ ' - . - 2- . a- ,- , ,- - -tog tS65 lt~ 101 2 S3 23Stt m: S Natural gas based fertilizer exports appear only marginally attractive for a limited period of time. The basic conclusion that emerges is that any possible surplus of gas that may emerge in the 1990's will not be large or long-lived enough to justify major export programs based oni gas. Certainly up to the end of the 1980's, the economic price of gas is equal to the value of its thermal fuel-oil equivalent, which, in 1982 prices is about $4.20. This will rise more or less in line with the world price of oil, For the period from 1990 to the year 2000, the shadow price of gas may be about 20 or 25 percent below its fuel-oil equivalent. Depending on world market conditions, this may indicate that some exports of gas based chemicals should be considered, provided the net-back they generate for Egypt's gas is not below 75 percent of the value of its thermal fuel oil equivalent. - 75 - The Economic Price of Electric Power Electric power is an important non-tradable input in the Egyptian economy with an economic value that must be derived from the opportunity cost to the economy of producing an incremental amount of power. More precisely the economic price of power relevant for investment planning decisions is the average long-run incremental economic cost of meeting a projected demand path. The cost to any user can be broken down into three essential components: (i) Primary energy costs (ii) Capacity expansion costs (iii) Transmission and installation costs Moreover, in the case of electricity, one must distinguish between marginal cost during peak and off-peak periods. Capacity expansion costs should be charged to peak users only since it is peak-time use that forces capacity expansion. Primary energy costs are by far the most important determinant of the shadow price of electricity. For Egypt, it is reasonable to assume that the calculation of the incremental energy cost for the peak period should be based on the operation of an incremental combustion turbine which would burn natural gas. On the other hand, the primary energy cost for the off peak period should be based on the operation of the least efficient incremental base load steam power plant which would burn fuel oil. At a cost of fuel of $175 per ton of oil equivalent and provided gas is priced at its fuel-oil equivalent, the primary energy costs in 1981/82 would be: (i) Peak Period: (price of gas/heat content of gas) x heat rate = ($175/toe/40 million BTU/toe) x 16,240 Btu/Kwh = about 7 cents/Kwh (ii) Off Peak (price of fuel-oil/heat content of fuel-oil) x heat rate = ($175/ton/42 million BTU/toe) x 11,000 Btu/Kwh about 4.5 cents/Kwh If and when the economic value of natural gas falls below its fuel-oil equivalent, the energy cost should be reduced accordingly. On the other hand, fuel-oil prices are projected to increase over time, so both the peak and off peak primary energy costs of power generation will increase accordingly. Finally, in the long-run, coal-fired plants or nuclear reactors may affect the computation of economic prices. Calculation of capacity costs is based on the capital cost of Shoubra El Kheima (3 x 300 mw), the largest power plant coming on stream in the 1980's. The components of the cost, including operation and maintenance cost were evaluated at economic prices and the average incremental capacity cost was estimated at about 2.5 cents/Kwh. Now consider an industrial user, operating 20 percent of the time at peak hours and 80 percent of the time at off peak hours, with an incremental transmission cost of 0.5 cents per Kwh. The shadow price of electricity to this user would be: - 76 - 1981/82: (0.2 x 7.0 cents) + (0.8 x 4.5 cents) + (0.2 x 2.5 cents) + 0.5 cents = 6.0 cents/Kwh 1984/85: (0.2 x 7.4 cents) + (0.8 x 4.8 cents) + (0.2 x 2.5 cents) + 0.5 cents 6.3 cents/Kwh, still in constant 1981/82 dollars, but at higher fuel prices. Note that at present a typical new industrial user in the public sector would pay between 1.5 and 2 cents per Kwh, less than one third of what it costs the economy to generate incremental power. Some of the existing, old users pay even lower prices, sometimes less than 10 percent of the economic cost. 2.3 Price Distortions in the Egyptianl Economy: A Comprehensive Overview In the two preceding sections, the analysis was focused first on some of the key macroeconomic shadow prices that affect all investment projects and second, on the economic values of Egypt's substantial energy resources which also have a pervasive influence on the investment planning process. While the pricing of capital, labor, foreign exchange and energy ralses the most important and fundamental issues for investment planning t:hese macroeconomic parameters can only give us a broad framework for determining the "strategy" of good *nvestment planning. The broad strategy consisting of a large investment effort in the production of domestic tradable commodities, needs to be backed by the "tactics" that will lead to a successful structural transformation: which particular products or activities deserve priority in the economy-wide effort to expand exports and strengthen import substituting production? Are the price and cost realationships as they appear to private and public producers in Egypt a usefuL guide to selecting the right "tactics"? Are there some general shadow pricing rules thiat can be derived from a more detailed analysis of the Egyptian price system? In this section, we shall report on the results of a comprehensive effort to estimate accounting ratios (ratios of shadow to market prices) for a large set of commodities and services in the Egyptian economy in order to gain a better understanding of the nature and interdependence of the price distortions present in the economy, and in order to find some answers to the questions raised above. The method used for estimating economic prices is an adaptation of a practical procedure which is generally accepted in the literature on social cost benefit analysis. The market prices of goods and services are divided into their foreign exchange and domestic cost components; these are then valued in terms of the unit of account and summed to give the accounting or shadow price of the commodity. It is also possible to describe the shadow price structure in terms of ratios of the shadow prices of commodities to their market prices. When data are given in terms of domestic currency values rather than in terms of physical quantities this formulation - entitled the "accounting ratio", is particularly convenient. To estimate the marginal social cost of a commodity we begin by distinguishing between two classes of inputs into its production, goods and services and primary inputs. Primary inputs are inputs wh:ich have their accounting prices determined outside the goods market - for example foreign exchange, labor, and capital -- or which represent transfers of income -- for - 77 - example taxes/subsidies and incomes accruing to private individuals. The choice of primary inputs is somewhat arbitrary. Our list, along with estimates of the accounting ratios applicable to each input, is contained in Table 2.12. The estimation of efficiency prices disregards the premium there is on savings. Extended efficiency prices take this premium into account.l/ Ultimately one has to express the costs and benefits of any commodity in terms of P1, foreign exchange. The intervening inputs are designated either because we wish to be able to test the sensitivity of the estimated accounting ratio to assumptions made concerning their accounting prices or as a matter of convenience in having the total (direct plus indirect) content of the item for some of our analytical work. Thus, unlike other studies of this type, we distinguish taxes and subsidies as separate input items in order to trace the direct plus indirect effect of consumer subsidies on commodity prices. Similarly, in order to be able to use as a cost-benefit criterion the DRC or domestic resource cost ratio, capital inputs - buildings, machinery and vehicles - are included as primary inputs, rather than as direct commodity inputs. Our list includes all of the important items for which the problem of weighing benefits arises. Thus it is relatively simple to trace the impact of altertiative assumptions concerning the weights assigned on the system of economic prices. Table 2.12 Accounting Ratios for Primary Inputs in Egypt Accounting Ratio Efficiency Extended Primary Input Prices Efficiency Prices P1 Foreign Exchange 1.000 1.000 P2 Skilled Labor 2/ 1.040 1.050 P3 Unskilled Labor drawn into Urban Industrial Employment 2/ .456 .760 P4 Unskilled Labor drawn into Rural Industrial Employment .560 .653 P5 Capital Buildings 1.650 1.650 P6 Capital Machinery .965 .965 P7 Capital Vehicles .910 .910 P8 Extra Incomes of Private Sector 0.000 0.000 P9 Non-Traded Agriculture 1.000 1.000 PlO Taxes/Public Sector Surplus 0.000 0.000 Pll Subsidies 0.000 0.000 1/ See Section 2.1 above for estimates of the savings premium or consumption discount. 2/ Average over public and private sectors. - 78- The market price of an input is transformed into its shadow price in two stages. First, the direct factor costs and costs of the commodity inputs involved in supplying one LE of the good are estimated. For example, the costs of supplying an imported input such as machinery spare parts to the final purchaser will consist of the direct foreign exchange cost (cif value), tariffs, transportation, port handling and the distributor's margin. The cost composition of a non-traded good can be found in a similar manner. In the second stage of the analysis the direct plus indirect factor cost content of supplying the commodity is estimated by tracing the factor cost of supplying the intermediate inputs into the production of the commodity in question. The sum of the direct factor inputs and those used indirectly in providing intermediate inputs are then multiplied by the relevant accounting prices to determine the shadow price of the good or service. The similarity of the method to input-output analysis is apparent, but the construction of the input-output matrix for the economy proceeds along somewhat different lines. The input-output accounting tableau appropriate for this method appears in Figure 2.4. Those familiar with orthodox input-output tables will recognize some important departures from the standard presentation. First, goods are divided into the categories tradable and non-tradable; and domestic activities sub-matrices are reported for each. Tradable activities are treated as if the marginal source of supply is represented by changes in the demand for importables and/or the supply of exportables. Import competing and export producing activities are dropped from the input-output table and replaced by the transport and distribution and trade and taxes sub-matrices which sumaarize the direct marginal social cost content (at domestic market prices) of a unit increase in final demand. For non-traded activities the Leontief column consists of four components: (a) a tradable content vector, (b) a domestic activities vector, (c) a transport and distribution vector, and (d) a value added vector. Tradable inputs into non-traded activities are treated symmetrically with tradable deliveries to final demand, since at the margin tradable imports have their shadow prices fixed on the international market. Thus, the only domestic activities rows which provide inputs into non-tradables are other non-tradable activities. The primary factors matrices show the foreign exchange and tax content of tradable commodities (the trade and taxes sub-matrix) and the value added content of non-tradable activities. The sum of any column across both commodities and factors is LE 1.00 at market prices. Let us denote the two input value matrices in Figure 2.4 as: A = (aij) a square matrix in which each of the aij shows the direct input of commodity i per unit of commodity ji. P = (Psj) a rectangular matrix which shows the direct primary factor inputs into the delivery of one LE of the good at market prices. - 79 - Figure 2.4 Modified Input-Output Tableau for Accounting Price Estimates A MATRIX (Lxn) i'N ... X Tradable Activities Non-Tradable Activities -0- T Sradable Inputs into Non-tradable Production Sm I Ill~~~~~~~~~~~~~~~~~~~ °0- I Non-Traded Activities Transport and Distribution Transport and Distribution I .i I . 1 P Hatrix(o'xn) Foreign Exchange and I Domestic Value Added Taxes Matrix matrix Kl. - 80 - Let the accounting ratio for each primary factor be defined as r5 (s = 1,...P) and the commodity accounting ratios by fj (j = 1, ..n). Then in matrix notation f = Af + Pr in which f and r are the vectors of commodity and primary input accounting ratios respectively. This yields F = (I-A)Y1Pr = Pr where P = (I-AY-1P, the matrix of total direct plus indirect requirements of primary inputs. If we have estimates of the primary input accounting ratios, the commodity accounting ratios follow quite simply, once the A and P matrices have been specified. The keyr complication is the following, however: since the parameter estimates of some of the primary factor accounting ratios depend themselves on the commodity accounting ratios - for example the shadow wage rate - it is necessary to follow an iterative procedure. First, reasonable but arbitrary values are assigned to the primary input categories and preliminary estimates of commodity, accounting ratios are derived. These are then used to estimate improved values of the factor accounting prices and the process is repeated. Convergence to a reasonably stable set of values can normally be achieved in two to three iterations. The estimates of direct and total factor costs and the accounting ratios derived from them apply to the 1979-1981 period, although in some cases it was necessary to refer to data from earlier years to provide a picture of the cost composition of certain non-traded activities. The estimated accounting ratios for the commodities evaluated by the above method are presented in Table 2.13. Table 2.13 Major Accounting Ratios by Category/Egypt Tradable Goods 1 TI Aluminum 1.061 2 2 Busses 0.737 3 3 Cement 2.185 4 4 Chemicals (industrial)(subs.) 2.158 5 5 Chemicals (inorganic) 0.959 6 6 Chemicals (organic) 0.942 7 7 Electric Machinery 0.965 8 8 Electrical Distribution Machinery 0.830 9 9 Electrical Motors 0.849 10 10 Fittings and Fixtures 0.852 11 11 Gloss Products 0.949 12 12 Iron and Steel Products 0.937 13 13 Iron and Steel Building Materials (subs.) 2.358 14 14 Iron and Steel 0.928 15 15 Jute Yarn 0.846 - 81 - 16 16 Jute Bags 0.746 17 17 Machinery (metal working) 0.965 18 18 Machinery (textiles) 0.965 19 19 Machinery (office) 0.768 20 20 Machinery Spare Parts 0.965 21 21 Metals (ferrous) 0.965 22 22 Metals (non-ferrous) 0.998 23 23 Metal Products 0.899 24 24 Paints and Pigments 0.911 25 25 Paper and Printing 0.951 26 26 Paper (subs.) 1.769 27 27 Paper Products 0.786 28 28 Packaging Materials 0.806 29 29 Plastics 0.810 30 30 Rubber (crude) 0.975 31 31 Rubber Products 0.788 32 32 Tires and Tubes 0.818 33 33 Tobacco (unmfg.) 0.904 34 34 Telecommunications Equipment 0.870 35 35 Trucks and Lorries 0.910 36 36 Wood (crude) 0.994 37 37 Wood Products 0.975 38 38 Vehicle Spares 0.868 Agricultural Inputs and Outputs 39 Al Agricultural Machinery 1.159 40 2 Agricultural Machinery Spares 1.021 41 3 Agricultural Implements 0.992 42 4 Bags 1.280 43 5 Fertilizer (wtd average) 1.663 44 6 Pesticides 1.976 45 7 Seeds 1.149 46 8 Maize 1.313 47 9 Onions 4.259 48 10 Rice 2.043 49 11 Soy Beans 0.992 50 12 Sugar 0.969 51 13 Wheat 1.591 Petroleum Products and Natural Gas 52 PPI Crude Oil 1.010 53 2 Diesel 6.751 54 3 Fuel Oil 15.299 55 4 Gas Oil 6.265 56 5 Kerosene 5.883 57 6 Naptha 4.438 58 7 Petrol 1.527 58a 8 Natural Gas 15.299 - 82 - Urban Consumer Goods (Tradable) 59 Ul Beef (rationed) 1.978 60 2 Beef (non-rationed) 1.007 61 3 Butagas (LPG) 4.822 62 4 Coffee 0.679 63 5 Clothing 1.106 64 6 Consumer Durables 0.501 65 7 Edible Fats 1.221 66 8 Fish 0.969 67 9 Fruit 0.658 68 10 Footwear 0.973 69 11 Lentils 1.666 70 12 Maize 1.797 71 13 Milk and Products 0.968 72 14 Medicines and hygiene 0.939 73 15 Passenger Automobiles 0.571 74 16 Rice 5.407 75 17 Sesame 0.929 76 18 Soap and Detergents 0.821 77 19 Sugar (rationed) 1.202 78 20 Sugar (non-rationed) 0.483 79 21 Tea 0.401 80 22 Textiles (non-rationed) 0.970 81 23 Tobacco Products 0.383 82 24 Vegetables 0.919 83 25 Vegetable Oil (rationed) 5.229 84 26 Vegetable Oil (non-rationed) 2.599 85 27 Wheat 3.517 86 28 Wheat Flour 1.250 Rural Consumer Goods 87 Rl Lentils 0.971 88 2 Maize (non-subsidized) 0.927 89 3 Meat (non-rationed) 1.163 90 4 Rice (non-subsidized) 1.799 91 5 Sesame 1.042 92 6 Sugar (non-rationed) 0.536 93 7 Vegetable Oil (non-rationed) 2.487 94 8 Wheat (non-subsidized) 1.520 Non-Traded Goods 95 Ni Animal Fodder 1.085 96 2 Bread Baking 1.156 97 3 Banking and Insurance 0.328 98 4 Beverages 0.731 99 5 Biscuits and Confectionery 1.058 100 6 Building and Construction 1.669 101 7 Building Materials 3.773 - 83 - 102 8 Cotton Cloth (rationed) 2.985 103 9 Cigarettes 0.619 104 10 Electricity 3.321 105 11 Entertainment and Culture 0.779 106 12 Food Packing 0.947 107 13 Food Distribution 1.237 108 14 Garments (subsidized) 1.112 109 15 Grain Milling 1.592 110 16 Housing (rural) 1.626 111 17 Housing (urban - low and middle income) 1.569 112 18 Housing (urban - high income) 1.535 113 19 Milk Products 1.266 114 20 Meat Processing 0.886 115 21 Miscellaneous Office Services 0.862 116 22 Personal Services 0.958 117 23 Port and Harbor Charges 1.315 118 24 Printing and Publishing 1.236 119 25 Rail Transport (passengers) MC 1.199 120 26 Rail Transport (goods) MC 1.213 121 27 Rail Transport (price) MC 0.000 122 28 Retail Distribution 0.711 123 29 Road Maintenance 1.423 124 30 Road Transport (passenger) 1.270 125 31 Road Transport (goods) 1.365 126 32 Services NES 1.627 127 33 Telecommunications 0.972 128 34 Transport (wto png) 1.343 129 35 Vehicle Repair 0.909 130 36 Wholesale Distribution 0.798 The 130 commodities in Table 2.13 are divided into six major groups - tradable intermediates, agricultural inputs and outputs, petroleum products, tradable urban consumer goods, tradable rural consumer goods, and non-tradables. This coverage of commodities includes all of the major SITC three digit categories in Egypt's external trade statistics, major consumer goods, and all of the non-tradable sectors represented in the 1977 input-output table. Thus the frequency distribution of accounting ratios in Table 2.12 is quite representative of the overall relationship between accounting and market prices in the Egyptian economy. Table 2.13 gives us a comprehensive set of major accounting ratios. We have in fact gone farther and used these major ratios to estimate another 600 accounting ratios which we needed for our study of comparative advantage in agriculture and industry. This extended set of accounting ratios is available at the Ministry of Industry and Mineral Wealth. A summary measure of the "typical" accounting ratio is the median of the distribution of all 130 commodities which is .993. The mean is 1.549 indicating the effect of a number of commodities with extremely high ratios of the accounting price to the market price. There are relatively few commodities with low accounting ratios in our distribution, and these are consumer goods which are typically heavily taxed, tobacco, coffee, tea and - 84 - alcohol. Because of the heavy subsidization of many consumer items, the median accounting ratio for tradable consumer goods is .973. The median of the distribution of petroleum products is 5.88 indicating the magnitude of the subsidies to petroleum products. Subsidies and production taxes in the agricultural sector are similarly indicated by the median of the distribution of agricultural inputs and outputs of 1.28. The system of subsidies also works its way through the structure of production and exerts a major influence on the social marginal cost of non-traded commodities. Non-traded goods in our sample have a median accounting ratio of 1.21, thus for the typical non-traded good the accounting price exceeds its market price by approximately 21 percent. Overall the picture which emerges is of a distribution of accounting ratios characterized by a very high variance and a large incidence of values exceeding unity. There are some heavily protected sectors of the Egyptian economy, but in contrast to many developing countries there are a substantial number of activities in which pricing policy has suppressed. the domestic market price below the shadow price. The most notable of these sectors is the energy sector, but accounting prices exceeding unity are also found in agriculture and among subsidized urban consumer goods. A detailed discussion of data and the methods used to establish the input structures of the commodities listed in Table 2.12, is available in a seperate appendix. At this stage, it may be useful to review briefly a number of general issues which affect the appropriateness of the methodology. These are: (a) the degree of tradability; (b) increasing returns to scale; (c) variable relationships between international and domestic prices; (d)inelastic world supply and demand, and (e) multiple exchange rates. These topics also introduce the important issues of the time perspective of the analysis and the degree to which individual project analysts should undertake supplementary shadow price estimates in addition to those presented here. 1/ (a) The Degree of Tradability A crucial underpinning of the border price rule on which the system of accounting prices is based is that potentially tradable goods are in fact traded at the margin. In the absence of that assumption -- say for example because of fixed import quotas or heterogeneity of products -- changes in the domestic supply of or demand for potentially tradable commodities may result in changes in their domestic price with no effect on the trade balance. In such circumstances accounting ratios based on the relationship between border and domestic prices will not provide a correct estimate of marginal welfare change and, hence, of the marginal social cost/benefit associated with the commodity. The cost-benefit analyst has essentially two options in dealing with commodities for which the degree of tradability is uncertain. The first is to treat all potentially tradable commodities as traded cn the rationale that it is likely that for minor changes in final demand imposed by the project, quotas or other quantative interventions will be adjusted upward to l/ The reader who does not wish to dwell on the following methodological discussion can proceed directly to the concluding section on Page 121. - 85 - reflect the increased demand. The alternative is to treat such commodities as non-traded goods. It is then possible to analyze their social costs of production in the manner described above, or in the case of commodities which are in inelastic domestic supply to estimate the changes in producer's and consumer's surplus which occur as a consequence of a marginal change in supply or demand. Clearly the second alternative involves substantially more work for the project analyst and introduces a greater margin for error. Therefore most cost benefit studies have, wherever possible, treated tradables as fully traded. This approach has been followed in this study, but with several important exceptions. These are primarily in the area of subsidized and rationed consumer goods, notably textiles and clothing, where the level of product quality is substantially lower than the minimum standard in international trade. Although these items fall into a category which is potentially tradable, they are in fact non-traded goods, and we shall detail the assumptions made concerning their social cost when dealing with these specific industries in Part III of this Report. (b) Constant Costs or Variable Returns to Scale The input-output method outlined above implicitly assumes that the separate items making up the marginal social cost of a commodity vary linearly with the quantity of the good demanded. If this were not so, the A and P matrices would vary with the scale of demand. This is not precisely the same thing as assuming constancy of average costs, since the accounting prices are applicable only to marginal changes in supply or demand. Where large changes in the availability of an item are contemplated the project analyst must, as always, carefully consider the possible changes in economic costs associated with non-marginal changes, and the accounting ratios presented here would not in general be applicable. Allowances for variable returns to scale may be made by allowing variations in the aij and Psj over different intervals of output. In practice this can be. done only to a limited extent. Moreover, given our limited knowledge of returns to scale in the non-traded goods sectors of the Egyptian economy, any such adjustments would be largely arbitrary, and we have therefore chosen not to make them. The marginal social cost coefficients in our input-output structure represent the best information we have on the cost composition of those activities. (c) Variable Relationships Between International and Domestic Prices Wherever domestic prices are administratively set, as for example is the case with fixed producer and consumer prices, the relationship between domestic and international prices may vary over time with changes in either price. 1/ This has rather vexing consequences for accounting ratios based upon the relationship between the market and shadow price of a commodity taken at one particular moment. Although the appropriate accounting price remains the border price, when the ratio of prices changes, the accounting ratio must also change. In the case of agricultural commodities which exhibit considerable year to year variations in international prices, the presence of 1/ Obviously the presence of quantative restrictions is another example of a variable relationship between world and domestic prices, since changes in domestic demand or supply will alter the quota premium of the commodity. -- 86 - fixed domestic prices could imply almost continuous updating of accounting ratios. In general, the economist estimating a set of shadow prices must use his judgement concerning the medium term relationship between domestic and foreign prices. In the Egyptian context where there have been substantial changes in domestic prices of price controlled traded commodities since 1979 we have in general focused on the relationship between these domestic prices which, given past practice, may be expected to prevail for several years and the "normal" world price as represented by the average of the past several years prices. These accounting ratios should remain relatively stable over the next few years, but major movements in either price would require revision of the input-output value coefficients and the accounting ratios. (d) Inelastic World Supply or Demand Cases in which a country faces less than perfectly elastic foreign supply or demand curves for a commodity pose a slight complication in the estimation of accounting ratios, but can be allowed for w:ithin the general approach by adjusting the input coefficients to reflect the marginal export revenue or marginal import cost of the commodity. Social pricing exercises will also require that the change in producer and consumer incomes resulting from the price change be evaluated. For Egypt the major commodity market in which the quantity exported could havie a significant impact on the world price is that for long staple cotton. But many other exports may be subject to high but less than perfectly elastic foreign demand, a fact incorporated in the model presented in Chapter 1. When one believes this to be a significant factor not already taken into account via trade and transport margins accounting ratios should be adjusted to reflect the difference between marginal revenue and price. It should be clear from the Loregoing discussion that the general system of estimating shadow prices is quite flexible with regard to its ability to accommodate various institutional and policy constraints which affect the relationship between market and social prices. The implementation of these procedures, however, in order to calculate a basic set of shadow prices for an economy such as Egypt, is a fairly laborious and time consuming task. This is because the construction of the A and P matrices requires detailed analyses of the markets for commodities, a project which can use almost unlimited amounts of information. In view of the alternative methods available for estimating more aggregated national parameters in cost-benefit studies what are the advantages of a more detailed approach? From the point of view of the present study we would argue that there are three important gains from taking the greater time required for a highly detailed shadow pricing exercise: (i) It requires a careful examination of the workings of many commodity markets and industries and thus generates valuable information about the economic factors underlying the present situaition. This is of particular value in Egypt where administered pricing decisions impinge at both the producer and consumer margins in the markets for many commodities. Our approach allows us to trace the impact of these interventions through a number of interconnected markets. - 87 - (ii) Because we wish to apply the accounting prices to an examination of comparative advantage and international competitiveness quite a wide array of accounting ratios is required, and it is convenient to estimate them within the context of a general shadow pricing exercise. (iii) The work, once completed, can be updated relatively easily to reflect changes in the policy environment. Once the impact of a policy change on the coefficients of the A and P matrices has been worked out, it is simple to trace the impact of these changes on the full set of accounting ratios. Thus we have attempted to work with as wide a range of items as possible within the resources available. By distinguishing between various types of commodities - e.g. types of transport, agricultural products, petroleum products, etc. - we are able to consider in detail the ways in which government pricing and taxation policies are affecting the incentive structure of the economy relative to what might be desirable in view of the true structure of economic costs and benefits. (e) Exchange Rate Changes and Multiple Exchange Rates All values of commodities and factors of production presented and discussed so far were expressed in terms of constant 1979 "border Egyptian Pounds" - that is Egyptian pounds freely convertible at the average nominal exchange rate prevailing in 1979. If one wished to switch from border pounds to dollars as the unit of account it is simple to divide the accounting value by the nominal exchange rate. Either unit of account provides a consistent welfare index differing only by a scalar value. Since 1979, however, two changes have occurred in the exchange rate regime which must be addressed. First, there has been a marked widening in the exchange rates offered in each of the three segments of the Egyptian foreign exchange market - the "central bank pool", the "commercial bank pool", and the "free" market financing own exchange imports. In 1979, transactions in the commercial bank and central bank pools both took place at a rate of .70 LE to the dollar, and those on the "free" market took place at rates not exceeding .78. By 1981, although the central bank rate remained at .70, the commercial bank rate had increased to .84 and the parallel market rate had increased to around 1.00. The weighted average nominal exchange rate has increased to about .80. Thus, the period from 1979 to 1981 was marked by a shift from an essentially unified to a multiple exchange rate regime and by a nominal depreciation of the Egyptian pound. How do these two actions affect the estimates of accounting prices and accounting ratios? First consider the question of a nominal devaluation. The change in the exchange rate will have no impact on the world price of tradable commodities (denominated in terms of foreign currency) for which Egypt is a price taker. Domestic prices will rise by the amount of the devaluation but relative traded goods prices will be unaffected. Accounting ratios for traded goods will also be unaffected. To see this, consider the case of a tradable commodity which is subject to an ad valorem tariff TAR = (l+t). The - 88 - accounting price denominated in dollars is Pw and in terms of border pound is PwR, where R is the nominal average rate of exchange. The domestic price is PWR(TAR) and the accounting ratio is therefore: fj =PwR/PwR(TAR) 1/TAR The level of the nominal exchange rate is irrelevant to the shadow price of the perfectly traded commodity and to its accounting ratic,. It nevertheless remains true that because a nominal value has changed (in this case R) we have to deflate to constant 1979 prices if we wish to compare real resource costs in the two periods. If the unit of account is dollars and dollar denominated world prices are unchanged this may be accomplished simply by dividing border pounds in each period by the nominal average exchange rate prevailing in that period. If we wish to retain border pounds of constant purchasing power as the unit of account then we must deflate the nominal border pounds in each period by,a discount factor equal to Dt = R79 / Rt. Either approach provides a consistent index of the real resource cost of a traded commodity. 1/ A similar argument applies to the accounting prices and accounting ratios applicable to non-traded goods, as long as the devaluation is simply an adjustment for differential inflation and has no real relative price effects. A purely nominal devaluation implies that non-traded goods prices rise in the same proportion as the adjustment in the exchange rate and that therefore the relative price of traded and non-traded goods remains constant. With constant relative prices, the structure of production is invariant to the change in the exchange rate; hence the input-output structure on which non-traded goods shadow prices are based remains unchanged as do the shadow price and accounting ratio. 1/ To illustrate this consider the following simple example. A project uses 100 units of an input in both 1979 and 1981 with a constant world price of US $1.00. The commodity is subject to a tariff of 10 percent ad valorem. The effect of the exchange rate adjustment may be seen from the following table: Year Units Pw Accounting Value R Value in Domestic Accounting US $ Border LE Value Ratio 1979 100 1 100 .70 70 77 .909 1981 100 1 100 .80 80 88 .909 It is clear from the table that the real resource cost of the input -- its accounting value in US dollars is unchanged between the two periods, as is the accounting ratio. In moving from domestic market values to accounting values one would first multiply by the accounting ratio to arrive at current border pounds. To arrive at 1979 US dollar values one would divide by the nominal exchange rate (R). To value commodities in border pounds of constant purchasing power one would multiply the 1981 current border value by the discount factor 70/80 = .875. Both techniques yield the correct answer that the real resource cost of the input is unchanged between the two periods. - 89 - If the devaluation involves real relative price changes, the effect of the exchange rate adjustment is more complex. The relative price change can be expected to alter the input-output coefficients on which the shadow pricing system is based and will also change the estimates of the marginal social products of labor and capital. A real exchange rate adjustment therefore alters the accounting ratios applicable to non-tradables and, hence, affects the overall distribution of accounting ratios in the economy. Predicting the net effect of this adjustment on the accounting price system is quite difficult. In the case of Egypt, we do not believe that the adjustment in the exchange rate between 1979 and 1981 reflects a real exchange rate adjustment. Indeed, increases in non-traded goods prices may have led the exchange rate, suggesting that the nominal change from .70 to .82 reflects adjustment in the foreign exchange market to maintain constancy of the real exchange rate. The shift from a unified exchange rate regime to a multiple exchange rates poses somewhat different problems. In Egypt access to various elements of the foreign exchange market is determined by the ownership of the enterprise as well as by the type of good. Thus, it is possible for a single commodity to be imported at three different rates of exchange depending on the final user or importer. The exchange rate system, therefore, operates like a system of indirect taxes and subsidies. Enterprises with access to the central bank pool receive an implicit subsidy on imports entering at the rate of .70, but pay an implicit tax on exports receiving the same rate, relative to the commercial bank and parallel market rates. A similar, although converse argument, applies to firms importing and exporting exclusively at the parallel rate. Differences in the exchange rates represent transfers between suppliers and users of foreign exchange, rather than variations in the real resource costs of commodities supplied to various categories of users. If the exchange rates were specific to commodities it would be possible to handle the implicit tax/subsidy element of the multiple exchange rate system in a symmetric fashion to that applied to trade taxes and subsidies. One would choose one exchange rate as a base and show deviations in the market price border price relationship due to different exchange rates as taxes or subsidies. Because in Egypt the exchange rate may differ for differing commodity-user pairings we have adopted a slightly different approach. We choose as a base border Egyptian pounds convertible at a rate of .70 in 1981. (Note that this is equivalent to constant price 1979 border Egyptian pounds and was, therefore, chosen for convenience.) We can then specify two "exchange rate accounting ratios", EAR's, which allow us to convert from border LE at the commercial or parallel rate to border LE at the central bank rate. To find the accounting value of a traded commodity whose price is denominated in terms of domestic currency in 1981, we multiply by both the commodity accounting ratio and the exchange rate accounting ratio to arrive at the resource cost in terms of border pounds convertible at the central bank rate. This value in turn may be converted into dollars at the central bank rate if desired. - 90 - The purpose of making this adjustment is very similar to the rationale for expressing values in terms of constant purchasing power. We wish to reflect the ultimate impact on the trade balance of a change in expenditure at domestic prices. Consider the commodity discussed above with world price Pw' tariff rate TAR and accounting ratio f-. The domestic price is variously P1 = PWRTAR P2 = P.RcTAR, P3 PwRTAR, depending on the exchange market to which the purchaser has access, where R, Rc and Rt are the exchange rates in the central bank, commnercial bank, and free market pools respectively. Since the world price is constant, border pound prices must also reflect the constancy of the opportunity cost of the good. Define the exchange rate accoulating ratios EARc = R/Rc and EARf = R/Rf. The accounting value of the commodity in border pounds (central bank rate) may be found by: Plfj = P2fjEARc = P3fjEARf = PwR TAR(L/TAR) = PwRc(l/TAR)(R/Rc) = PwRfTAR(1/TAR)(R/Rf), which obviously differs only by a scaLar, R, from the world price Pw. Hence the effective accounting ratio for any commodity-user pair consists of the product of the commodity accounting ratio fj and the exchange rate accounting ratio EARi (i = c,f). The exchange rate accounting ratios are central bank rate, 1.00, commercial bank rate, .70/.84 = .833, and free market rate, .70/1.00 = .70. Note that when the exchange rate accounting ratios are applied there is no need for a further adjustment to arrive at 1979 border pound since the exchange rate is equal in both periods. 1/ 2.4 Conclusion Figure 2.5 summarizes the frequency distributions of accounting ratios for the 130 commodities included in the study and for important subsets of these commodities. One, at first surprising point which emerges is that the median accounting ratio is close to one. Those familiar with other studies of (border) accounting prices or effective protection in developing countries may find this result striking. In most countries, protection of a wide range of tradable consumer and intermediate goods results in accounting ratios for tradable commodities which are below unity, often by a wide margin. The median of our sample of 94 traded commodities is .97, and fully 43 percent of the accounting ratios for tradables exceed one. Since non-traded goods are then linear combinations of tradables and primary inputs it is natural to find that their accounting ratios are also close to and often exceed unity. What is the source of this shadow pricing phenomenon in Egypt? Since the opening of the Egyptian economy in 1973, the government: has tried to insulate certain consumer goods and producer intermediates from changes in world prices and in the nominal exchange rate via a pervasive system of price I/ For the project analyst whose accounts are given mainly in US dollars an alternative approach is to convert the central bank border price values of non-traded goods and labor given in this paper to dollar values using the rate of .70 . Either approach provides a consistent index of social value and the choice is dictated largely by convenience. - 31 - Figure 2.5 Distribution of Accounting Ratios g{on-Tradables median 1.213 JO~~~~~~~~~~~~~~~~~~~~~~~~d Imports - Median .965 . I Z9 M.edian .982 1 *_ All Values FrequencY I Median .993 iL 6 4A~ ~ LZ~ ~ ~ Lfl ~' ~ ~ "~ '~ ~' ~ * :ner-iai. Value 92 - controls and subsidies. Among these commodities are domestically consumed petroleum products, basic agricultural staples, including wheat and other food grains, oils, sugar and meat, locally produced and imported intermediate products such as steel reinforcing rods, cement, and other construction materials, and consumer products produced by the public enterprises including shoes, clothing, and cotton cloth. Various rationing schemes have been implemented to control excess demand in the markets for these commodities and prices have not been allowed to increase in line with international prices. At the same time, agricultural policy has permitted the coexistance of implicit taxes via fixed producer prices set at levels below the import and export parity prices of agricultural commodities combined with subsidies on major agricultural inputs. One consequence of this structure of subsidies and taxes has been to make the accounting ratios for a large number of agricultural inputs and outputs greater than one. The overall impact of the system of taxes and subsidies is apparent from Figure 2.5. The median of the full distribution of 130 commodities is .99. If this is typical of the central tendency of the distribution of accounting ratios for all commodities in Egypt (including those whose accounting ratios we have failed to estimate) it indicates that, on average, there is little overvaluation of the Egyptian currency resulting from the structure of nominal protection because taxes, tariffs, subsidies and price controls tend to be counteracting and on average may tend to cancel out in terms of their effect on the exchange rate. If the existing structure of protection and price controls were to be eliminated and domestic prices were permitted to adjust to their border price equivalents, there would be about as many domestic prices that would rise as there would be prices that would decline in the absence of any adjustment in the nominal exchange rate. It is likely then that there would be very little need for an exchange rate adjustment to compensate for the change in the pattern of taxes and subsidies. This result contrasts with the more usual estimates of standard conversion factors which are less than unity. In those cases prior to any nominal exchange rate adjustment the prices of most goods would decline to their international equivalents. The nominal exchange rate would then increase to restore equilibrium in the goods market. It is important to stress here that the exchange rate adjustment discussed with respect to changes in the structure of protection is a purely comparative static one, reflecting changes in the levels of tariffs, subsidies and price controls. The "dynamic" exchange rate issue was discussed in Section 2.1 where we argued that the structural transformation of the Egyptian economy will require a real exchange rate adjustement over time. Focusing on the median, however, tends to obscure the massive sectoral variations in the structure of relative accounting and market prices in Egypt. There is great variability in the accounting ratios. The standard deviation of the scatter of 130 commodities is 1.70 and exceeds the mean by ten percent. Clearly, the process of administrative price determination in Egypt has resulted in extreme variability in the relationship between market prices and opportunity costs. Thus, any summary measure of the pattern of price distinctions such as the standard conversion factor masks the important sectoral variations in the relationship between accounting prices and market prices and the negative welfare effects of these distortionis. - 93 - These general observations are borne out by a more detailed examination of certain subsets of commodities. The median value for exports is .98 which exceeds slightly that for importables of .96. In both cases, the standard deviation is large although less than the mean, indicating that the distributions are somewhat more compact than the overall distribution. The median values do mask substantial variations in individual accounting ratios and, therefore, fail to provide useful measures of the opportunity costs of individual commodities. The potential for large efficiency gains is there but there are unfortunately no general rules of thumb that one can follow and proposed investments in the traded goods sector should be appraised individually. Summary conversion factors are inadequate guides to the social costs and benefits of any particular investment. Non-traded goods and services are more closely grouped (coefficient of variation .54) which reflects the fact that they are the weighted averages of a large number of items. Both the mean and the median of the distribution of non-traded goods, however, exceed one by a substantial margin (1.33 and 1.21, respectively). When we recall that the accounting ratio for a non-traded good is the ratio of its maiginal social cost of production to the domestic market price, the impact of the system of subsidies on intermediate goods and on the relationship between market and social profitability becomes apparent. Those activities which intensively use such non-traded goods and services as electricity, construction, and road and rail transport receive substantial implicit subsidies relative to the opportunity cost of providing those inputs. If the accounting ratio applicable to their output is close to the median value of one, it is quite likely that profits at market prices will exceed social profits. Moreover, the fact that private costs are below economic costs for these items may encourage excessive substitution of these inputs for others relative to the optimum input proportions at social accounting prices. The relationship between the median accounting ratios for non-traded goods and the standard conversion factor has an important implication for judgements concerning the existing allocation of resources between tradables and non-tradables. The marginal social benefit accruing from the production of a non-traded good is measured by domestic willingness to pay converted into the numeraire. A first approximation to willingness to pay in terms of the unit of account is given by the product of the domestic price and the standard conversion factor. 1/ Because the standard conversion factor is close to one, the domestic price is a fairly good approximation of marginal social benefit. We know from our estimates of accounting ratios for non-traded goods that marginal social costs exceed marginal private costs for the typical non-traded good in Egypt. Hence, at the margin, social costs exceed social benefits for the typical non-traded activity. If the existing structure of taxes and subsidies were removed, the supply curve for non-tradables would shift upward 1/ One could achieve greater precision by employing a demand price conversion factor appropriate to the non-traded commodity in question. - 94 - and we would expect a rise in the domestic price of non-tradables and a reduction in their output. Thus relative to a distortion free environment, there is over production of non-tradables at the expense of traded goods producing activities. A similar argument may be advanced concerning peteroleum products sold domestically. The median accounting ratio for these products is 5.88. This means that for each pound spent on petroleum products in Egypt, the opportunity cost in terms of foreign exchange earnings foregone is approximately six pounds. It is difficult to find a more dramatic example of the divergence between market and economic prices. Proposed investments which are intensive in the use of petroleum products will tend to use them excessively relative to appropriate factor proportions at economic prices and will have higher levels of private than social profitability. The main lesson to be drawn from these estimates of economic prices is that in Egypt, as in many countries, private profits or public financial surpluses and or deficits provide an inadequate indicator of the social profitability of investment and of potential areas for efficient competition in export or import markets. In Egypt, however, the great variety and large number of interventions in product markets, and the resulting great variability in the distribution of accounting ratios, means that simple adjustments of market rates of return for general patterns of distortions are also impossible. In economies, for example, where the typical accounting ratio is less than one and the distribution is relatively compact, it is almost always true that projects producing exports for which the international elasticity of demand is high and purchasing inputs on the domestic market will have higher rates of return at economic prices than at market prices. If such projects are commercially viable, they are socially desirable. In Egypt no such rule of thumb applies and each project must be evaluated individually to determine its social profitability. This is due to the fact that prices facing Egyptian consumers and producers are seriously out of alignment with international relative prices and relative economic costs. It is not that Egypt is "protecting" industry or any other major sector. On the contrary, many subsectors in industry or agriculture in fact face negative protection due to price controls. The problem is that prevailing prices are so much out of line with the underlying economic values that the result appears to be an almost random system, protecting some products, hurting others, with no apparent purpose, reflecting mainly the accumulation of historic accidents and cumulative interventions, sometimes reinforcing one another, sometimes cancelling out. Two points are worth stressing in conclusion: (i) In Egypt, perhaps more than elsewhere, project- evaluation and project planning based on economic pricing is a crucial necessity. Economic rates of return are likely to be very different from financial rates of return. A consistent and careful screening of projects is likely to make an invaluable contribution to economic management and augment t:he return Egypt gets on the substantial resources that should be devoted to investment. - 95 - (ii) Shadow pricing and government planning cannot, however, bear the entire burden of improving resource allocation. Financial profitability does not depend on shadow prices but is determined by actual market prices. As long as financial rates of return are very different from economic rates of return, political and commercial pressures will tend to counteract the economic objectives of investment planners. With existing price distortions there will continue to be dangerous opportunities for extremely wasteful projects in many areas, because projects with low or even negative economic rates of return can be financially quite profitable. Conversely, projects with good economic returns may not be undertaken because they would not lead to large financial profits. The difficulties and conflicts this situation creates should not be underestimated and one cannot expect a mixed market economy to function well under these circumstances. While careful economic pricing and project evaluation can help reduce misallocation and while plarners may try to increase the productivity of investment, there is an urgent need to complement and support the process of investment planning with policies that adjust the pattern of domestic relative prices to reflect economic opportunity costs. This will permit greater concordance between commercial viability and economic efficiency, reduce the burden on the government, reduce the level of conflict in the system and help Egypt achieve an efficient allocation of investment so that the sacrifices made today are not wasted and can lead to greater and more rapid improvements in the future. EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING PART II AGRICULTURE - 96 - Chapter 3 Recent Agricultural Trends and Trade Performance 3.1 Background and Overview In Part II of this Report we turn to an analysis of agriculture, one of the two major tradable commodity producing sectors of the economy. The objective is to examine issues of trade strategy and investment planning in agriculture within the overall perspective and framework of analysis described in the preceding chapters. 1/ Chapter 3 provides a description of recent trends and trade performance. Chapter 4 discusses the policy regime affecting agriculture and analyzes the structure of comparative advantage by comparing the economic profitability of various agricultural activities. Chapter 5 extends this analysis by taking a careful look at some key issues for investment planning in agriculture. Finally, Chapter 6 attempts to integrate our f;indings and incorporate them in a forward looking simulation model built to quantify the effects of alternative policy choices. The 1970's marked an important watershed in the role of agriculture in the Egyptian economy. Historically, agriculture has been the dominant sector, accounting not only for the bulk of employment and output, but also crucial in providing foreign exchange earnings and budgetary support. This central role had been underscored by the relatively strong performance of the agricultural sector during the 1952-70 period. The program of land reform and government instituted cooperatives following the 1952 revolution, introduced a measure of dynamism to Egyptian agriculture. During the sixties, agricultural growth gained further momentum reaching an average of almost 5 percent per annum for the decade. The completion of the Aswan Dam in 1965 provided a major impetus by increasing the cropped area and allowing for productivity increases through improved water supply. At the end of the sixties, however, the pace of progress in agriculture faltered. In contrast to the previous two decades, agricultural growth averaged about 2 percent per annum through the seventies. At the same time, demand for agricultural products grew rapidly, following the income growth generated by the "open-door" policy and the emergence of several new sources of foreign exchange earnings. As a result, imports of agricultural goods surged while the surplus of exportable crops was steadily eroded. The overall trade balance for the agricutural sector, which was in surplus of $300 million in 1970, showed a deficit of $800 million in 1977 and $2.5 billion in 1980/81. 1/ This effort draws on the extensive work done on Egyptian agriculture under the leadership of the Ministry of Agriculture, including the various research outputs of the Ford Foundation Farm Management Project and the Ministry of Agriculture - USAID - University of California Agricultural Systems Development Project. Two recent policy oriented documents that require special mention are: Dr. Youssef Wally's statement on "Strategy of Agricultural Development in the Eighties", January 1982, and the Ministry of Agriculture - USAID - USDA report of the Presidential Mission on "Strategy for Accelerated Agricultural Development in Egypt", May 1982. - 97 - Table 3.1 Agriculture Sector Developments: Some Key 1:ndicators 1960 1970 1980/81 Share of Agriculture in Total Value Added (percent) 27.9 25.3 20.0 Agricultural Exports as percent of Total Exports 33.0 25.0 9.0 Overall Agricultural Trade Balance ($ million, current prices) 255.0 300.0 -2500.0 Land - Population Ratio (feddans per person) 1/ 0.21 0.18 0.15 1/ 1 feddan = 1.038 acres The turnaround in the agricultural situation stems from: (i) the fundamental constraint of extremely limited land and the inability so far of large public investments in new lands to significantly add to the productive base; (ii) the progressively worsening situation with respect to the water table and soil salinity resulting from inadequate drainage and poor water management; (iii) the cumulative impact of the goverment's price and production policies, which have distorted the cropping pati:ern and eroded incentives to the detriment of overall productivity; (iv) Labor shortages resulting from increased outmigration from the sector; (v) urbanization and the rapid growth of domestic demand with unabated population growth and the surge in incomes since 1974; and (vi) institutional deficiences in applied research, extension and marketing. Despite its huge land area, only 3 percent of Egypt (6.5 million feddans or 6.74 million acres) is actually cultivable at present. The population density to arable land is one of the highest in the world and the average size of holdings is extremely small. The completion of the Aswan High Dam has raised cropping intensity in the 5.5 million feddans of the Old Valley and the Delta through perennial irrigation, and has allowed the addition of one million feddans of "new" lands. However, a large proportion of the reclaimed lands, about two-thirds, has not been fully productive, partly due to deficiencies in technical design and the "company" approach to managing reclaimed lands. Apart from the limited supply of land, water management has become an important constraint for Egyptian agriculture, perversely enough with the increased availability of water after the completion of the High Dam. In accordance with the traditional pattern, water has been provided free of charge which, with the typical on-off pattern of distribution, has led farmers to over-irrigate, resulting in a steadily rising water table and increased salinity. The deterioration in the soil conditions has prohibited or reduced - 98 - crop production in both old and new lands. By the mid-1970's, it was estimated that about 35 percent of the land was suffering from salinity problems and over 90 percent of the land had problems with the water table. Thus, in order to maintain and increase productivity, the bulk of the cultivable land will require drainage on a large scale. During the 1960's, investment in drainage had been minimal and it was only in the early seventies that a belated start was made in addressing this problem. Another major constraint affecting agricultural productivity is the pervasive government intervention in the sector, which dates back to the 1952 revolution. Paradoxically enough, the principal objective of government policy following the revolution had been to promote agricultural growth. To this end the goverment instituted a major land reform program and introduced a system of supervised cooperatives to promote a more edaphic crop iotation and improve input distribution and marketing. Indeed, the initial impact of this policy was highly favorable in stimulating productivity growth and effecting a broad based commercialization of Egyptian agriculture. It became increasingly evident, however, that given the extremely limited land area, an expansion in the productive base would be required. Accordingly, the government decided to build the Aswan Dam and embark on an ambitious land reclamation program. This investment program placed a heavy burden on the budget at a time when agriculture was itself the principal source of budgetary resources. To mobilize the necessary surplus, the government progressively introduced a system of price and cropping controls, using the cooperatives as the principal conduit of this policy. A system of compulsory planting and deliveries to the government was established in the early sixties, with procurement quotas of 100% for cotton and varied rates for other crops. At the same time, the government nationalized all trade in cotton, which was then Egypt's most important source of export earnings, and the principal cash crop of Egyptian agriculture. Not all crops were affected by the area and direct price controls and notable exceptions included fruits, vegetables and fodder, which has led to an increasingly dualistic agriculture. The policy of price and area controls was supported by the goverment's input distribution policy. The Government of Egypt, as the monopoly supplier of key inputs such as chemical fertilizers, insecticides, seeds, tractors, and, since the early sixties, credit, has used the cooperatives as the sole agency for the distribution of these inputs at the local level. Prices are fixed by the government and the available supplies of these inputs are distributed to the farmer in quantities determined by the cropping patterns set by the government. During the 1970's, a village level network of agricultural banks were created which now carry out many of the administrative functions including provision of credit and distribution of inputs. Crop area controls have been maintained through the seven-:ies, although not imposed as rigorously as in the previous decade. The main instrument of government policy in the seventies has been price intervention, both directly, through the setting of procurement prices for a few key crops, and indirectly, through wholesale price controls and use of imports to dampen demand. Because of the fundamental shift in the overall resource situation since 1974, with the emergence of several new sources of "exogenous" revenue--foreign aid, petroleum, remittances, and the Suez Canzl--the emphasis - 99 - of government agricultural policy has shifted from resource extraction to maintaining stable domestic prices. The increased availability of these new, primarily, foreign exchange based resources, allowed the government to import unprecedented quantities of food to meet incremental demand. This has tended to reduce the urgency of addressing the problems of the domestic agricultural sector and led to a passive agricultural policy for most of the decade. As the lagging performance in agriculture became apparent, the government sought to bolster agricultural prices for basic crops, particularly since 1978, although mostly in a piecemeal manner. While substantial, the increase in prices has not matched the growth of prices and incomes in the uncontrolled agricultural sector and in other sectors of the economy. Consequently the gap between domestic and international prices for the basic agricultural crops actually widened during the course of the decade, reflecting a continued taxation of these crops through price policy. Moreover, net returns in agriculture have been affected even more adversely because of a substantial increase in real wage costs in recent years due to continued outmigration from the sector and growing labor shortages. The policies governing prices and production have had an extremely deleterious effect on agricultural incentives, particularLy since the magnitude of the burden has grown on a cumulative basis. First of all, the government's intervention has distorted the cropping pattern, as farmers have, in spite of penalties, switched to more profitable crops such as berseem, fruits and vegetables. The persistent and very high level of taxation has depressed agricultural incomes and has left little surplus for reinvestment to the detriment of long-run productivity. Finally, because of their central role in implementing the government's controls and extraction policies, the cooperatives have progressively become more administrative and regulatory in nature and their function as catalysts of agricultural growth and innovation has been undermined. Government investment in agriculture has also been very modest during the last decade. While the initial intent of the policy of resource extraction from agriculture was to support public investment within the sector, the surplus generated by the sector was increasingly diverted to general development expenditures, and military and social spending, including support of the government's program of distribution of subsidized commodities to a rapidly growing urban population. In fact, following the completion of the Aswan Dam, public investment in agriculture waned. The share of agriculture, irrigation and drainage in total public investment fell from about 25 percent in the mid-sixties to about 7 percent in the mid-seventies. Moreover, much of the investment, following the completion of the Aswan Dam was targeted to the reclamation of new lands, which unlike the High Dam, had only a limited impact on increasing the agricultural productive base. Meanwhile, the additional supplies of water without an adequate drainage system resulted in problems of waterlogging and salinity, thereby eroding the productivity of the old lands. During the seventies, the government reversed its investment strategy, de-emphasizing land reclamation and initiating a country-wide drainage program. However, relative to the magnitude of the problem, the investment effort was small and not sufficiently supported by a system of adequate maintenance. Since 1979 there has been a moderate resurgence of investment in agricultures. On the public side this reflects the - 100 - resumption of large scale land reclamation efforts after almost a decade of interruption and some pick-up in the government's drainage program. There has also been a substantial increase in private investment but this has been exclusively directed towards mechanization, poultry and livestock fattening. In summary, the principal trends affecting the agricultural sector during the seventies were: (i) very little increase in the overall crop area in contrast to the previous two decades; (ii) increasing problems of waterlogging and salinity, which was one of the factors underlying the poor performance of yields; (iii) except for cotton, virtually no increase in yields for basic crops during the second half of the decade; (iv) widening gap between returns to controlled and uncontrolled crops resulting in a continued increase in the area of berseem, fruits and vegetables at the expense of basic field crops; (v) increased demand for food commodities after 1974, particularly for livestock products, which are relatively more intensive in the use of land. As a result of these underlying trends, there has been a growing imbalance between supply and demand for agricultural commodities. Table 3.2 compares supply and demand trends for the principal agricultural commodities between the periods 1960-74 and 1974-81. Domestic supply, per capita demand and total demand are expressed in average annual percentage growth rates for the two periods. The "gap" between domestic supply and demand growth is shown in the final columns and indicates the magnitude of the demand-supply imbalance during the two periods. It is immediately apparent from the table that, in virtually every case, the gap between demand and supply growth widened considerably after 1974. Also evident--from the difference between per capita and total demand growth--is the general impact of population growth on total demand. What is striking is that not only is Egypt's population growth rate relatively high, but that it has actually increased marginally, from 2.4 percent in the 1960-74 period to 2.6 percent in the post-1974 period. Underlying these general trends are, however, important differences between the various commodities. A more detailed discussion of the factors underlying the performance for individual agricultural goods is provided later in the chapter, but some broad differences among the various groups of commodities can be readily observed. In the case of basic food commodities, the source of the growing imbalance has been a pronounced weakening in supply growth. Demand for these commodities has grown at only a moderate pace in spite of virtually fixed subsidized selling prices, reflecting the low income elasticity of demand and some quantity rationing by the government. One exception was sugar where demand accelerated to 11.6 percent per annum after 1974 from 4.8 percent in the 1970-74 period. Another instance was maize, where both the increase in demand and the relatively better supply performance can be explained by its role as the principal summer fodder and hence, derived demand resulting from the greater profitability of livestock production. Unlike basic food commodities, there has been a marked increase in the demand for livestock products (meat, poultry, fish and dairy) reflecting the rapid income growth that has occurred since 1974. Since these products are mostly uncontrolled, the increased demand resulted in an upward pressure Table 3.2 Demand and Supply Developments for Principal Agricultural Commodities (average annual percent change) 1960-1974 1974-81 Per Capita Total Domestic Demand-Supply Per Capita Total Domestic Demand-Suply Demand Demand Supply Gap Demand Demand Supply Gap Basic Food Commodities Wheat 4.1 6.6 1.8 4.8 3.8 6.4 0.6 5.8 Maize 1.8 4.3 3.7 0.6 3.9 6.4 3.5 2.9 Sugar 2.6 4.8 3.5 1.3 8.9 11.6 2.6 9.0 Beans -3,2 -0.9 -1.5 0.6 -0.2 2.3 -1.6 3.9 Lentils -0.3 2.0 1.1 0.9 1.4 3.8 -29.0 32.8 Edible Oils 3.6 6.1 1.3 4.8 4.6 7.2 0,6 6.6 Exportable Field Crops C Cotton 1.3 3.7 -0.9 4.6 4.2 6.8 1.8 5.0 Rice 2.4 4.9 2.2 2.7 0.3 2.8 1.5 1.3 Onions (winter) 0.7 1.6 0.8 0.8 2.5 4.9 1.3 3.6 Groundnuts -3.4 -1.9 -0.3 1.6 2.9 6.1 3.9 2.2 Fruits and Vegetables Citrus 5.1 7.3 8.3 -1.0 -0.5 2.0 1.4 0.6 PoLaLoes 3.7 6.2 5.2 -1.0 5.9 8.5 7.9 0.6 Tomatoes 1.6 4.1 4.1 0.0 2.5 5.1 5.1 0.0 Livestock Products Red Meat -1.0 1.2 1.6 -0.4 3.8 6.4 1.8 4.6 Poultry 0.1 2.5 2.5 0.0 7.2 9.9 2.8 7.1 Fish -2.9 -0.4 -0.6 0.2 10.2 13.0 4.5 8.5 Milk -0.7 1.7 1.5 0.2 4.9 7.5 1.6 5.9 -102 - on prices. This, in turn, induced a supply response though not enough to close the gap. The supply increase was more marked in the case of poultry and fish, where the land constraint is not a binding factor. Although meat and milk production increased only moderately, it has required a continued expansion of berseem (not shown in the table) and maize area, underlining the extreme land intensiveness of large livestock production. Since, the overall crop area has remained stable, this has occurred at the expense of basic field crops and cotton. Fruits and vegetables are also not directly controlled, and witnessed similar upward pressures on prices with a consequent increase in their crop area (also at the expense of field crops). While vegetable and non-citrus production expanded at a somewhat faster pace after 1974, citrus production increased only slowly in spite of an area expansion because of falling yields. The demand-supply imbalance has been comparatively small for fruits and vegetables. This reflects strong supply performance and the greater role of market prices in regulating demand. Cotton production has shown considerable variability since 1960, but on net, output has shown a declining trend as the area devoted to cotton has steadily declined. This trend was, however, dramatically reversed after 1978 following an almost 30 percent sustained increase in yields, which more than offset the continued shrinkage in area. Demand for cotton by the domestic textile industry, which in 1974 constituted 50 percent of total production, grew at a faster rate after 1974, primarily due to increased domestic consumption of finished products. While supply growth has outpaced demand since 1978, for the cumulative period 1974-81 output growth lagged considerably behind domestic absorption, thus leading to a net drop in the exportable surplus. For the other miscellaneous export field crops (onions and groundnuts), domestic production stagnated particularly in recent years as both crop area and yields declined. Since domestic demand growth grew rapidly, the decline in excess supply (exports) has been very pronounced. The impact of the underlying demand and supply trends on trade performance is shown in Table 3.3, in terms of the level of exports or imports, and self-sufficiency ratios. The overall trend has been one of rapidly increasing imports for primary food commodities and livestock products, and steadily falling exports for the principal exportable crops: cotton, rice, onions, groundnuts and citrus. Only potato exports have recorded a small increase. Correspondingly, except for potatoes, the self--sufficiency ratio (domestic supply as a ratio of total domestic consumption) has uniformly declined. Agricultural exports, which constituted 87 percent of total merchandise exports in 1960 fell to about 35 percent in 1974 and 13 percent by 1981. Food imports, on the other hand, rose from 12 percent of total merchandise imports in 1960 to 22 percent in 1974 and about 25 percent in 1981.. The overall agricultural trade balance moved from a surplus of $255 million in 1960 (9.0 percent of GDP) to a surplus of $120 million in 1974 (1.0 percent of GDP), and to a deficit of over $2.5 billion by 1981 (9.3 percent of GDP). If these trends were to continue unchecked, they would, in conjunction Table 3.3 Trade Performance and Self-Sufficiency for Principal Agricultural Commodities (Exports and Imports in thousands of tons; self-sufficiency in domestic supply or percent of total domestic consumption) 1960 1974 1981 Exports (+) Self- Exports(+) Self- Exports (+) Self- or Sufficiency or Sufficiency or Sufficiency Imports (-) Ratio Imports (-) Ratio Imports (-) Ratio Basic Food Commodities Wheat -624 69.8 -3200 36.8 -5878 24.8 Rice +272 143.9 +136 111.2 +25 101.7 Maize -95 94.0 -388 86.6 -1300 71.1 Sugar +42 114.2 -23 96.0 -580 53.2 Beans +11 lQ0.4 910 S -90 69.8 Lentils -2 92.3 -13 81.2 -85 5.6 Edible Oils -6 95.4 -151 49.7 -355 31.6 Other Exportable Field Crops Cotton +375 400.0 +232 211.0 +165 149.6 Onions (fresh only) +164 170.0 +104 150.0 +40 117.0 Groundnuts +3.8 17.2 +7.4 12.6 +7.5 18.0 Livestock Products Red Meat - 16 94.5 -1 99.7 -125 73.3 Poultry .. 100.0 -1 99.2 - -60 62.8 Fish -7 94.5 -19 92.4 -130 53.6 Milk -85 94.2 -138 92.5 -1150 62.2 Fruits and Vegetables Citrus +20 106.8 +162 120.3 +140 114.0 Potatoes +91 135.1 +100 118.2 +145 113.6 Tomatoes +4 100.4 +2 100.1 +3 100.1 - 104 - with the gradual exhaustion of oil and gas reserves, analysed in Chapter 1, lead to formidable foreign exchange problems for the Egyptian economy. Production Structure and Cropping Pattern While the quantity of land available is very limited, Egypt's agricultural land is highly productive and ideally suited to intensive agriculture. The soils are of great depth and fertility. All of the cultivated area is irrigated and the Nile provides an abundant, and now perennial, source of water supply. Thus, Egypt is spared the vagaries of rainfall, it enjoys maximum sunlight, is endowed with excellent soils, and the sub-tropical climate permits year round plant growth. Under these conditions, it is not surprising that Egypt has an overall cropping intensity of 190 percent and higher yields than virtually all developing countries. Egypt's agricultural land, which constitutes 3 percent of total land area, is limited to a narrow strip along the Nile river from Aswan to Cairo, known as the Nile Valley or Upper and mid-Egypt and the Delta or Lower Egypt which fans out from Cairo to the Mediterannean sea. There are a few oases, the only sizeable one of which is Fayoum. The total cultivated area is 6.5 million feddans of which roughly 900,000 feddans are "new" lands reclaimed from the desert during the sixties. Only about a third of these reclaimed lands are currently productive, which, therefore, has not offset an estimated loss of 500,000 feddans of arable land during the 1960-1980 period due to urbanization. Land holdings are fragmented with 90 percent of the titles less than 5 feddans. Leasing is common so that the average operating unit is even smaller, probably on the order of 2.5 feddans, and because of crop rotations only a fraction is under any single crop. There are two major crop seasons -- winter (November - May) and summer (May - October) -- and a less important Nili or late summer season (August - October). In addition, there are perennial or year-round crops including orchards (primarily citrus) and sugarcane, which is grown in Upper Egypt. Wheat and berseem, produced for both own consumption and sale, are the two most important winter crops. A part of the berseem area is linked to cotton since it is followed by cotton in the summer. This berseem area is of 3-4 month duration to allow for cotton planting, which takes up a full seven months. Long, or full-season berseem, on the other hand, occupies the land for about seven months. In the summer, cotton and rice are the important cash crops, while maize and millets (sorghum) the major subsistence crops. Prior to 1965, because of water unavailability during the summer months, maize was primarily a Nili season crop. But now the greater proportion is grown as a full summer crop with consequently much higher yields. Vegetables, since they are of shorter duration, are grown during all three seasons. Other crops of importance are barley, onions, garlic, soyabeans, groundnuts and sesame. The overall cropping pattern is determined by the government's quota controls and price interventions, the farmer's own consumption needs and his degree of commercialization and by soil limitations and climate. Because of cotton's heavy demand on the soil and to prevent the buildup of pests, farmers have been encouraged to adopt a crop rotation sytem for the basic field crops. The typical crop rotation is a three year system based on three - 105 - principal crops of roughly equal importance, each of which occupies a full seven months: wheat, long berseem, and cotton. In this basic 3-year system, cotton is preceded by a legume 1/ (generally beans or short berseem) in the first year; full season berseem followed by maize or rice in the second year and wheat followed by maize or rice in the third year. The farm is usually divided into as many portions as there are crops in sequence, because of the multipurpose nature of the crops although each portion would typically be incorporated into a large block. In Upper and mid-Egypt, pulses (beans and lentils) sometimes replace berseem as the winter crop. Sorghum or millets may be substituted for maize, in hotter areas, particularly in Upper Egypt, and barley for wheat in the scanty rainfall area of the Mediterannean coast. Where the network provides enough water (primarily in the lower Delta), rice predominates over maize as the summer cereal. Thus, within the overall cropping pattern for the major crops, there is some regional specialization. For minor crops such as groundnuts, sesame, onions and garlic, the degree of concentration is greater since the crop areas are small and limited to just a few governorates in each case. Thus, winter onions are grown exclusively in Upper Egypt, garlic production is concentrated in Minya governorate, groundnuts in Ismailiya and sesame in the Qena governorate of Upper Egypt. While the broad cropping pattern described above depends on several factors including the farmers' own needs and crop rotational constraints, changes in the cropping pattern during the last two decades reflect the shift to perennial irrigation and the impact of government crop area controls and incentive policies. The current system of government-managed cropping pattern evolved after 1952 with the establishment of supervised agricultural cooperatives. Initially, the cooperatives effected influence over the cropping pattern through their control over fertilizers, improved seeds and other inputs. Direct control by the government was instit:uted in the early sixties and formalized in 1966 under Law 53, which gave the Minister of Agriculture authority to regulate the cropping pattern with explicit control over a specified list of crops including industrial crops (cotton, sugarcane and flax), export crops (groundnuts, onions, garlic, potatoes and oranges) and several basic food crops (wheat, beans, lentils, sesame, rice and maize). The Law also authorized the Minister, with approval from the Hligher Committee of Production and Planning, to set compulsory delivery quotas and their respective procurement prices. Although Law 53 gave the Minister wide-ranging authority over the overall cropping pattern, the actual setting of the cropping pattern has been more of an indicative process with close consultations between the Ministry, the local authorities and the cooperatives. At the outset of each agricultural year, the Ministry formuLates a cropping pattern based on target production for t'ie various crops, which is subject to agreement with the local authorities and the cooperatives, and is then formalized as the official or planned cropping pattern. Since it is the production of the delivery crops that is important, implementation of the cropping pattern has focussed on ensuring that milimum area targets for these crops are met, in particular, that for cotton and to a lesser extent, wheat and rice. _/ These are nitrogen-fixing plants which restore the nitrogen depleted by other crops, particularly cotton. - 106 - At the end of the crop season, farmers are required to sell all or specified quotas of their output to the government. In addition to their control over input supplies, cooperatives are empowered to levy fines to enforce crop area targets and delivery quotas. For cotton, sugarcane and soyabeans, all output has to be sold to the government. Raw cotton is Egypt's most important agricultural export, and of course, an input to the domestic textile sector. In addition, cottonseed is the primary oilseed in Egypt and as such used in the production of edible oils and cottonseed cake used in animal feed. Both the spinning industry and the edible oil industries are entirely government owned. For the food delivery crops, the amount that has to be compulsorily sold to the government is set in terms of fixed quantities which varies among governorates and may be periodically altered. Onions, garlic and peanuts are procured solely for export. Rice procured by the government is distributed at subsidized prices to urban consumers and the surplus exported. Other commodities procured for domestic distribution at subsidized prices are beans, lentils, sesame, and wheat. Although maize was included in the list of delivery corps, it has never been subject to area controls or delivery quotas. Potatoes and oranges are not subject either to direct control. However, all exportable surplus for oranges are compulsorily chanelled through public export companies. Since procurement prices have been substantially below world prices, the combined effect of the area controls and forced procurement has been a substantial tax on these crops. The tax has been used to generate direct fiscal revenues from export, to supply low-cost inputs for industry and to support the government's subsidized food distribution program. Naturally, the burden has not been imposed on crops and related agricultural activities which were not subject to government controls such as livestock and poultry, animal fodder production and a large proportion of the fruits and vegetables sector, which has led to an increasingly dualistic agricultural sector. While crop area controls and procurement policies constitute the principal elements of the government's agricultural policy, crop incentives and therefore the cropping pattern, also reflect indirect policy interventions. The regulation of input supplies is one such policy that has been already mentioned. More important, particularly since 1974, has been the government's food subsidy program, through which the government has used large scale imports to support distribution of subsidized food commodities at virtually fixed prices, thereby depressing domestic agricultural prices for these commodities. In the case of agricultural outputs, where there are no direct controls on farm prices such as meat, fruits and vegetables, the government has often imposed wholesale price controls, though ineffectively. The impact of this gamut of policies on the structure of incentives and on the sectoral terms of trade is discussed in detail in the following chapter. Here only the overall impact of these policies which has been to create a widening gap between returns to orchards, vegetables, animal production, and returns to basic field crops are noted. Since area controls have not been imposed rigidly, particularly in the 1970's, this has led to a corresponding shift in the cropping pattern. - 107 - Table 3.4 lists in some detail the crop patterns for the years 1960-63, 1970-73 and 1978-81, while Fig. 3.1 shows the shifts that occurred among the major groups of crops during the last decade. The total cropped area increased by about 8 percent between 1960-63 and 1978-81, reflecting a further expansion in irrigation, new land development and a greater intensity of cultivation. Most of this increase took place in the sixties and the total crop area has shown no increase since 1975. Compared to t:he total increase in crop area, orchard land during this period increased by almost 240 percent and vegetable land by 225 percent. The area devoted to sugarcane, which is a government-controlled perennial field crop grown in Upper Egypt, increased rapidly during the sixties and early seventies reflecting productivity gains with increased water availability, but stabilized in the second half of the seventies as the relative profitability of the crop weakened with a stagnation in yields. Even within the established rotational system of the field crops, significant shifts have taken place. The most important has been the progressive increase in the area devoted to full season berseem from 690 thousand feddans in 1960-63 to almost 1.8 million feddans by 1981. This increase has been at the expense of cotton, whose area declined from 1.8 million feddans in 1960 to 1.2 million feddans in 1981, and secondarily, beans and lentils whose combined area fell from 447 thousand feddans in 1960 to 250 thousand feddans in 1981. This trend has, interestingly enough, eased the rotational constraint imposed by cotton. Among the winter crops, wheat area has remained roughly stable during the entire period. As a consequence of the spread of perennial irrigation after the completion of the Aswan High Dam, the area under summer crops increased more rapidly than for winter crops. The area under rice increased rapidly during the sixties--by almost 550 thousand feddans in absolute terms--following the increased water availability, but has declined during the last decade. The area devoted to maize also increased substantially, but unlike rice, the increase continued through the seventies. This is because the green stalk of maize is used as animal feed during the summer months and thus corresponds to the increase of berseem area in winter, and such reflects the increased derived demand resulting from the higher profitability of animal production. Finally, the continued decline of the non-fodder linked field crops has been even more pronounced in the case of the minor, but relatively important, export crops: groundnuts, onions and garlic. In the following section, we shall examine in more detail the factors underlying the production and trade perforrmance of the various agricultural products. 3.2 Recent Trends and Trade Performance Cereals Cereals constitute the most important group in thes Egyptian crop system, accounting together for almost 43% of the total crop area. There are two winter cereals (wheat and barley) and three summer cereals (maize, rice - 108 - Table 3.4 Area of Major Crops : 1960-63, 1970-73 and 1978-81 (in thousands of feddans) 1960-63 1970-73 1978-81 Winter Crops Full Season Berseem 690 1,570 1,753 Short Season Berseem 1,750 1,232 1,013 Wheat 1,387 1,285 1,374 Broad Beans 365 292 243 Lentils 78 64 21 Barley 128 82 102 Onions 44 32 22 Fenugreek 55 27 26 Flax 27 29 62 Vegetables 49 179 258 Other 83 87 88 Summer Crops Cotton 1,760 1,576 1,182 Rice 791 1,103 997 Maize 271 1,209 1,421 Sorghum 414 462 401 Soyabeans -- 2 94 Sesame 45 40 35 Groundnuts 46 36 30 Vegetables 260 348 492 Other 46 86 98 Nili Crops Maize 1,456 344 482 Sorghum 55 30 15 Vegetables 138 212 256 Other 18 33 35 Total Winter Crops 4,750 4,879 4,954 Total Summer Crops 3,594 5,056 5,000 Total Nili Crops 1,667 619 788 Orchards 147 251 350 Sugarcane 122 194 250 TOTAL CROP AREA 10,270 10,805 11,092 Figure 3.1 SHIFTS IN CROPPING PATTERN: 1970-1981 (PERCENT CHANGE FROM 1970) 40- VEGETABLES FRUITS 20h- / 7 LONG/,PERSEEM /--._ MA} ZE/SORGHUM w U 0_ 0e _LHEAT . ___ _K a. .........~~S. ' ' ' X - - RICE -20- ' .9,* ¢' tt X C?TTON -30~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~- -sel~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ - - --- -1 -40 BEANS & LENTILS -510- X I X 1978 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 YEARS - 110 - and sorghum). Barley is grown in only a limited area on the Mediterranean coast. Wheat is thus the major winter cereal and is grown in virtually all regions of the country. Maize is the principal cereal during the summer, followed by rice and sorghum. Maize and sorghum are both dual purpose crops serving as staple food for the farmers and meeting the fodder requirements of his animals during the summer months. Rice and wheat are grown as cash crops, although on-farm consumption, particularly for wheat, constitutes a significant and growing proportion of output. In recent years output of wheat straw has become almost as important as that of wheat itself due to the generally rising trend of fodder prices. There is a north-south axis of specialization among the summer cereals. In the northern part of the Delta where the soil is heavier and less well drained maize is replaced by rice, and towards the south maize in turn is replaced by the heat tolerant sorghum. In the transitional zone of the south, maize and sorghum are competitive crops as are rice and maize in the north. Table 3.5 indicates trends in output area and yield for the various cereals. Wheat output increased rapidly during the first half of the 1970s in spite of little increase in area. This was largely due to the introduction of high yielding varieties whose share rose at a spectacular rate from 0.3% of total area planted in 1972 to 37% in 1974. Since then the area under high yielding varieties declined at an equally sharp rate, falling to 0.1% by 1980 because of a host of difficulties encountered. While yields of high yielding varieties have been almost 20% higher than other varieties, they are subject to greater variance. High yielding varieties (HYV) also require higher labor inputs and cash, and the value of the straw is less. Furthermore, harvest time is more critical than for other varieties and, therefore, HYVs are more susceptible to the labor and equipment shortgages of the peak season. Perhaps the most serious drawback of the imported HYVs was their lack of resistance to rust disease under local conditions. In recent years the government has miade an effort to introduce locally developed hybrid varieties but so far they have not matched the yields of imported HYVs. As shown in Table 3.5, maize output rose rapidly during the 1960s in spite of a large decline in area. This reflects the important technological change that took place when water became available in the summer from the Aswan High Dam. Prior to that maize was primarily grown in the traditional flood (Nili) season. The percentage grown in the summer was less than 5% of the total maize area, although yields for the summer crop were 70% higher. Following the increased availability of water, summer maize rose to 75% of total acreage by 1970 with a consequent increase in average yields. Maize yie:Lds showed little increase throughout most of the 1970s but the total area increased by almost 400 feddans during the decade. This reflects the greater profitability of maize due to its role as the principal summer fodder. This role has also led to an increase in the lower-yielding Nili season crop in recent years because of a shortage of fodder during the late summer months. It has also prevented a major expansion in the area of hybrid maize since these higher yielding varieties do not serve such a dual purpose role. Hybrid maize account for only 15% of the total summer crop, although grain yields are more than 20% higher. 111 - Figure 3.2 PRODUCTION, CONSUMPTION AND.TRADE OF CEREALS: 1978-1981 WHEAT 7- 8-. 04- 3)M 2.6- PRODCPUCON 2- - ,- I I I 1978 1071 t972 1075 1974 2075 1976 1077 1978 1079 1988 I081 YEAR R-ICE MAIZ 5.8- 4.5- 4.8- VCNP.WmTIVt -3.8- 2.5- 2.9- 1.5 8.9- t978 t171 1972 1979 1874 107X; 1978 2977 1978 1070 1082 1981 IrAS - 112 - Table 3.5 Cereals : Trends in Output, Area and Yields (computed on the basis of 3-year moving averages and expressed as annual percentage change) 1960-70 1970-75 1975-81 Wheat Output - 0.4 6.0 - 0.5 Area - 1.0 0.2 0.4 Yield 0.6 5.8 - 0.9 Rice Output 5.7 - 2.2 0.4 Area 0.5 - 2.6 - 0.7 Yield 5.2 0.4 1.1 Maize Output 3.4 2.4 3.0 Area - 1.8 2.9 1.5 Yield 5.2 - 0.5 1.5 Sorghum Output 3.7 - 1.1 - 3.9 Area 1.0 - 0.4 - 3.0 Yield 2.7 - 0.7 - 0.9 Sorghum, like maize, experienced a once and for all increase in yie:Lds during the 1960s linked to the shift in the growing season from Nili to summer, but during the 1970s both area and yields declined resulting in a 26% faLl in output during the decade. This was partly on account of the loss of better areas to maize and sugarcane as well as due to diminishing land productivity stemming from inadequate drainage. The increase in water availability during the summer also permitted a major expansion in rice area in the 1960s. Yields have risen steadily to a level where they are among the highest in the world. The increase in rice production was not sustained during the 1970s as the crop area steadily declined due to the relatively lower profitability of rice with respect to maize. In addition to its importance as a domestic food grain and, until recently, as an export earner, rice is valuable as a reclamation crop in new lands during the salt leaching phase of development. Research efforts have resulted in the introduction of several new varieties with even higher yields and greater pest resistance. Egypt is a net importer of wheat and maize and, until recently, an exporter of rice. With a population growth rate of over 2.5 percent, increased urbanization and lagging food grain production, the domestic food - 113 - supply situation has deteriorated. Rice and wheat production remained absolutely flat in the second half of the seventies. Incremental demand had thus to be met through imports in the case of wheat, and through a reduction in the exportable surplus in the case of rice (Fig. 3.2). Presently, domestic wheat production is just barely sufficient to meet the needs of the rural population, who have so far by and large benefitted less from the highly subsidized distribution program. For rice, a similar two-t:ier pricing system exists, but until now, domestic procurement by the government was sufficient to cover urban needs and allow for some exports. By 1982, however, this exportable surplus had been completely eroded, and a persistence of recent trends would soon lead to Egypt becoming an importer of rice. This would have a strong negative impact on the budget since import prices are almost two and one-half times greater than prices currently being paid to Egyptian farmers. Unlike wheat and rice, human consumption of the ccarse grains (maize and sorghum) is limited only to rural areas. A large (estimated at one half) and increasing proportion of output of these grains is used to feed animals, which'is the underlying factor in the continued increase in their aggregate area and production. Nevertheless, with the surge in commercial poultry and calf-fattening operations, domestic production has not been. able to meet animal feed requirements. The government has closed the gap by importing maize which it supplies to animal and poultry feed mills, and secondarily to individuals, at subsidized prices. Maize imports, which were negligible in the early seventies have reached an estimated 1.4 million tons, or 30% of total consumption, by 1982. Cotton 1/ Egypt is a relatively small cotton producer, growing only 5 percent of world production, but it is a major cotton exporter, particularly of longer-staple varieties in which production is concentrated. Currently, Egypt accounts for about 30 percent of world trade in long-staple cotton and its share of extra-long staple is about 60 percent. Cotton has played a pivotal role in Egyptian agriculture, and indeed, in the Egyptian economy for over a hundred years. It is the principal cash crop and the focal element in the cotton-rotation system, and until recently, was the principal source of export earnings. Since 1965, there has been a secular decline in the area planted to cotton. This reflects the heavy tax imposed on the crop, and farmers have switched to more profitable crops in spite of government area controls and fines. Total cotton area declined from 1.9 million feddans in 1960/61 to 1.2 million feddans in 1930/81 and only just exceeded 1 million feddans in 1981/82. Cotton yields rose substantially in the second half of the 1960's but then declined during the 1970-75 period. 1/ This analysis draws on a special paper on Demand for Egyptian Cotton prepared by M. Thigpen in January 1979 (IBRD draft pape:r) and the research outputs of the Egyptian Cotton Study component of the Ministry of Agriculture - USAID - University of California Agricultural Development Systems Project. - 114 - Since then, yields have risen progressively, particularly after 1978. Among the reasons cited for the recent impressive performance are: elimination of marginal areas with lower yields as the total crop area has progressively fallen, an excellent breeding program, more effective pest control, and, significantly improved crop incentives since 1978. Reflecting the underlying trends in area planted and yields (Figure 3.3), cotton lint production fell from an average level of 507 thousand tons in 1969-72 to 381 thousand tons in 1975-78, but then rose to an average level of 513 thousand tons in 1980-81. The recent yield performance has been so spectacular that cotton production reached a record level of 529 thousand tons in 1980 despite a 40 percent cumulative decline in area during the last two decades. Figure 3.3 AREA, PRODUCTION AND YIELD OF SEED COTTON: 198-1l981 178- liA- Ice YIELD1 148- 12e- Be- 88- IMC I90 t Q04 IQ80 I9GM 1970 1972 1Q7.4 1978 1978 1089 YEAFt Within this overall trend, there have been important compositional shifts among the different staple length varieties, as indicated in Table 3.6. There are three staple length varieties of cotton grown in Egypt: extra-long staple, long staple and medium staple cotton. In the 1964-66 period, long-staple cotton accounted for only 26.3 percent of total production; by 1980/81 its share had increased to 73 percent, whereas the medium staple variety which comprised almost 30 percent of the cotton produced in 1964-66, was virtually eliminated by 1980-81. The increase in long-staple (LS) cotton has also to some extent been at the expense of the extra-long staple (ELS) varieties, particularly after 1978. A striking trend during the recent period of rapid overall yield increases has been the narrowing in yields between ELS and LS cotton. Historically, yields of ELS have been more than 20% lower than that for LS cotton, but they have increased at a faster rate recently, so that the gap is now less than 5%. Reflecting these improved - 115 - yields, ELS production recorded large increases in 1979 and 1980. Because of the difficulties in marketing the additional surplus and build-up of stocks, the government has cut back the crop area under ELS, which has resulted recently in an absolute fall in production (from 167 thousand tons in 1979 to an estimated 110 thousand tons in 1982) and has reduced the share of ELS in total production to less than 25%. Table 3.6 Cotton Production Trends by Staple Lengths (annual averages) 1964-66 1969-72 1975-78 1980-81 '000 m.t. per cent '000 m.t. per cent '000 m.t. per cent '000 rn.t. per cent Extra-Long Staples 213.1 44.0 205.0 40.4 146.2 38.3 123.5 26.1 Long Staples 118.4 24.4 167.5 33.0 155.8 40.8 373,3 70.7 Medium Staples 153.2 31.6 135.3 26.6 79.9 20.9 16.4 3.2 TOTAL 484.7 100.0 507.8 100.0 381.9 100.0 513.2 100.0 Domestic mill consumption of cotton at present amounts to about 60% of total production. Egypt was one of the first countries in the region to develop a textile industry. For many years, this industry has produced virtually all the cotton yarn and cloth to meet domestic requirements and, since the 1950's, cotton textile exports have become an important source of foreign exchange earnings. Deliveries of cotton to Egyptian mills increased at an average rate of 3.3 percent per annum between 1960 and 1974, but since then, have averaged almost 6 percent. Since exports of yarn and finished textiles have remained relatively flat during the 1970's, the more rapid increase in textile output is accounted for by a surge in domestic demand. As in the case of many other commodities, the acceleration in domesitic demand of textiles since 1974 reflects the overall rapid growth of incomes in the post-1974 period and the government's policies of subsidization and price controls on a large proportion of finished products. To offset the impact of output price controls, selling prices of raw cotton to domestic mills have been adjusted at a slower rate than either the increase in export prices or prices paid to the farmer. By 1981, these selling prices were about 48 percent of the export price in the case of extra-long staple cotton and 45 percent for long staple cotton, and were even lower than the cost of procurement from the farmer. Declining production and increasing domestic consumption have until recently led to a steadily falling availability of cotton exports. The fall was most pronounced during the 1970-78 period with both production falling rapidly and consumption growing at a faster rate (Figure 3.4). The turnaround in production since 1978 has resulted in a moderate recovery of exports. Total exports of cotton amounted to 160 thousand tons during the 1980/81 - 116 - season and an estimated 208 thousand for 1981/82, compared with 140 thousand tons in 1977/78 and 318 thousand tons in 1970/71. While substantial, the increase in exports since 1979 has not kept pace with the growth of the exportable surplus, resulting in a more than doubling of stocks during 1979-81 and substantial losses due to poor storage conditions. 1/ This, in turn, has induced the government to reduce further the area planted to cotton. Figure 3.4 PRODUCTION, EXPORTS AND MILL CONSUMPTION OF CO7TON LINT: 1965-1982 E . 1 sm- ~ ~ ~ ~ A Staes Egpts Ishaei world exta-on stapl cotto market hastdcie stapleainegypt' powndexprs inreasedow unti 1978.t Thorisg is because doesgtic maieisconsu ptio ias treadtive alyyintensive ze in the longoandmediumrstaple vtariecoties.However,othe shif sinces179i productionn txowrdsr long-hsetapmle hihqaiycotton.atotherexpeseoo extralogrtaple cottoudn, hasreucend the relatied Sae.Eytsshare of thel extra-long staple vaitcn hxortable surplus han deledtine evene futher mdeclines (inue35 10,atog the export of extra-long sal otn millornaumptore dtisrledtiscussiontofsthe sntock build-up problem seepl Hecke-rman, D., HI. Khedr and H. Kheir-el-Din, "Problems of Cotton Stock Accumulation: Overpricing vs. Excess Supply", Ministry of Agriculture - University of California ADS Project (draft). - :117 - Tab-Le 3.7 Cotton Exports According to Staple Lengths (annual averages) 1964-66 1969-72 1975-78 1980-81 '000 m.t. per cent '000 m.t. per cent '000 m.t. Per cent '000 m.t. per cent Extra-Long Slaple 201.2 58.9 174.7 57.0 101.8 68.6 91.0 55.8 Long Staple 177.2 34.4 118.2 38.5 46.5 31.4 72.0 44.2 Medium Staple 22.7 6.7 13.8 4.5 0.0 0.0 0.0 0.0 TOTAL 341.1 100.0 306.7 100.0 148.3 100.0 163.0 100.0 During the last two decades there have been major shifts as well in the direction of cotton exports in response to changes in Egypt's overall trade orientation and market trends in the consuming countries. Table 3.8 indicates the broad trends in the direction of cotton exports. The industrialized countries, and those of Western Europe in particular, have been the traditional markets for Egyptian cotton. However, with the decline of the textile industries in these countries and increased competition from synthetic fibres, exports of cotton to the developed countries as a whole fell to 29 percent of Egypt's total cotton exports in 1970 from 70 percent in the 1950's. Table 3.8 Direction of Cotton Exports (as percent of total exports) 1951-53 1970-73 19375-77 1980-81 Developed Countries 71.3 35.2 41.0 51.9 of which: Western Europe 57.4 24.0 24.0 35.5 : Japan 4.6 10.7 16.3 15.8 Centrally Planned Economies 13.4 53.2 55.5 45.5 of which: USSR 3.4 29.8 16.7 0.0 : China .. 4.1 9.3 16.8 Developing Countries 15.3 11.7 3.5 2.6 of which: India 13.1 8.7 1.5 0.0 - 118 - During this period the Centrally Planned economies replaced the industrialized countries as the principal customer for Egyptian cotton. Exports to the Soviet Union alone comprised about 30 percent of Egypt's cotton exports in this period. Since the mid-1970's, however, there has been a marked reversal in this trend. The developed industrial countries now once again account for the greater share of Egypt's cotton exports, although the Centrally Planned economies remain an important market. Exports to the Soviet Union were discontinued after 1977, but China has become a major client accounting currently for about 17 percent of total exports. In the past, a very large proportion of sales, particularly to the Centrally Planned economies, were in terms of bilateral currency agreements. But now, with the exception of China, virtually all payments are made in convertible currency. Sales to the Centrally Planned economies are still governed by bilateral agreements, which have to be periodically negotiated and as such are more subject to year-to-year fluctuations than sales to industrialized countries which are determined through a market process. Exports to developing countries are presently quite small as Egypt's only significant market was lost with the development of long staple production in India. The marketing authorities, though, have recently stepped up their efforts to find markets among the new textile producers of South East Asia. Because of the relatively small size of the international markets for the longer staples of cotton, in which Egypt specialises and has had traditionally a large share, considerable attention has been focussed from the point of view of trade strategy on the twin issues of: how much cotton should Egypt produce and according to what varietal mix. The debate has been intensified by the marketing difficulties encountered during the 1979-81 seasons, particularly for ELS cotton, and the resulting build up in inventories. On the one hand there is the growing impression that the markets for Egyptian ELS are specialized and limited and that there is little potential for a substantial increase in exports. At the same time there is a general reluctance to cut back cotton production, in which it is felt Egypt has a natural comparative advantage. At the core of this debate is the issue of the long run elasticity of demand for Egyptian cotton. In order to address this issue we need to examine: the specific end-uses of Egyptian ELS cotton, as well as the structure of the overall cotton and related fibre market. The primary characteristics of Egyptian ELS cotton are the strong, fine, long staples that make them particularly suitable for producing sewing thread and for spinning the highest quality combed cotton yarns. The manufacture of sewing thread is by far the single largest end-use of ELS cotton at present in the importing countries. Yarns produced from ELS are used for fine apparel fabrics, laces, embroidery fabrics, knitted goods, household fabrics and industrial cloth. ELS cotton is not a unique import in these uses and can be substituted for by other fibers, including shorter staple length cotton as well as synthetic fibers. In the case of sewing threads, the principal substitute is high-tensile polyester fiber and synthetic core yarns coated with lower quality cotton. There is an even greater potential for substitution in the production of fine quality and specialized yarn. Although its greater staple length gives ELS an inherent advantage in the spinning process, innovations in the spinning and cloth industries have made it possible to substitute longer staple varieties with shorter staples or synthetic fibers for virtually any kind of finished product. - 119 - As a result of the greater substitution possibilities, there is now much closer linkage between the various staple lengths as well as synthetic fiber markets. A recent analysis of the international cotton market!! has empirically demonstrated that: (i) the markets for different staple lengths of cotton are well integrated, with, as expected, the closest linkage between staples of proximal length, and (ii) the price premia for particular staple lengths appear to be fairly stable reflecting their superior quality and cost advantage in the production of yarns. This would suggest that the demand for any staple is highly elastic at the margin, particularly Dver a span of time. An effort to maintain a high premium in the short run through restricting exports would only lead to an eventual substitution by other varieties. Since this substitution often involves a once-and-for-all adjustment in equipment, it cumulatively undermines the inherent cost advantage of the longer staple varieties and progressively reduces demand. The integration of the cotton market also suggest that if the premium is maintained in lint with the quality and cost advantage of the longer staple, so that price competitiveness is maintained, the long-run demand would be fairly elastic and an increase in exports result in a small but not a substantial drop in price. Many of the structural changes that took place during the 1960s and 1970s, and that have led to increased subsitutability within the fiber market, were motivated by true innovations such as the emergence of low-cost yet versatile synthetic fibers and the introduction of new product lines based on man-made fibers, but the large scale substitution of ELS by shorter staples and synthetic fibers also reflects the consistently high price premia on ELS during this period. Table 3.9 indicates the magnitude of the premia on Egyptian long staple and extra-long staple cotton over other cotton varieties. Egyptian cotton has clearly been the most highly priced in its respective staple categories. In recent years though there has been a marked narrowing trend between the prices of Egyptian cotton and other varieties as a result of increased competition. Apart from increased substitution by other staple and synthetic fibers, key developments that have affected market demand for ELS are: the loss of two principal markets -- the Soviet Union and India -- as both these countries have increased production to cover their own import needs, and the stagnant growth of the textile sectors in the industrialized countries. Until the mid-1970s the Soviet Union and India together accounted for about 40% of ELS exports. Increased domestic production of ELS varieties in these countries have allowed them to attain self-sufficiency by 1977. Exports of ELS to industrialized countries have shown a declining trend reflecting, in addition to widespread substitution, the shift in world textile production to the newly industrializing countries. Until now, these new textile producers, have been a minor market for ELS cotton. As a result of these trends, global demand for ELS has declined since the 1960s. The rate of decline accelerated after 1975, and by 1981, demand had reached its lowest point since the 1950s at 175 tons compared with about 300 tons at the beginning of the 1970s. 1/ Monke, Eric and Todd Petzel, "Integration of the International Market for Cotton", Working Paper 4, Agriculture Development Systems Project, Ministry of Agriculture - University of California. - 120 - Table 3.9 Cotton : International Price Differentials by Staple Length (period averages in percent) 1973-78 1979-80 1981-82 Egyptian ELS Premium Over: American ELS 22 16 10 Peruvian ELS 91 61 57 Egyptian LS 15 13 15 Mexican MS 102 71 67 American SS 124 88 88 Egyptian LS Premium Over: American MS 74 45 43 Mexican MS 77 52 45 American SS 95 66 64 The decline in demand was matched during most of this period by a drop in supply, as the exportable surplus fell in the two principal exporting countries, Sudan and Egypt. Accordingly, there has been only a modest adjustment in the price premium on ELS cotton. Egypt's exports of ELS declined at a faster rate than world exports during the 1960-78 period with a consequent decline in its share of the world market. Following the large yield increases since 1979 Egypt's exportable surplus rose sharply. Despite a downward adjustment of the premium for both ELS and LS varieties, only 75% of the exported surplus could be marketed during 1979-1981 reflecting slack overall demand due to the loss of the Soviet and Indian markets and the generally depressed conditions in the world economy. In 1981 the premium on both extra long staple and long staple cotton was adjusted further downwards. Together with the continued fall in Sudanese ELS production, this has resulted in a 30% increase in exports during the 1981/82 season from the previous two years and almost 90% more than the levels of the mid-1970s. A large part of the increase was for long staple varieties. Nevertheless, Egypt's share in the world ELS market has risen once again to almost 60%. From the preceding discussion on the structure of the international cotton market and of recent trends, we can summarize the important issues affecting Egypt's long term trade strategy in cotton. Firstly, ELS and LS varieties do enjoy a certain long run quality premia in terms of their prices. It is possible to maintain this premia at a higher level in the short run but this would only result in an eventual loss of market. There is no -- 121 - Figure 3.5 EGYPT'S SHARE IN TOTAL WORLD ELS EXPORTS: 1SBS-1982 4 a 12N- D Wa. MSEX S~ ~~EPQ lOSo 1067 1Iw9 1071 11073 Iwo 1977 1079 1a1 YEARS specific indication on the magnitude of this long run premia, but recent market surveys suggest that the longer staple varieties are competitive on the basis of existing relative prices. While the price premium is higher, the greater the staple length, yields tend to be inversely correlated, with yields generally greater for the shorter staple varieties. The recent experience in Egypt, however, suggests a significant narrowing in yields between the long staple and ELS varieties. If this trend is due to varietal factors and not the reallocation of marginal land, Egypt could still profitably expand its ELS area. In general for any two staple lengths, the relative profitability is determined by the relationship of the price premia to the yield difference. A final issue relates to the use of long staple cotton by domestic mills in production of coarser yarn. Two possibilities for substitution exist: importing short staple cotton to release the longer staple variety for export, or producing the higher yielding short staples in Egypt itself.l/ Efforts to introduce such varieties are currently underway but so far with not much success. Large scale production of short staple cott:on in Egypt would require technological adjustments in the ginning mills from the present cylindrical rollers to serrated ones. Savings of foreign exchange by importing 1/ The principal varieties under consideration are the American Macnare 220 and 235 varieties which are of short staple length and with extremely high yields. - 122 - medium and short staple cotton could also be substantial. At current levels of production and based on general magnitudes for the elasticities of demands, the foreign exchange gain could be as much as $50-$60 million. 1/ Based on these considerations, the key elements in Egypt's trade strategy for cotton should be: (i) ensuring long run price competitiveness of Egyptian cotton vis-a-vis other staples; (ii) increased marketing effort towards the new textile producers as these countries shift their production to finer quality products, (iii) substitute where possible short staple in domestic consumption, and (iv) explore using ELS in new products for export. Pulses (Beans and Lentils) While relatively small in terms of area and total production, pulses constitute an important part of the Egyptian diet. Fava beans (broad beans or foul) are the most important, followed by lentils. Minor pulses include chickpeas, lupines and fenugreek. Pulses are grown primarily in Upper Egypt, and among all crops, have perhaps been the most adversely affected by problems of drainage. Yields of beans declined by about 10 percent during the second half of the seventies, while, in the case of lentils, yields declined by more than 35 percent. Table 3.10 Trends in Area, Production and Yields of Major Pulses (area in '000 feddans, production in '000 m.t. and yields as tons/feddan) Beans Lentils Area Production Yield Area Production Yield 1960-64 365 282 0.77 77 48 0.62 1972-74 283 289 1.02 69 56 0.81 1980-81 241 211 0.88 13 6 0.43 This has affected the relative profitability of the crops and has led, in spite of several price increases, to a declining trend in crop area during the last: decade. The combined effect has been a marked drop in production, particularly of lentils. Consumption of both beans and lentils has fluctuated considerably during the last decade, and has shown no significant trend, 1/ See Chapter 10 for an analysis of domestic resource cost and comparative advantage in Egyptian cotton textiles. - 123 - probably in part due to quantity rationing by the governme!nt. Nevertheless, because of the downward trend in production, imports have risen, particularly after 1978. By 1981, domestic production of lentils had fallen to only 5% of total consumption, while, in the case of beans, imports accounted for almost a quarter of total consumption. During the last season (1982), production and government procurement of beans recorded substantial increases reflecting the large increases in producer prices announced by the Government, thus allowing Egypt to once again gain self-sufficiency in this crop. Sugarcane Next to cotton, sugarcane is the most important industrial crop and a major field crop of southern Egypt. Three governorates -- Minya, Qena and Aswan -- account for 93 percent of the total area planted. With increased water availability, sugarcane area has expanded rapidly from 96 thousand feddans in the early 1950s to 196 thousand feddans in 1970-72, and has stabilized since the mid-1970s at a level of about 250 thousand feddans. Since sugarcane is grown for three annual harvests, it is not part of the usual crop rotation system. Table 3.11 Trends in Area, Production and Yields of Sugarcane (area in '000 feddans, production in '000 m.t. and yields as tons/feddan) Area Production Yield 1960-64 122 4,726 38.73 1965-69 145 5,635 38.86 1972-74 201 7,360 36.62 1977-79 248 8,399 33.87 1980-81 251 8,544 34.03 Yields declined by about 15% during the last decade as a result of the expansion of sugarcane into marginal area, deterioration of cane varieties, poor soil drainage and growing labor shortages. Nevertheless, average yields are still among the highest in the world. M4ost of the sugarcane is grown under contract, and production is generally limited to milling capacity. About 6.5 million tons of sugarcane is currently processed by the sugar industry, or about 85% of existing capacity. Domestic production of raw sugar from sugarcane reached 695 thousand tons in 1981. This was also the first year of sugar production from sugarbeet. A first: plant for processing sugar beet has been recently set up with an eventual capacity of 100 thousand tons. Production in 1981 amounted to 20 thousand tons, based on a sugar beet area of 10 thousand feddans. Since sugar beet: is a seasonal crop and can be grown over a more widespread area, including lower Egypt, the government has been encouraging the expansion of this crop. - 124 - Domestic supply of sugar has been unable to keep pace with consumption in recent years largely because of the high income elasticity of demand for sugar. All sugar, both for household and industrial consumption is distributed by the Supply Authority. A part of the sales to individuals is on a ration basis at a highly subsidized price, and the remainder at a higher but stiLl regulated price. To close the demand-supply gap, the Supply Authority has been importing increased quantitites of sugar. Thus, from having reached a position of a net exporter in the early-1970s, Egypt by 1981 had to import 600 thousand tons of sugar, or almost half its total sugar consumption. Figure 3.6 PRODUCTION, CONSUMPTION AND IMPORTS OF RAW SUGAR: 1970-1981 1.2- CONSUMPTM.N )e.8- 1978 1971 1972 197S 1974 1976 1970 1977 1978 1070 1988 1981 YEAFt Oilseeds and Products In addition to its fibre-producing role, the cotton plant is also the source of the most important oilseed in Egypt. In fact, until recently, cottonseed was the sole oilseed to be processed domestically, and the entire edible oil industry was based on its production. Cottonseed output declined during 1970-77 following the secular decline in cotton area, but recovered substantially since 1978 due to the large increase in yields. Apart from cottonseed, soyabeans are the only other oilseeds that are processed by the edible oils industry. It is a relatively new crop, but the total area has expanded rapidly from 3 thousand feddans at the beginning of the 1970s to 110 thousand feddans in 1981. The quick proliferation of - 125 - Table 3.12 Trends in Area, Production and Yields of Cottonseed and Soyabeans (area in '000 feddans, production in '000 m.t. and yields m.t./feddan) Cottonseed Soyabeans Area Production Yield Area Production Yield 1970-72 1568 892 0.57 3 1 0.40 1974-76 1349 698 0.52 10 6 0.61 1980-81 1211 834 0.68 96 111 1.15 soyabean area reflects the extremely attractive incentives provided to farmers and the exemption given to soyabean producers from the cotton area controls. Currently, about 80 percent of industrial edible oil produ,tion is from cottonseed and 20 percent from soyabeans. About 20 percent of the soyabeans is still imported, since soyabean processing capacity at present exceeds domestic output. Domestic production of edible oils remained flat during the last decade, with increased soyabean availability offsetting thes decline in cottonseed production. Consumption, on the other hand, has grown at a rapid rate leading to a doubling of imports during the last decade. All industrially processed edible oil is distributed by the Supply Authority, and the bulk of the sales on a rationed basis but at highly subsidized prices. The present annual consumption of edible oils is 450 thousand tons of which about one-third is locally produced and the rest imported. Table 3.13 Trends in Output for Ecdible Oils and Byproducts ('000 m.t.) Edible Cottonseed Soyabean Oils Cake Meal 1970-72 124 374 n.a. 1974-75 148 293 n.a. 1980-81 140) 347 72 Other than edible oils, an important by-product of cottonseed and soyabean processing is the solid residue, or protein meal, which is a major component in processed animal and poultry feed. - 126 - Figure 3.7 PRODUCTION, CONSUMPTION AND IMPORTS OF EDIBLE OIL: 1973-1981 2-_ . / 8 - :s- I I /\/,FI II lea~~~~~~yv 1070 IS71 1972t 1Q73 94 IQ7S 1Q76 197 1078 1Q79 192 96 Flax, like cotton, is a dual purpose crop for fiber and oil. The fiber is used by the linen industry and flaxseed is the main source of vegetable oil for the paint industry. Both area and yields of flax have shown an upward trend during the last decade with a consequent increase in flax and unflaxed output. Flaxseed production reached an average level of 260 thousand tons in 1979-81 compared with 80 thousand tons in the early 1970s. Other minor oilseeds include groundnuts, sesame and sunflower. None of these are at present commercially processed in significant quantities. Both groundnuts and sesame are subject to compulsory deliveries. Groundnuts are procured entirely for export, while sesame is procured for domestic distribution by the Supply Authority. Due to weak producer incentives, the area under groundnuts declined from 42 thousand tons in 1970 to 28 thousand tons in 1980-81. With only a moderate increase in yields, production, and hence the exportable surplus, have declined concomittantly. Table 3.14 Trends in Area, Production and Yields of Other Oilseeds (area in '000 feddans, production in '000 m.t. and yields in m.t./feddan) Sesame Flaxseed Groundnuts Area Production Yield Area Production Yield Area Production Yield 1970-72 41 22 0.53 26 12 0.48 38 27 0.71 1974-76 30 15 0.50 49 25 0.50 31 22 0.70 1980-81 39 17 0.42 60 32 0.53 28 20 0.72 - 127 - The area under sesame has shown considerable fluctuation during the decade, but on net, has remained roughly the same. Like most crops in Upper Egypt, sesame has been affected by faLling yields resulting from poor drainage. Consequently, production declined by almost 20 percent during the decade, despite very large price increases in recent years. About 30 percent of sesame production is procured for domestic distribution., and until the early 1970s was sufficient to meet urban consumption needs. With the fall in production, the government has been forced to meet its distribution needs through imports, which increased to 22 thousand tons in 1981, or about 56 percent of total consumption. Animal Fodder Egyptian clover, or berseem, is the only important forage crop grown in Egypt. Total area under berseem amiounts to about 2.8 million feddans, or 25% of the total cropped area. This is more than the combined area of its two principal competitors, wheatŽ and cotton, which together account for 2.4 million feddans. Berseem is grown as a winter fodder and to enhance soil fertility, before and after cotton. Several cuts can be taken during the course of the season. If one or two cuts are taken the crop is referred to as temporary clover, and can be followed by cotton. If a full four cuts are taken, the crop is followed usually by a summer cereal, either maize or rice. Since maize is the major source of green fodder during the summer, it tends to be linked to trends in the berseem area. Total berseem area has increased only slightly during the 1970s. But, the share of full-season berseem has increased from 55 percent in early-1970s to 63 percent by the end of the decade. Since full season berseem output is almost two and one-half times greater than that of the temporary season crop, this implies a total increase in berseem production of about 15 percent taking into account estimated yield increases. Although yields are high, it should be possible to produce more fodder with less land because no breeding efforts have been made, and, as in other instances, drainage is limiting yields. To alleviate the shortage of green fodder meat production is relying increasingly on processed animal feed. About 1.4 million t:ons of animal feed concentrate was produced in 1981. A typical concentrate consists of: 45% cottonseed cake or soyabean meal, 20% maize, 25% wheat bran, 5% rice bran, 3% molasses and 3% minerals and salts. Poultry feed production has also increased rapidly since 1975 in response to a widespread proliferation of commercial poultry operations, reaching almost 600 thousancd tons in 1981. Poultry feed typically consists of 60% corn, 20% soyabean meal and other residues. Both animal and poultry feed are distributed primarily through government channels at highly subsidized prices. - 128 - Figure 3.8 TRENDS IN BERSEEM AREA: 196S-1981 2.76- 2.2>- 92.2Z- |2.88- FULL SESISON BEkSEE - . 7s I t I I a06m 1067 1060 1971 107S 1076 1977 1979 106t YEARS Onions and Garlic These are both minor field crops, but traditionally important because of their high export value. The bulk of the exports are from the winter season crops because of their higher quality and water content and greater export demand during this period. For both crops, production is concentrated in a few governorates, primarily in mid- and Upper Egypt. The shift to perennial irrigation has led to a rising water table and a higher incidence of diseases which have adversely affected yields. Farmers are required to meet fixed delivery quotas for both crops but additional quantities are also procured. All exports are channeled through El Nil and El Wadi companies, the two public sector export agencies. Controlled procurement prices and the decline in yields have eroded profitability of onions, leading to a decline in the main crop area of about 33% over the last decade. This has to some extent been offset by an increase in the practice of interplanting onions with other crops. Garlic area and production increased moderately through the last decade but output has still not reached the level of the mid-1960's. Exports have declined steadily for both onions and garlic because of growth in domestic demand and low procurement prices. In response to this trend, the government has sought to strengthen producer incentives but so far without a major inpact on production and exports. - 129 - Tab:Le 3.15 Trends in Area, Yields, Production and Exports of Onions and Garlic (area in '000 feddans, production and exports in tons and yields in tons per feddan) Onions Garlic Area Yield Production 1/ Exports Area Yield Production 1/ Exports 1965-66 50 7.6 380 155 17 5.9 99 57 1970-72 31 7.8 259 89 8 7.4 66 13 1974-75 27 9.7 300 85 12 7.5 59 18 1980-81 20 8.4 929 40 14 8.0 66 10 1/ Includes interplanted crop output. Meat and Dairy Animals, in Egyptian agriculture, are not just a source of meat and milk production, but provide draft power as well for lifting water, land cultivation and transport. In these latter functions though they are being increasingly replaced by machines as the relative scarcity of land has pushed up the opportunity cost of maintaining animals for draft purposes alone. Meat and milk prices have generally not been controlled and many production inputs including animal feed haVe been heavily subsidized. This has favored livestock production and led to an increased demand for animal fodder. Since crop residues are limited and there is virtually no rangeland available, livestock production is dependent on animal fodder grown onl fully arable land. Currently, about 25% of winter land is tied to the production of animal fodder and an estimated 20% of the crop area during the summer. Meat thus competes more directly with food crops in Egypt than in moSt countries. Labor shortages and increased returns to meat and milk production have given a major impetus to the mechanization of several key farm operations in recent years. In contrast to just a few years ago virtually all land preparation is tractorized, as is the threshing of wheat. Traditional animal powered sakias for lifting water are also being replaced by mechanical pumps though at a slower pace. Most farmers though continue to rnaintain animals as they serve as a store of wealth and as collateral necessary for obtaining credit. Over the longer term the shift towards mechanization can be expected to improve the efficiency of meat and milk production. In spite of the release of animals through mechanization and greater fodder availability, meat production has grown at only a slightly faster rate after 1974. This reflects the intrinsically high land intensiveness of livestock production and the overall low levels of livestock productivity in Egypt. Production of red meat amounted to 340 tons in 1981 compared with 302 - 130 - Figure 3.9 PRODUCTION, CONSUMPTION AND IMPORTS OF MEAT: 1 97B- 198 . ' ' / ~~~~~~~~0HLf7:=N am 107 1071 1972 187S 1074 107 176 1207tQ7 1078 1070Q 1a08 1081 thousand tons in 1974 and 284 tons in 1970. On the demand side, urbanization and income growth have resulted in an accelerated growth of consumption, approaching 7% per annum after 1974. Per capita demand which fell from 9.8 kg in 1.960 to 8.8 kg in 1974 has consequently risen to 10.8 kg by 1981, although still relatively low by international standards. The rapid increase in demand led to a sharp upward trend in prices. In October 1980 the government established price ceilings at the wholesale and retail levels but these have not been rigorously implemented. Since 1980 the government has also substantially increased the level of imports for distribution at subsidized prices through urban cooperatives. A similar trend in production, consumption and, hence imports, have characterized milk as well. Production of milk rose to 1.8 million tons in 1981 from about 1.6 million tons in 1970, but consumption has grown at a much faster rate, so that imports, which were negligible in 1970 reached 1.1 milLion tons on a reconstituted basis by 1981. Poultry production is not constrained by land availability and has consequently witnessed a more rapid rate of growth than livestock production. Poultry meat production is currently about 140 thousand tons of which more than two-thirds is chicken meat. Egg production amounts to about 2.4 billion table eggs. As in the case of red meat, poultry meat consumption grew rapidly since 1974. -- 131 - Figure 3.10 PRODUCTION, CONSUMPTION AND IMPORTS OF POULTRY: 1970-t 981 2- 28- I I t178 t971 t172 IQ7S 1974 1075; 19176 1077 1078 17W I08 1081 YEAF4 The sector has witnessed a major transformation during the past decade. During the 1960s, the informal village section accounted for almost 90% of the total supply of chicken and eggs, whereas, presently, commercial poultry operations provide more than half of domestic supply. The government established the first commercial scale poultry operation, the General Poultry Company, in the mid-1960s, which accounts for the bulk of commercial poultry production. Since the mid-1970s the sector has also witnessed a big surge in private investment. Indeed, the poultry sector has been one of the most dynamic elements in the resurgence of private investment. The bulk of domestic lending for agroindustries in recent years has been directed to poultry and egg production, and poultry ventures accounted for 26% of investment outlays for agroindustries and 10% of total investment within the Law 43 framework. Several of the commercial poultry operations that have been initiated are fully integrated, with boiler and laying houses, feed mills, hatcheries and slaughter plants. Compared with other agricultural activities, poultry production is capital intensive rather than land intensive. For larger plants and feed mills, most of the equipment and know-how is imported. Production inputs also have a high import content. Maize and soyabean meal, the two principal components of poultry feed, are imported by the government and sold to feed mills at subsidized prices. Parent stock for broiLer and egg production and antibiotics are at present also mostly imported. The import of inputs and capital equipment have allowed domestic production to expand at a faster rate, but in many of these areas there is considerable potential for import substitution in the medium term. - 132 - Poultry production is well suited to the Egyptian situiation given the severe constraint on land. At the margin, poultry production is three times more efficient than red meat in terms of energy conservation from feed. Because of the rapid proliferation of commercial poultry operitions, the technology is now quite well understood in Egypt. Furthermore, the short breeding cycle allows a quick improvement in stock and gains in productivity. With time, many of these learned skills should be transferable to the farm sector as well. Fish Egypt's fishery resources consist of both marine and inland sources. Marine resources supply about 15% of annual fish production, and are comprised of the coastal areas of the Red Sea, the Gulf of Suez, the Mediterranean, and to a limited extent, the outer seas. The total marine catch declined during the 1970s from a peak of 60 thousand tons in 1964 to a pres3ent level of about 30 tons. The principal factor underlying this decline has been the reduction in the flow of nutrients carried by the Nile with the construction of the Aswan Dam, which has reduced the sustainable yield along t:he Mediterranean coast. Inland water fisheries account for more than 75% of the current annual production of 150 thousand tons. Inland fishing Ls carried out on littoral lakes, man-made lakes, the Nile and its tributaries, and more recently, on fish farms. The littoral lakes are already heavily fished and their area is being progressively reduced with silting and reclamation for agriculture. Of the two large man-made lakes, the catcn from Lake Qarun has been declining steadily due to rising salinity, while Lake Nasser's current catch (about 23 thousand tons) is close to its estimated maximum yield. Fish farms now cover an area of about 35,000 feddans, mostly in the Delta, and produce about 15% of domestic fish output. Of all the aquatic resources, fish farms hold the greatest potential for increased fish production. The Nile Valley and Delta offer several factors suitable for fish culture, including large tracts of flat land too salty or alkaline for crop production, favorable climatic conditions, indigenous, fish species well suited to these conditions, adequate soil for water retention and an irrigation and drainage network providing good control of water flows. Modern fish farming though is still relatively new in Egypt, and hampered by institutional weaknesses, lack of operational experience, unclear land use policies and lack of key inputs. If these constraints can be eliminated fish production could be an important source of animal protein, since like poultry, it does not compete for scarce land. In Chapter 6, we discuss the economic viability of a typical fish farm. Because of the decline in the marine catch, fish production fell from 120 thousand tons in 1960 to 110 thousand tons ir, 1974 but has increased to a present level of almost 150 thousand tons with thie development of the inland fisheries. As in the case of other animal produets, consumption has increased at a faster pace after 1974, so that imports have risen from 19 thousand tons in 1974 to 130 thousand tons in 1981. A large proportion of these imports are sold through government channels at subsidized prices. - 133 - Fruits The toVal area planted in fruits rose by more than 50% during the 1970s reflecting the relative freedom of domestic prices and the absence of government controls. Once an area is registered as an orchard it is exempted from all cropping requirements. Total fruit area presently amounts to just over 360 thousand feddans of which citrus alone accounts Eor 55%, mangoes 8%, grapes 16%, bananas 4% and guavas 4.5%. Most fruits are produced for domestic consumption. Table 3.16 Trends in Area, Production and Yields of Major Fruits (area in '000 feddans, production in '000 tons and yields in tons per feddan) 1970-71 1974-75 1980-81 Area Produjction Yield Area Production Yield Area Production Yield Oranges 119 637 5.4 133 838 6.3 162 908 5.6 Mandarin 14 137 6.3 15 93 6.3 17 72 4.3 Lemon 9 ()7 7.8 10 53 5.5 18 66 3.7 Grapes 33 ill 3.4 40 223 5.5 56 298 5.1 Mangoes 25 63 2.4 23 89 3.9 28 111 3.9 Guavas 10 44 4.5 12 70 5.7 17 109 6.5 Bananas 10 88 9.1 12 111 9.6 16 135 8.9 TOTAL 246 279 368 Only citrus fruits, and some special varieties of mangoes are exported. However, several fruits such as grapes, bananas and apples are import substitutes. Citrus fruits constitute almost 40% of the value of total fruit production and oranges are the principal fruit within this group. Oranges also comprise the bulk of all fruit exports. Prices for citrus fruit per unit area tend to be less than for other fruits because of wholesale price controls imposed by the Ministry of Supply and the relatively low procurement prices paid for exports. Consequently, although citrus area recorded a substantial increase during the 1970s, tne rate of growth was less than that of total fruit area. Citrus yields like other fruits, tend to show large annual variation. The general trenc discernable within the annual fluctuations is one of a large increase in yields in the first half of the 1970s and a general stagnation thereafter. Thus, average yields for oranges during 1980-81 were 5.6 tons/feddan compared with 6.3 tons/feddan in 1974-75, and 4.3 tons/feddan in 1970-71. The continued area increase has offset the weak yield performance somewhat, so that production of oranges soar from 830 thousand tons in 1974-75 - 134 - to about 910 thousand tons in 1980-81. Consumption has also grown at a more moderate pace during this period, but nevertheless, leading to a drop in the exportable surplus from an average of 190 thousand tons in 1974-75 to 120 thousand tons in 1980-81. All citrus exports are processed by the El Wadi CompEany, a public sector company under the Ministry of Economy. A recent Bank loan helped expand processing capacity to about 325 thousand tons, which is at present underutilized because of the fall in exports. El Wadi procures oranges on a contract basis as well as from post seasonal purchases. Two grades of oranges are procured, a high quality grade for export to Saudi Arabia and the EEC and a somewhat lower grade for export to the East European countries. Table 3.17 indicates the direction of exports for oranges. The Eastern Bloc, and the Soviety Union in particular, remain the largest customers of Egyptian oranges, but the Arab countries have become an increasingly important market as well. Exports to Arab countries now comprise 27% of total citrus exports compared with 5% in the early 1970s. Prices received on sales to these latter countries tend to be the most favorable. Exports to Western Europe have declined in both absolute and relative terms. Although the world's largest import market, competition is much stiffer than in other markets. A major impediment to the expansion of citrus exports is pricing policy. Low controlled domestic prices have encouraged more rapid growth of consumption and reduced relative profitability. While prices paid by El Wadi for citrus exports are higher than domestic prices, the differential does not Table 3.17 Export of Sweet Oranges by Destination, 1980 Quantity Percent ('000 tons) EEC 15.9 11.0 Eastern Europe 83.6 58.0 of which: Soviet Union 72.7 50.4 Arab Region of which: Saudi Arabia 25.6 17.8 North Yemen 11.4 7.9 Asia 6.1 4.2 TOTAL 144.2 100.0 - 135 - sufficiently reflect the additional cost of special inputs required for exportable oranges and the risks associated with the variability of yields. Since citrus production is relatively labor intensive, overall incentives have also been adversely affected by rising labor costs. Adjusting both domestic and export procurement prices should be given high priority. Some liberalization oij domestic prices would strengthen producer incentives and regulate the growth of domestic consumption. An even greater upward adjustment is warranted for exportable citrus on the basis of current world prices so as to encourage production for exports. Although Egypt is a relative]Ly small exporter compared with countries such as Spain, Morocco and Israel, it possesses several important advantages. In addition to its fertile land, Egypt: is climatically the: most favored country for the production of early season oranges, for which export demand is the greatest. Its proximity and cultural links to the Arab world are also to its advantage. Although current exports to the EEC are small, prospects for further growth may be affected by the accession of Spain and Portugal to the EEC. The magnitude of the impact is unclear and may be more than offset by development of alternate markets. In any case, in the medium term, net domestic supply rather than demand is likely to be the determining factor in the level of exports. Possibilities for exporting industrially processed citrus products also exist and are discussed in Chapter 9. In 1981 about 6,000 tons of oranges were processed into juice, mostly for exports. Other than oranges, fruit exports are negligible consisting of small amounts of grapefruit, lemons and mangoes. Vegetables Like fruits, vegetables have been one of the most rapidly growing components of Egyptian agriculture. As short duration crops, vegetables are grown during all three seasons and production is concentrated around metropolitan areas. Total area under vegetables expanded from 500 thousand feddans in the early 1960s to 700 thousand feddans in 1970 and reached 1140 thousand feddans in 1981. Of the present total winter vegetables covered 318 thousand feddans, summer vegetables 525 thousand feddans and Nili vegetables 294 thousand feddans. Production includes an extremely wide variety of vegetables. Tomatoes, potatoes and watermelons are the principal vegetables produced. Onions and garlic, though vegetables, were discussed in a previous section, since unlike other vegetables they are government controlled crops. Table 3.18 indicates trends in output, area and yields for the principal vegetables during the past decade. With both area and yields recording continuous increases, production of vegetables showed larger gains than other field crops. - 136 - Table 3.18 Trends in Area, Production and Yields of Major Vegetables (area in '000 feddans, production in '000 tons and yields in tons per feddan) 1970-71 1974-75 1980-81 Area Production Yield Area Production Yield Area Production Yield Tomatoes 242 1,595 6.6 302 1,918 6.4 328 2,460 7.5 Potatoes 71 499 7.0 97 714 7.4 163 1,215 7.5 Watermelon 72 720 10.0 99 1,099 11.1 116 1,142 9.9 Cucumber 28 165 5.9 35 211 6.1 46 250 5.5 Zucchini 46 345 7.5 31 168 5.4 57 442 7.8 Haricot 23 78 3.4 46 250 5.5 70 256 3.7 Cabbage 28 280 10.0 33 310 9.3 36 364 10.0 Eggplant 24 220 9.3 24 216 8.8 33 290 8.9 Green Pepper 17 120 6.9 18 120 6.7 25 169 6.9 TOTAL 708 805 868 Tomatoes, which are grown during all three seasons reached a production level of 2.4 million tons in 1980-81. Production of potatoes has reached 1.2 million tons of which about half are grown in the summer and half in the Nili season. A large proportion of the seed for the summer potato crop is still imported, mainly from Holland and the U.K. Virtually all vegetable production is targeted to domestic markets. Potatoes are the only exception where exports have fluctuated around 140 thousand tons for the last several years. Two countries, the U.K. and Holland account for virtually all potato exports. The principal competitors for these markets are Cyprus and Greece. Following complaints about poor quality from British importers, the government sponsored Potato Grower Cooperative has strengthened quality control. Tomato exports are small in absolute terms and lower than what they used to be in the early 1960s. Exports in 1980-81 averaged a paltry 3 thousand tons directed mostly to the Arab countries. Export of water melons, which have a lucrative market in the Gulf, have averaged 12 thousand tons in recent years. Various other fresh vegetables are exported in small quantities. These include green beans (principal market: Holland), artichokes (Arab countries), green peppers (Western Europe and the Arab world) and green peas (U.K. and the Arab world). Except for potatoes, most vegetable exports are air freighted with consequently very high transport margins. The institutional framework underlying the export of vegetables is extremely weak. Only in the case of potatoes is there a moderately effective organizational set up. An umbrella organization, the Potato Growers Cooperative (PGC), oversees the supply of inputs and is responsible for storage, grading and marketing. The PGC does not export directly but uses the services of private exporters as well as the public El Nil Company. - 137 - The El Nil Company also handles small quantities of fresh vegetable exports. It has recently been equipped with modern facilities for packing and grading but exports of fresh vegetables by the company have not shown any significant increase. The private sector accounts for 70,' of exports of fresh vegetables. While only a few firms are responsible for the bulk of private sector exports, they are nevertheless too small to reap any economies of scale. Production is dispersed and supplies are erratic so that the exporters maintain only an infrequent presence in the market. Exporters usually buy tomatoes and fresh vegetables from individual farmers and manually grade, size and pack them in the fields. Adequate infrastructure and handling facilities including machine sizing equipment, refrigerated transport: and efficient port handling are lacking. Another constraint in the export of vegetables is the large number of government agencies affecting export policies, including t:he Ministries of Agriculture, Supply, Economy, Finance and the Central Bank. Two supervisory committees have been established to enhance coordination: one for potatoes, onions, garlic and dried crops, and the other for fresh vegetables, flowers medicinal and aromatic plants. The committees are essentially regulatory in nature, setting minimum 'prices' which are used as benchmarks for evaluating foreign exchange earnings, and ensuring that exports do not impinge on domestic supplies. In the extreme case exports of an item are completely banned for the season. Both of these policies undermine flexibility and hamper development of exports. For most vegetable exports, Egypt faces the typical dilemma of the small exporter. On the one hand, it is difficult to create markets given the lack of reliable supplies. At the same time, production for exports is restricted by lack of adequate infrastructure and marketing outlets. One solution, given the diffuse structure and domestic orientation of production, is to create enclave production zones just for export. Initially, such efforts would have to be commercial operations, and, therefore on new lands, to ensure smooth linkages between production, domestic handling and marketing. Several such efforts are underway including a 2000 feddan farm for producing tomatoes solely for export. The latter is part of a joint-venture operation with a U.S. company using the latest technology developed in Southern California, and with expected yields of 18 tons per feddan, or 240% greater than current average yields in Egypt. Such effort augment scarce capital resources in agriculture, and should be encouraged. Moreover, the technologies learned may eventually have a spillover effect on the more traditional agriculture. As in the case of fruits, Egypt possesses several, natural advantages for the export of vegetables. Its fertile soil, excellent: climatic conditions yet variability between different zones allow it to efficiently produce a wide range of horticultural products with a great deal of flexibility in terms of seasonal timing. It can thus fully adjust to the large seasonal variations in export demand. Its proximity and links to the Arab world are also important assets. The other large potential market for Egypt's exports is the EEC. Egypt's share of horticultural export's to the EEC is at present very small, except for potatoes, and to a lesser extent, onions. Egypt's competitive - 138 - position is likely to be adversely affected by the accession of Greece, Spain and Portugal to the EEC. The magnitude of this impact is uncertain. One analysis on the impact of EEC expansion on Egypt's agricultural production and trade,l/ indicates that EEC expansion will affect the potential development of Egypt's fruit and vegetables exports substantially, and make increases in exports more difficult. Another study,!/ based on overall supply and demand balances for the EEC in the medium term, suggests that prospects vary considerably among commodities and that both growth and price prospects may be quite favorable for several commodities including some in which Egypt specializes such as; potatoes, onions, oranges and green beans. Some of the adverse impact of EEC expansion could of course also be offset, if Egypt could succ:essfully negotiate new trading agreements with the EEC, particularly for key commodities such as potatoes, onions and oranges. In summary, Egypt should pursue a multifaceted approach towards the development of horticultural exports. Integrated commercial operations should be encouraged, but they are not likely to impact on the bulk of the agricultural sector. If small farmer based horticultural exports are to be expanded, a more effective marketing system has to be set up. Apart from government delivery crops, the only successful case of bulk exports is potatoes where the Potato Growers Cooperative plays a dominating role in providing inputs, packing facilities and marketing outlets. A similar cooperative for vegetables (Union of Producers and Exporters of Horticultural Crops) was established in 1972, but did not succeed in reaching a viable scale of operations. The principal constraints were: weak management, inadequate processing facilities and poor export marketing in part due to inflexible regulations. In spite of past experience, given the need for an extensive collection network, the cooperative marketing approach is still probably the only possibility for developing broad based horticultural exports. This will need a closer examination of the institutional set-up (both of the cooperatives and the marketing companies) and of government regulations, as well as a detailed market survey, in order to identify specific policy actions. An additional issue in the expansion of vegetable production and exports is the availability of water on a timely basis. Vegetables are relatively water intensive, and with the water constraint increasingly binding, greater attention has to be placed on monitoring its use and improving the efficiency of the overall system. While many challenges have to be addressed for Egypt to make a breakthrough in horticultural exports, the returns would make the effort extremely worthwhile. This coverage of vegetables completes the review of recent trends and analysis of trade performance for all the principal agricultural commodities. In the following chapters we shall focus on future development strategy and 1/ von Braun, Joachim and Hartwig de Haen, "Egypt and the Enlargement of the EEC," Food Policy, February 1982. 2/ "Fruit and Vegetables Exports from the Mediterranean Area to the EEC," World Bank Staff Working Paper No. 321, March 1979. - 139 - prospects for the sector. Chapter 4 analyzes the structure of incentives and resource costs in agriculture with an objective to providing insights on comparative advantage and directions of price reform. Chapter 5 provides an overview of investment allocation in the sector including planned allocations in the medium-term. We also analyze a few typical agricultural projects using the framework developed in Chapters 1 and 2 to illustrate some key issues of investment allocation. Finally, Chapter 6, summarizes the key issues of trade strategy and investment planning in the sector and examines growth and trade prospects using a comprehensive medium-term projection model. - 140 - Chapter 4 Incentives and Comparative Costs in the Agricultural Sector: A Selective Overview 4.1 Macroeconomic Environment and Sectoral Terms of Trade Given the limited possibilities for further expansion in the land base, a key factor in improving agricultural performance will be adjusting incentives to allow for a more efficient use of limited resources. In this chapter we analyze the incentives issue at the sectoral and at the crop level and examine comparative costs and returns for different crops and cropping patterns. Our objective is to provide a good analytical description of comparative advantage and incentives in Egyptian agriculture so as to identify directions for policy change and to provide an empirical basis for project selection and investment planning within the sector. During the 1960s, the principal influence on agriculture was government intervention, characterized by a conscious policy of resource extraction. In the 1970s government policy has been more passive and agricultural trends have been shaped by changes that have occurred in the overall macroeconomy and in the international economic situation since 1974. The key developments that affected the agricultural sector were: the progressive opening of the economy since 1974 and liberalization of segments of the domestic economy. the emergence and dramatic increase of new foreign exchange resources, which in turn, sustained a rapid pace of economic growth. the surge in international commodity prices resulting in a significant improvement in the international terms of trade of agricultural commodities after 1973 which has to some extent been reversed after 1980. the buildup of inflationary pressures in the domestic economy resulting from excess demand due to the more rapid growth of incomes, a widening of fiscal and monetary gaps, and the acceleration in world inflation. a large and growing program for the distribution of food commodities at virtually fixed prices targeted at mainly the urban population to offset the effects of rising inflation. support of this program through large scale imports of food commodities which have led to growing import dependence and indirectly depressed domestic agricultural prices. continued outmigration from the sector with greater opportunities for emigration and sustained rapid growth of the non-agricultural economy, leading to an accelerated growth of real wages in agriculture. - 141 - and, in response to the above trends, a progressive upward adjustment in agricultural crop prices in recent years. In this section we examine the impact of these developments on the agricultural sector at the aggregate level, and in subsequent sections of this chapter we analyze the effects on incentives and comparative costs at the crop/activity level. A summary measure of shifts in aggregate incentives is the sectoral terms of trade, or the change in agricultural prices in relation to prices in other sectors of the economy. Figure 4.la indicates the increase in aggregate crop prices during the 1970s compared with the increase in the prices of manufactures and services during the same period. The aggregate crop price index covers all field crops with the exception of orchards. Although meat and dairy products are not represented in the index, berseem, whose price is closely linked to that of livestock products, is included. The manufactures and services price index was derived from the official wholesale and consumer price indices. Weights were based on rural expenditure patterns. From Figure 4.la it would appear that agricultural crop prices increased at a faster rate than non-agricultural prices, particularly after 1978, suggesting a marked improvement in the sectoral terms of trade. However this conclusion is subject to important qualifications because of: (i) large variations among different crops: (ii) the understatement of uncontrolled items in the manufacturing and services price index; (iii) the more rapid increase in the rural cost of living than in other sectors, and (iv) a dramatic increase in real wages since 1978. Underlying the overall trend of the increase in agricultural prices during the past decade are large variations among different groups of crops, as evident from Figure 4.1b. In particular, the upward adjustment in prices of controlled crops over the cumulative period has been significantly less than the increases recorded by uncontrolled crops such as f-ruits, vegetables and berseem. Even in recent years, when the government has raised prices of controlled crops by relatively large orders of magnitude, the overall increase barely matched the price increases in the uncontrolled secl:or. Just as there has been a widening gap between controlled and uncontrolled prices in agriculture, some prices in the non-agricultural economy have been regulated, while others in the newly liberalized segments of the economy have grown rapidly. The official price indices are heavily weighted towards controlled items, and tend to understate the rate of inflation. Thus, the manufacturing and the services price index in Figure 4.la does not fully reflect the acceleration in inflation in the non-agricultural economy, suggesting a somewhat smaller gap in effect between the two indices. Another trend that makes the recent shifts in the agricultural terms of trade less favorable than it first appears is that the rural cost of living has risen at a faster rate than its urban counterpart (Figure 4.lc). This reflects the fact that the government's food subsidy program is mainly directed to the urban areas. The ruraL sector relies on its own production and markets to meet a substantial proportion of its needs for basic food commodities. An increase in crop prices has an immediate cffsetting effect on the rural cost of living, whereas there is no immediate link between agricultural output prices and urban consumer prices with the exception of uncontrolled items such as meat, dairy:, fruits and vegetables. - 142 - Figure 4.1 KEY INDICATORS OF AGRICULT'URAL PRICES AND INCOMES (a) (b) 1970-108 1972-182 588-- 788- CROP PRICE 488- 080- INDICES 308-~~ P/R 408 I - CROFPR J '. 288 - . - , 38- FIT 7/,; a- X ss_~~~~~za HANUFACMMRS & NDIXX tD4*- 1078 1072 1974 1070 1Q76 l0w 178 1072 1074 1070 1078 106 (c) (d) t97(-188 198-188 688 Aa-URAL WA788. 0U3~~~~~~~~~~~~~~~~~~~~~~~~~~0 488 ~ ~ ~ ~ ~ ~ ~ ~ ~~~~38 2|51 RURAL CPU E / 1070 1072 1074 1078 1078 to0 1Q78 1072 1074 1078 1978 I OS - 143 - Reflecting the large increase!s in prices and some gains in yields, nominal crop incomes rose rapidly (Figure 4.1c and Table 4.1). Real incomes have grown at a more moderate pace. Since 1974, growth in real crop incomes averaged about 2% per annum which is considerably less that the economywide growth of real income of about 8% per annum during the same period. Also, an increasing proportion of agricultural incomes have gone to labor. Following continued outmigration from the sector, real wages have risen sharply in recent years, with a consequent increase in labor costs and a corresponding decline in returns to other factors of production, notably land and capital. The acceleration of real wages with respect to crop prices and crop incomes is shown in Figure 4.ld. Non-labor incomtes have consequently increased at a slower pace than total incomes in nominal terms, and real non-labor incomes declined sharply during the second half of the 1970s (Table 4.1). Of course, the increase in labor costs has had a differential impact on crops as demonstrated in the next section. At the aggregate level,'the slow growth in crop incomes and the weak returns to land and capital have eroded overall incentives in the sector and have left little surplus for reinvestment within the sector. TabLe 4.1 Growth in Total Crop Incomes and Non Labor Crop Incomes (annual percent increase during period) 1970-75 1975-81 Total crop incomes nominal 10.8 15.9 real 0.6 2.0 Non labor crop incomes nominal 12.1 10.7 real 1.8 - 3.0 While the sectoral terms of trade discussed above captures in broad terms the impact of shifts in domestic prices on the agricultural sector, it does not reveal the magnitude of the net tax (or subsidy) on agriculture arising out of the divergence between "market" or observed prices and "economic" or efficiency prices. This divergence is quite important in the case of Egypt because of the pervasive government intervention in the economy. Chapter 2 described the analytical framework underlying "economic" or "accounting" prices and provided an extended list of economywide accounting ratios which define the relationship between economic and market prices. Since these accounting ratios represent the economic cost or benefit of using or supplying an additional unit of the commodity in terms of their market prices, they also indicate the net tax or subsidy underlying prevailing market prices. The final section of this chapter discusses detailed accounting ratios for agricultural commodities as part of the overall evaluation of - 144 - comparative costs and returns in Egyptian agriculture. Here, only provide some summary measures of these accounting ratios are provided in order to evaluate the aggregate impact of price policies on the sector. Most agricultural outputs and inputs are traded, so international prices serve directly as the benchmark for the respective accounting ratios. Summary indicators of the mean accounting ratios for agricultural outputs and inputs, as well as the net tax on agriculture, are given in Table 4.2 for four interspersed years of the 1965-1981 period. Although we have attempted to capture the magnitude of the distortions in the individual years, the comparability of the results needs to be qualified because of major changes in the underlying economic structure and in price and exchange rate regimes that occurred over this period. From 1965 to 1972, international prices for agricultural commodities were generally depressed. Thus, in spite of a more active policy of price and area controls, the overall tax on outputs was small, although there was a small tax on inputs as well during this period largely due to higher domestic prices of fertilizers. The mean accounting ratio of outputs rose sharply in 1975 following the upward trend in international commodity prices since 1973. International prices of inputs also recorded a sharp increase after 1973, primarily for fuel and fertilizers, leading to a net subsidy on agricultural inputs. Nevertheless, because of the small share of production inputs in gross output, the net effect was still a substantial tax on the agricultural sector. Table 4.2 Net Taxation of the Agricultural Sector Mean Accounting Ratios Agricultural Agricultural Net Tax Outputs Inputs Rate 1965 1.11 0.89 7% 1970 1.05 0.95 3% 1975 1.33 1.35 12% 1981 1.34 1.60 14% Between 1975 and 1981, domestic crop prices rose at an annual rate of 14.5% per annum, but as we noted above, this was probably not significantly above the overall economywide rate of inflation. On the other hand, the general rate of inflation in Egypt during this period has been much more rapid than in the international economy, necessitating a progressive devaluation of the Egyptian pound. A multiple exchange rate system has usually been in force, and the highest exchange rate (in terms of $ to LE) has been applied to agricultural exports and imports. Currently, for instance, agricultural exports and imports are converted at the Central Bank exchange rate (LE 0.70/$) compared with the commercial bank exchange rate of LE 0.84/$ which applies to the bulk of intermediate and industrial imports and a free market - 145 - exchange rate of over LEl/$ for most private sector imports. There is thus a large tax on agricultural exports and import substitutes through the use of the higher exchange rate. In our calculation of accounting ratios we have used the average exchange rate for the period. The more riapid growth of domestic agricultural prices compared with increases in corresponding international prices over the 1975-1981 but are expected to recover somewhat in the medium term. It should also be noted that international commodity prices weakened substantially in 1981, and though they fel'L further in 1982, international prices for most agricultural commodities are expected to rise substantially in the medium term from the 1981 levels. The subsidy rate on inputs increased further between 1975 and 1981 as the gap between domestic and international prices of fuel and fertilizer widened because of virtually no adjustments in controlled input prices. On net, the overaLl tax on the sector remained substantial at about 14%. 4.2 Comparative Costs and Returns to Land in Egyptian Agriculture Methodology Underlying Analysis of Comparative Costs At the core of our analysis of comparative advantage in the agricultural sector are the twin concepts of private and social (i.e. economic) profitability and the concomitant distinction between market and economic (shadow) prices. We saw in Chapter 2 that in Egypt actual prices are very far from reflecting the underlying economic values. In agriculture in general, tariffs, taxes, price controls and quantity controls make product prices and input prices very imperfect measures of economic: opportunity costs. In addition subsidized credit introduces further divergences between market and shadow prices. These considerations which were addressed in some detail in Section 4 of Chapter 2, often imply that resource allocation made on the basis of market incentives may be economically inefficient and consequently reduce social welfare, while activities which improve welfare are insufficiently rewarded. In this chapter we combine the estimates of economic prices presented in Chapter 2 with micro-economic data from the agricultural sector in order to analyze relative eff-iciency and international competitiveness in Egyptian agriculture. A productive activity is efficient if the economic value of its output exceeds the economic opportunity costs of the commodities and factors of production employed in producing it, If the full time profile of inputs and outputs is known and a suitable time discount rate is applied to costs and benefits occurring at different points in time, the net present value of any economic activity or project (actual Or- proposed) at full economic prices provides the correct measure of its net contribution to social welfare. Economic activities with positive net present values are efficient. In agriculture, particularly in Egypt where the land is highly versatile, there is virtually full mobility of factors among different cropping activities. The agricultural system is thus like one giant factory (or a composite of many small ones) which can produce a range of outputs (crops) given its available resources of land, labor and capital and subject to various technical constraints. There are thus two levels at which the issue of resource allocation has to be addressed. The first is the aggregate - 146 - one in which one would evaluate the social profitability of investment in agriculture by examining the full time profile of inputs and outputs. This is the issue that we are confronted with when analyzing alternative investment projects in agriculture, as we do later in Chapter 6. The present value criterion is well suited to carrying out such an analysis. The second issue of resource allocation is the choice of crops that should be produced with given endowments at a point in time. This is the issue of comparative advantage and the one we address in the remainder of this chapter. The present value criterion cannot be used for this analysis because we need a single period efficiency measure. Our point of departure in defining such a single period efficiency measure is the unit economic profit criterion: - ~~n B. .- A~. P. - Ef P J = pi L En j Pi s EJ (1) Unit Economic Economic Economic Economic Price per - Value of - XValue of Profit Unit Intermediate Prilil.ry Inputs Inputs Where Pj, Pi and Ps are the shadow price of output j and commodity and factor inputs used in the production of j in terms of border prices, and a and fsJ are the input output coefficients for commodity inputs and factors of production. Crop activities are judged efficiently if the level of unit economic profit, Bj, is non-negative. Assuming all inputs and outputs as tradable and no divergence between the value of public and private income, we can interpret the first two terms in expression (1) as the "value added at world prices" per unit of output: NIA = PI =1 This represents the annual net addition to national income, evaluated at the opportunity costs of established world prices. The third term represents the opportunity cost of factor inputs evaluated at economic prices. When the opportunity cost of factor inputs exceeds the net addition to national income, unit economic profits are negative, and the resources employed could be more efficiently used in their best alternatives. The unit economic profitability provides an absolute measure of social profitability. It cannot however indicate relative efficiency of different crops because its value varies with the price of each output. An efficiency criterion which provides both an absolute and relative measure of social profitability is the domestic resource cost ratio (DRC) which is - 147 - expression (1) rewritten as the ratio of domestic factor costs (the final term) evaluated at economic prices to value added at world prices. This is the criterion generally used in analyzing comparative costs in studies of industry. The domestic resource cost ratio measures the amount of "net" foreign exchange that domestic resources can generate for the firm or activity in question. If this rate of transformation exceeds one, the opportunity cost of domestic factors of production (in terms of foreign exchange) exceeds the addition to value added at world prices by these factors and the net benefit criterion would turn negative. 1/ To use the DRC criterion, we would need to define an accounting price for land. Land is a non-traded primary factor of production that cannot be decomposed into tradables and other primary factors. Its economic value is therefore determined by its alternate uses. If we assume that agricultural land does not have non-agricultural uses that exceed econcimic returns in agriculture, then the accounting price of land is determined by alternate returns to various crops. However, because of complex interrelationships among crops, the determination of the accounting price of land is not straightforward. Crops use land for different lengths of time and at different times during the calendar year. Thus, once a crop is grown on a piece of land, it automatically limits the use of that land during the remainder of the year. In some instances, the constraint is even more rigid, so that the crop can only be preceded (or succeeded) by a specific crop, as for example in the case with the berseem requirement for cotton. It is possible to explicitly list all of these interrelationships in a constrained optimizing framework so as to obtain an economic or shadow price of land for each of the time periods into which we choose to subdivide our calendar year. For our purpose which is to be able to evaluate relative economic profitability, we can follow a simpler approach. It is based on the assumption, which is quite appropriate in the case of Egypt, that land is the ultimate fixed factor of production. The policy objective then is to maximize social returns to land. We can thus modify expression (1) to be the economic profit or return per unit of land: n m- Bi/L P. a. - f f51 P (3) i s Economic Returns Economic Economic Value Economic Value per unit of = Price of - of Intermediate - of Primary Inputs land Output Inputs excluding land where the new element L is the land used in the production of the crop and which had earlier been incorporated in the final term, i.e. Lj = fmj. 1/ For a more complete exposition of the Domestic Resource Cost measure as a tool of economic analysis see Anne; 0. Krueger "Evaluating Restrictionist Trade Regimes: Theory and Measurement" in the Journal Df Political Economy, January 1972. See also an article by Michael Bruno entitled "Domestic Resource Cost and Effective Protection: Clarification and Synthesis" in the same issue of the JPE. - 148 - We still however need to account for the fact that crops occupy land for only a portion of the calendar year. One approach would be to simply divide returns per unit of land by the number of months occupied by the crop to obtain a homogenous expression of economic returns per feddan per month. A more meaningful approach is to analyze net returns to crops by crop rotations. This provides us with a measure of annual profitability of land and takes into account the cropping relationships in Egyptian agriculture. Since crop rotations are well defined in Egypt, we can first obtain economic returns for individual crops and then evaluate annual returns according to the various crop rotations. The two methods provide an empirically robust framework for analyzing relative rankings of crop and crop rotations, and a sound basis for evaluating comparative advantage and directions of policy change. Two considerations need to be kept in mind in evaluating relative rankings under the economic returns to land criterion. Firstly, relative rankings are not unambiguous and the ordering may change in response to relative factor or commodity prices. Indeed, as we shall see later in the chapter relative economic returns have been altered significantly due to shifts in factor and commodity prices. An additional consideration is that the factor accounting ratios estimated in Chapter 2 and applied in equations (1) and (3) are second best shadow prices in that they are estimated on the basis of an allocation of resources that corresponds to the existing pattern of distortions. Comparative advantage on the other hand, should be measured using economic prices which reflect the allocation of resources which would exist if the present structure of distortions were eliminated. Since the sectoral allocation of primary factors would change in these circumstances, it is possible that the ranking of economic returns of alternate crop activities could alter substantially, and that some activities classified as efficient under the existing pattern of distortions would be inefficient if all distortions were removed. The extent to which the estimates of economic returns to alternate crops fail to predict accurately the pattern of comparative advantage cannot be determined without much more specific knowledge of production functions and factor markets, but given the magnitude of differences between relative rankings of economic returns, it is doubtful that our policy conclusions would be affected by even relatively large changes in accounting prices. In addition to relative economic returns to various crops, it is important to analyze the structure of incentives to farmers since actual agricultural performance and trends is a composite of farmer response to prevailing incentives. Private financial returns as opposed to economic returns are determined by market prices, or more appropriately the prices farmers face, rather than economic prices. Thus by simply substituting observed or market prices in equation (3), we obtain an expression for private returns to land which is equivalent to the economic returns concept we had earlier defined. Some items included in the computation of economic costs are completely excluded from private costs. This is because farmers in Egypt do not pay directly for many important social overhead costs including extension and research, cost of credit, water charges and public investment in agriculture. We have taken all of these into account in computing economic costs while at the same time excluding them from private costs. - 149 - Private returns to land is one, though important, measure of incentives in a multipurpose cropping system where some farmers are land owners, others tenants, and when all farmers supply to varying degrees their own labor. In our analysis of private incentives, we present alternative indicators based on whether the farm is owned or tenant operated and whether labor is hired or farmer supplied. In the past, farmers consciously maintained a diverse crop mix, to meet: their own subsistence requirements first and then allocate land to various cash crops. With increasing commercialization of agriculture, well defined markets for food grains and animal fodder have emerged, so that the distinction between cash and non-cash incomes, an important element in traditional agriculture, is now less relevant. Having defined private and ec:onomic returns and costs, we can obtain two comparative measures of private to economic profitability. The first is the ratio of the private returns to land to the equivalent economic returns based on equation (3). The second is the effective protection rate which is based on total value added rather than land alone, and is given by the expression: rn -. a.P. (4) Pj2 Value p ; >est: r ?li P, -- a P, VS'Aije Auc½ci ac '%o'old Prices j i jJ 2 where Pj and Pi are the domestic market prices of output and inputs respectively. The effective protection rate (ERP) is the ratio of value added in domestic prices to value added at world prices and measures the increase in domestic value added permitted by the structure of trade protection and domestic price controls over the level of value added in the absence of such restrictions. The ratio of private to social profitability of land, on the other hand, includes divergences in private and social cost of primary factors excluding land, so that it is a bottor-line measure of the private rent permitted to land by the existing structure of protection, domestic taxes and the supply of land and capital compared with the rent to land that would have accrued in the absence of these distortions. Data and Assumptions Underlying Empirical Work Below we examine private and economic returns to 19 crops and meat. The crops together account for 85% of the total crop area and are fairly representative of the choices facing the farmer. Data on output, yields and farmgate prices were obtained from the Ministry of Agriculture. Since prices are ex-farm, they are expressed in terms of the unprocessed commodity. Output of byproducts such as straw are also included and make a considerable difference to total returns in some cases most notably for wheat. Table 4.3 lists the crops included in our analysis, as well as the breakdown of the costs of production and additional categories included in the computation of economic costs. - 150 - Estimates of the costs of production for the farmer are based on annual surveys carried out by the Ministry of Agriculture. While in some cases the classification of costs is not clearly defined, it provides a sufficient level of disaggregation for our calculations of comparative costs. These components are considered full tradable -- chemical fertilizers, pesticides and seeds. Two others, organic fertilizers and draft animals were treated as non-traded inputs. While it is possible in principle to decompose these inputs into primary factors and tradables, given the small magnitudes of these two costs we have used the standard conversion factor when determining their economic value. Labor costs are based on actual market wages, but rents are based on officially prescribed levels for tax purposes. Actual rents for uncontrolled crops are often considerably higher and therefore our estimates of returns in tenant-operated farms may overstate tenant incomes. Machinery services were decomposed into capital, fuel and labor components in determining the relevant account ratio. Table 4.3 Items included in Analysis of Comparative Costs and Incentives Outputs Farmer Incurred Costs Additional Social Costs Cotton Draft Credit for inputs Wheat Chemical Fertilizers Extension & Research Barley Organic Fertilizers Rice Seeds Water Maize Pesticides Drainage Sorghum Miscellaneous Costs Beans Machinery Lentils Labor White Onions Rent Groundnuts Sesame Sugarcane Short Berseem Long Berseem Summer Potato Nili Potato Summer Tomato Winter Tomato Oranges Accounting ratios for inputs and outputs were obtained from the shadow pricing framework described in Chapter 2. The international prices for outputs used in deriving the accounting ratios were based on trade statistics and supplemented by more detailed data from the Ministries of Supply and Economy. Input accounting ratios were based on actual imports cost and selling prices as reported by the Ministry of Agriculture. A summary list of accounting ratios for agricultural outputs and inputs was presented in Chapter - 151 - 2. The accounting ratios for outputs were based on deliveries to urban consuming centers and therefore included transportation margins from the farm. The accounting ratios used in this chapter are based on domestic and international prices at the farmgate and are consequently somewhat higher. An extended list of economic prices and accounting ratios unclerlying the analysis in this chapter is given in Appendix A-2. As we mentioned in Chapter 2, it is not appropriate to use the international price of a commodity as the benchmark of its economic value when the elasticity of demand for the commodity is not infinite. In such instances, the accounting ratios have to be based on estimates of marginal revenue rather than price. The most important case in point is cotton, where Egypt has a large share of the market. An additional complication is that several varieties are produced, each with its own price. The various varieties though can be grouped into i:hree broad categories: extra-long staple, long staple and medium staple cotton. In our discussion of cotton in Chapter 3 we noted that the long run marginal export revenue depends on the sustainable quality premia of the var:ious varieties. The accounting ratios were adjusted on this basis. For 198L, we have assumed that the long-run premia would be 5% below existing levels. Other examples of products for which international demand is not fully elastic are fruits and vegetables. This is due to quota controls imposed by importing countries and generally higher costs of market penetration. Empirical magnitudes of demand and supply elasticities on which to compute marginal export revenues are not readily available. We have used price elasticities of demand from a study on Fruits and Vegetables Exports to the EEC.l/ Since Egypt's share in exports of these commodities is very small, we obtain relatively high elasticities of demand for Egyptian exports, ranging from 18 for potatoes and onions to 20 for tomatoes and 22 for oranges. Incentive Structure and Private Profitability As we underlined in Chapter 3, government policies have had a determining influence on the level and structure of incentives in Egyptian agriculture. The various instruments that have been used include: area controls for a few key crops delivery quotas at fixecl prices additional procurement at fixed prices large scale imports of f-ood commodities low domestic selling prices, and wholesale or retail price controls direct and indirect input subsidies The kind and degree of intervention varies widely among different crops and outputs. In general, as we noted earlier, fruits, vegetables, meat and the fodder supplying crops (berseem, maize and sorghum) are subject to 1/ "Fruit and Vegetable Exports from the Mediterranean Area to the EEC", World Bank Staff Working Paper No., 321, March 1979. - 152 - little control whereas the basic food crops and industrial crops have been subject to a wide range of interventions, with a consequent impact on the incentive structure. Tables 4.4 and 4.5 indicate the level and growth of output prices, gross incomes and non-labor incomes for the principal agricultural crops. Incomes and income growth are determined by: (i) increases in output prices, (ii) productivity or yield gains, (iii) shifts in input prices, and (iv) growth of agricultural wages. At the beginning of the 1970s gross returns to controlled crops were already considerably lower in absolute terms than returns to berseem, fruits and vegetables. This gap widened during the first half of the 1970s with rapid growth in prices and incomes for uncontrolled crops and slower adjustment in the prices of controlled crops. In the second half of the 1970s prices of controlled crops were adjusted upwards at a faster rate leading to a modest narrowing in relative returns although the gap between controlled and uncontrolled crops remains large in absolute terms. In terms of the cost structure, the pricipal factor affecting returns has been the rapid growth of wages since 1977. The impact has been varied with the two fodder oriented crops, berseem and maize affected minimally, while labor costs have particularly affected sugarcane, orchards and vegetables. Table 4.4 Output Prices, Gross Incomes and Non-Labor Incomes (output prices in LE per ton; gross incomes and non-labor incomes in LE/feddan) output Prices Cross Incomes Non-Labor Incomes 1970 1975 1981 1970 1975 1981 19t70 1975 1981 Domestic Food rops Wi1est 35 51 89 58 102 207 31 62 84 Bti. 27 40 90 64 93 227 24 41 59 beans 57 85 235 62 93 239 41 58 132 T.-nt ii 101 150 421 81 120 216 53 87 104 barley 42 54 88 60 90 130 42 64 43 Sesame 125 200 603 62 102 247 43 69 12b 7no.,6tria1 Crops Cotton 116 162 385 105 139 409 51 68 195 S.garcanle 3 7 16 104 262 533 43 170 155 i"' 5- ,' AGRICULTURAL IMPORTS L} 0 A-RICULTURL EXPORTS 0 .5- i0- I T 1 F Th e~~~~~~~~~~~~~ -B-- - -T - - - - - - - - - - - - - - - - 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 YEARS - 205 - trends in Figure 6.2 illustrate most vividly the magnitude! of the agricultural crisis facing Egypt. Not only is the sharp deterioration in the agricultural trade performance over the 1970s apparent, but it is also striking, that even under our assumption of better growth performance based on some policy reforms, the overall deficit almost doubles in constant terms from $2.8 billion in 1981 to $5.2 billion by 1990. According to this scenario, the share of agricultural imports would rise from about 28% of total imports of goods in 1981 to over 50% in 1990. An immediate implication of this is of course that less resources will be available to other sectors and activities including investment. Thus the agricultural sector would become an increasing bottleneck to overall economic growth. This takes on special significance because of the central thesis of Chapter 1 -- that Egypt will need to replace its oil earnings by other exports and import substitution in a major way during the 1990s if it is to sustain even a modest pace of economic growth. Under these circumstances, an agricultural trade imbalance of the magnitude projected could precipitate a major economic and social crisis. 6.4 A Policy Package for Accelerated Growth The previous section underlined the magnitude of the challenge facing policymakers in the agricultural sector. Even with the adoption of "moderate" policy reforms it will be difficult to bring about a significant turnaround in the agricultural situation. This stems in large measure from the cumulative impact of past policies and trends leading to the very large magnitudes of existing distortions and overall work producer incentives as well as the generally inadequate state of agricultural infrastructure and institutions. As we argued earlier, a very large concerted and coordinated policy effort will be required to address these problems. Based on the discussion in the preceding sections we can identify three mutually supporting and interrelated growth strategy: (i) price rationalization; (ii) investment planning and allocation; and (iii) institutional reforms. The kinds of policy actions required in each of these areas has already been touched upon in previous sections. Below we summarize the main elements and then use the framework of the AGT model to analyze the impact of the suggested policy package on agricultural trends and the overall macroeconomy. Price rationalization The objective of restructuring agricultural prices is two-fold. Firstly, by aligning financial and economic profitability more closely, price rationalization provides the basis for a more efficient allocation of resources in the agricultural sector. Secondly, in addition to improved resource allocation, price rationalization would have an important effect on resource mobilization within the sector by raising the absolute level of prices in agriculture, thereby strengthening overall incentives and creating the necessary surplus in agriculture for on-farm investment. An economywide strategy for price reform focussing on resource allocation and resource mobilization as well as the related arguments concerning inflation and income distribution are discussed in detail later in Chapter 10. Here, we focus more narrowly on price rationalization within the agricultural sector. - 206 - The restructuring of agricultural prices would have to be primarily effected through adjustments in controlled producer prices. However, we argue that price adjustments would necessarily have to extend to consumer prices as well for the following reasons: (i) since only a subset of crop prices are directly controlled, consumer prices including related government interventions determine producer prices for a large number of agricultural commodities including meat; (ii) adjustments in domestic sales prices from their very low levels are required to regulate overall demand and curtail wasteful consumption; (iii) the gap between urban selling prices and rural "free-market" prices is already so large that an additional widening would undoubtedly lead to "leakages" of subsidized commodities to rural markets thereby increasing the fiscal burden. I A recommended set of price reforms for the agricultural sector, in our view would be: (i) substantial increases in prices of high value export crops such as onions, garlic, groundnuts and oranges. Egypt has a strong comparative advantage in these crops which should be exploited to the fullest within the constraints of the overall cropping system and regional specialization for some of the crops. (ii) while the gap between economic and financial prices is not as large for cotton, rice, sugarcane and wheat, because of their dominant share in the Egyptian agriculture, price adjustments for these crops are likely to be the most important in terms of overall impact. In the case of wheat, the objective should be to increase the price of grain relative to that of straw so that farmers would have the incentive to increase yields through adoption of better farm practices and technologies. (iii) raise selling prices of imported meat closer to world levels but increase quantities imported as well so as to augment domestic supply and regulate the increase in domestic prices. (iv) adjustments in domestic selling prices of rice, wheat, sugar, oil, beans and lentils from the present very low levels with offsetting wage increases as discussed in Chapter 10. While the government may wish to provide some essential foods at controlled prices, these have to be selected from the broad list of commodities at present subsidized and efforts should be made to target such support to the most needy groups. To induce productivity growth through more efficient allocation of resources and intensification of production, such price reforms would have to be accompanied by, in addition to the investment and institutional measures cited below, by gradual liberalization of area controls and of input supplies as market signals more closely approximate economic values. - 207 - Investment Planning and Allocation Our review of investment allocation and selective analysis of projects in Chapter 5 clearly indicated the potential for high economic returns from additional public investments in Egyptian agriculture. Indeed, there is an urgent need for rehabilitation and upgrading cf the water distribution and drainage system as well as for extending drainage to yet uncovered areas to both maintain land productivity and allow for further overall productivity growth. As we noted, it is crucial that such investments be accompanied by adequate maintenance programs. Another area where economic returns are very high, and where the scale of required investments are relatively small is in the extension and research system which enables farmers to adopt improved technologies. As we stressed in Chapter 5 such new technologies are dependent on the maintenance of land productivity which in turn implies a properly functioning irrigation and drainage system. Thus, investments in extension and research, and investments in the water system are complementary and together constitute the key factors for augmenting productivity growth in the old lands. Because of the very high potential returns, such a combined investment package should receive the highest priority. While there has been a renewed emphasis on drainage in recent years and the government has made a start in addressing the rehabilitation needs of the irrigation system, the scale of required investments far exceeds those currently planned. Also, there is still insufficient emphasis on maintenance of existing and new investments, and the issues of optimal design and phasing of investments need to be given closer scrutiny. In the area of extension and research, a new action plan at the national level has been drawn up and a more dynamic program at the field level is being attempted to be introduced for a single Governorate through the Minya Agricultural Development Project. Efforts in this direction could provide the basis for a more effective extension and research system, but will require considerable strengthening of investments in this area as well as institutional measures. The analysis in Chapter 5 also indicated that investments in new lands could also be economic, although returns are likely to be lower than investments in old lands. Moreover, rehabilitation of lands already reclaimed but currently unproductive should be given greater priority than new reclamation of desert lands. Given the increasing population pressures on land, new lands development include benefits beyond just agricultural production such as easing congestion in the old lands and preventing further loss of arable land. While it may thus be imperative to develop new land areas it is important to reiterate the essential lessons in Chapter 5: (i) new lands development should be spatially integrated to benefit from economies of scale; (ii) soil conditions, and water and infrastructure requirements should be assessed prior to development; (iii) the cropping pattern should emphasize non-fodder crops; and (iv) energy costs of lifting water should be taken into account. Some of these issues are being addressed within the framework of the Land Master Plan but so far the investment strategy remains diffuse thereby reducing the effectiveness of ongoing projects. Additional investments in agriculture which are not land dependent are in fisheries and poultry. Commercial investments in bol:h of these areas have been increasing and in both instances have demonstrated high economic rates of return. Participation of the private sector has risen which has - 208 - therefore augmented scarce public resources. There is considerable scope for expanding such commercial investments as well as improving productivity of more traditional operations. Increased fish and poultry production could thus meet a large portion of animal protein needs in Egypt. While we have not attempted to provide an exhaustive list of investment opportunities in Egyptian agriculture, it is evident that there is considerable scope for strengthening the investment program both in terms of the overall investment allocation to the sector and through a reordering of priorities towards projects with the highest economic returns. Such an intensified investment strategy would be an essential component of the policy package on which our high-growth scenario is based. Institutional Reforms Both the price reforms and the strengthening of investment planning and allocation would need concomittant reforms in the institutional structure. As we noted earlier, one of the most difficult issues in Egypt's agriculture development is the overlapping function of a multitude of ministries and departments involved in the agricultural sector. A detailed set of proposals for streamlining responsibilities and strengthening coordination has been put forward recently in a joint USDA - Ministry of Agriculture report. 1/ These proposals which include the recommendation for a supra-ministerial office for agriculture needs to be given careful attention. Even within the Ministry of Agriculture important institutional issues such as the framework of the extension and research system needs to be addressed. In many ways, institutional reforms are the most difficult to achieve but without major efforts in this direction neither price reforms nor improved investment planning can be implemented. The scenario that we present here assumes a large measure of success in developing the strategy outlined above. The AGT model does not explicitly derive crop productivity from investment and price policies, but we have based our assumptions of crop productivity growth on micro-studies including the Minya Agricultural Development Project, which together with complementary infrastructure upgrading, would be a typical subcomponent of an accelerated development strategy. We have also taken into account the growth targets underlying the FY82-87 Five Year Development Plan, although the periods covered are not fully comparable. One difference between the growth strategy outlined here and the Plan is that we have place greater emphasis on resource allocation according to comparative advantage than on considerations of "self-sufficiency". We believe that such a strategy would allow Egypt to utilize its agricultural potential to the fullest and lay the basis for sustained self-reliance. In addition to the exogenously specified crop productivity growth and underlying investment and price policies, specific assumptions underlying the high-growth scenario were: IT "A Report of the Presidential Mission on Strategies for Accelerating Agricultural Development in Egypt", USDA - Ministry of Agriculture, May 1982. - 209 - (i) the same level of land reclamation as in the base case (500,000 feddans) but with corresponding higher yields; (ii) an annual loss due to urbanization of 10,000 feddans over the projection period reflecting even tighter land use policies; (iii) increases in procurement prices that would close the gap between domestic and international prices at 3-5 percent; (iv) domestic selling prices for non-rationed subsidized food commodities are raised by 3 percent more than what would be required to keep their ratio to world prices constant. Table 6.11 outlines our assumptions of crop productivity growth in this scenario compared to the base-case scenario. Because of the higher productivity growth, including for fruits and vegetables, a smaller proportion of land is required to meet domestic demand for fruits and vegetables than in the base case. Reflecting the assumed restructuring of relative prices, we have projected a small decline in the relative share of the berseem area. As a consequence of these two trends, the area left to the basic field crops is much greater than in the base case. Table 6.12 compares crop area allocations projected in the high growth scenario in 1990 to the base case. Because of the projected shift in cropping pattern and higher crop productivity growth, particularly in the second half of the decade, agricultural output growth averages 3.4 percent during 1985-90 compared with 2.5 percent in the base case scenario. In international price terms, the growth of output is higher, 3.9 percent in the high-growth scenario compared with 2.7 percent in the base case. This reflects the shift towards crops in which Egypt has a greater comparative advantage. On the demand side, the faster upward adjustment in selling prices leads to a generally slower increase in demand for food conmodities than in the base case. The net effect of the stronger supply performance and slower growth in demand is a much improved overall trade performance. The projected export levels assume in addition to the improved net-supply situation, increased efforts towards market development. Table 6.13 lists in detail the projected export and import levels and the respective self sufficiency ratios characterizing the high-growth scenario. As can be seen from the table, the exportable surplus of cotton is maintained at roughly the same level even during the second half of the 1980's. Exports of horticultural products as well as exports of onions and garlic record very substantial increase. Also, due to the projected increase in rice area and yields and the somewhat slower growth in demand, Egypt is able to regain its position as a net rice exporter by 1990. This allows a doubling of total agricultural exports in constant prices betweeen 1981 and 1990. The major improvement in terms of overall trade performance is on the import side. Wheat imports alone are projected to be more than one million tons less than in the base case. On the whole, the trade balance in the high growth scenario shows a projected deficit of $3 billion in constant 1980/81 prices compared with $5.2 billion in the base case scenario. Other key indicators of the differences characterizing the two scenarios are given in Table 6.14. An additional point wori:h noting is the - 210 - Table 6.11 Yield Comparisons between High-Growth and Base Case Scenarios (tons per feddan) Actual Base Case High Growth 1981 1990 Scenario 1990 Wheat 1.38 1.70 2.00 Rice (Paddy) 2.34 2.81 3.20 Maize 1.67 2.00 2.25 Sorghum 1.58 1.80 1.90 Beans 0.87 1.00 1.15 Lentils 0.42 0.60 0.75 Cotton 1.33 1.43 1.51 Sugarcane 34.00 39.00 43.00 Sugarbeet 12.00 16.00 16.20 Soybeans 1.02 1.40 1.45 Onions 7.50 9.60 10.60 Garlic 6.17 7.50 9.00 Potatoes 7.56 9.00 10.40 Tomatoes 7.54 9.30 10.50 Citrus 5.21 7.20 8.10 Berseem 22.00 24.00 25.00 Table 6.12 Crop Area Comparisons between High Growth and Base Case Scenario: 1990 Base Case Scenario High Growth Scenario '000 '000 feddans percent feddans percent Wheat 1423 11.80 1542 12.60 Rice 953 7.90 979 8.00 Maize and Sorghum 2339 19.40 2154 17.60 Cotton 1170 9.70 1260 10.30 Sugarcane and Sugarbeet 289 2.40 306 2.50 Long Berseem 1953 16.20 1982 16.20 Fruits 422 3.50 367 3.00 Vegetables 1326 11.00 1101 9.00 Onions & Garlic 157 1.30 122 1.00 - 211a - significant differences in the fiscal impact between the two scenarios, indicating the importance of price increase for subsidized commodities not only in terms of the level of domestic demand but also on the public sector resource balance. Table 6.13 Trade Performance and Self-Sufficiency for Principal Agricultural Commodities; High Growth Scenario ('000 tons and percent) 1981 1985 1990 Self Self Self Exports(+) Suffi-- Exports(+) Suffi-' Exports(+) Suffi- or cienc17 or ciency or ciency Imports(-) Ratio Imports(-) Ratio Imports(-) Ratio Basic Food Commodities Wheat -5028 30.4 -6505 30.3 -6594 38.7 Rice 20 101.4 - 82 95.5 260 113.5 Maize -1000 76.2 -1619 68.4 -1985 66.8 Sugar - 515 56.8 - 559 55.0 - 468 63.8 Beans - 50 80.6 - 39 87.2 - 23 92.9 Lentils - 85 5.6 - 98 5.8 - 65 41.4 Edible Oils - 335 30.5 - 406 27.9 - 410 30.9 Exportable Field Crops Cotton 504 144.4 591 156.3 659 152.8 Onions 95 119.8 90 115.3 300 146.4 Garlic 11 108.0 20 112.3 73 141.0 Groundnuts 7 136.8 15 162.5 65 350.0 Livestock Products Red Meat - 118 74.2 - 197 65.1 - 224 63.3 Poultry - 60 70.0 - 78 68.7 - 57 79.9 Fish - 150 46.4 - 195 44.3 - 206 46.9 Milk -1150 62.2 -1720 51.6 -2110 46.2 Fruits and Vegetables Citrus 130 114.4 145 112.9 350 128.3 Other Fruits 0 100.0 10 101.0 30 102.7 Potatoes 145 113.6 95 107.0 190 112.4 Tomatoes 4 100.2 10 100.3 65 101.9 Other Vegetables 28 100.6 35 100.7 98 101.7 - 211b - Table 6.14 Comparison of Key Indicators Underlying the Base Case and High-Growth Scenarios Actual Base Case High Growth 1980/81 Scenario Scenario 1990 1990 -------------Percent---------------- Output Growth - 2.5 3.4 (Annual Averages 1980-1990) Net Subsidies 1/ 9.0 22.0 11.0 (as % of GDP) -$ Million (Constant 1980/81 Prices)- Agricultural Exports 0.5 0.5 1.0 Agricultural Imports 2.9 5.2 3.9 Overall Trade Balance -2.5 -4.7 -2.9 It is quite clear from the preceding analysis that a more concerted growth strategy in agriculture could have a significant impact on agricultural trends as well as on key macroeconomic resource balances. The magnitude of this impact as well as the progressive deteriorating trend without major policy reforms argues strongly for a major policy effort in the sector. On the basis of such a concerted policy effort, the agricultural sector should be able to both increase exports substantially as well as limit the growth of additional imports. It is important to emphasize though that even on the basis of this "optimistic" growth scenario, agriculture is unlikely to provide the major source for export growth or even cover its own import needs. The overall agricultural trade balance will continue to show a substantial deficit even with high productivity growth reflecting the fundamental constraint on arable land and the limited potential for increasing the land base. This deficit could grow rapidly if sufficient investment and policy reform fail to be directed towards agriculture and it is therefore essential to prevent what cou]Ld become a major threat to Egypt's social and economic stability. But even with very good performance the deficit will remain and perhaps even slowly increase. This implies that if the anticipated decline in oil revenues during the 1990's is to be offset, a major increase in industrial exports will become an absolute necessity. In the next part we turn to an analysis of such a potential role for the industrial sector and the key issues that are likely to determine production and trade performance in Egyptian industry. 1/ Food subsidies less export taxes. EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING PART III INDUSTRY - 212 - CHAPTER 7 The Historical and Institutional Context 7.1 Background The first phase of Egyptian industrialization took place during the administration of Mohammed Ali in the early 1800's. Compared to other developing countries, Egypt was an "early starter". The initial industrialization efforts were based on setting up modern industries under the control of the State for the purpose of import substitution. Textiles and food processing plants were established but there was also emphasis on foundries and metal workshops for military use. Indeed one of the major factors behind Mohammed Ali's industrialization effort was his desire to strengthen and increase the self-reliance of the Egyptian army. These early import substitution attempts had to be adandoned, partly because some of the basic prerequisites of successful industrialization were not available at that time, but also because complete "laissez faire" was forcibly imposed on the economy by outside powers. Government monopolies in trade and production were abolished and a completely open trade regime (which lasted until 1930) was installed. Foreign capital flowed into Egypt and world market conditions began to dominate the course of development. Investment and expertise were directed mostly to agriculture, trade, finance and infrastructure, rather than to industrial development, which no doubt reflected the nature of comparative advantage at that time. By the end of the 19th century economic activity was mainly focussed on exporting agricultural commodities (mostly cotton) and on some processing of these commodities. A narrowly-based industrial sector, devoted to processing agricultural products for export was almost exclusively owned and financed by foreign interests. The complete laissez-faire which allowed unrestricted competition from imported goods acted as a disincentive to private Egyptian investment in industry and "favored strict specialization in the production and export of cotton".l/ Thus, by the turn of the century domestic private capital had been devoted almost exclusively to the development of a landed aristocracy, whose activities were focussed on the production and trade of cotton. After the First World War Egypt gained greater political and economic autonomy and investment of local capital in import substituting industries began. A number of enterprises financed and managed exclusively by Egyptians began to emerge. The government was able to provide some protection for infant industries, which led to the development of a domestic cotton textile industry and some import-substituting enterprises producing consumer non--durables. To some extent private investments began to shift from land and urban property to industry. By 1940, the Misr Group included 21 affiliated companies, with investments ranging from textiles and tourism to building materials, pharmaceuticals and mining. 1/ Mabro & Radwan, The Industrialization of Egypt, 1939-1973, Clarendon Press, Oxford, 1976. - 213 - Direct government intervent:ion in the private sector of the economy was minimal between 1930 and the start of the Second World War, although government investment in large and important public works projects, such as the irrigation system, was significant. Most of the economy was private, and the emerging industries were protected by low-cost credit in addition to tariffs. During the Second World War, the government began to intervene more actively in the economy, instituting exchange controls, trade licenses and cotton production policies, as well aLs establishing fixed rents and some price controls. Private enterprise flourished during the war due to domestic shortages of imported goods and to the large expenditures and special needs of the allied forces stationed in Egypt. 7.2 Evolution in the Political and Institutional Framework, 1952-1982 It is against this background that one can place industrial development and industrial policy since the 1952 Revolution. Three phases of development can be usefully distinguished in terms of the policy framework within which industry has operated over the last three decades: Phase I (1952-1960): the industrialization drive in a free enterprise setting. Phase II (1961-1973): nationalization and creation of a dominant public sector. Phase III (1974 to the present): liberalization efforts and transition to a mixed economy. The Search for "National" Capitalism The Revolution of 1952 expanded the role of government investment in the economy not in order to dismantle private enterprise but, on the contrary, to strengthen the national economy within an essentially free enterprise setting. The national bourgeoisie was seen as the spearhead of modernization and industrialization. The government: began to invest in heavy industries such as steel in an effort to encourage a rapid process of industrialization. But between 1952 and 1956 the economy continued to be based mainly on newly established private enterprises, in an environment of protectionism and tax and credit incentives. However, a general recession following the economic boom during the Korean War, and a few politically motivated sequestrations between 1952-1956 dampened private sector investment activity during these years. A "Production Council" was created in 1954 to appraise the economic viability of large and capital intensive industries such as iron and steel, paper, rubber tyres, fertilizer and raLilway rolling stock. The new ventures were established as joint-stock companies under the private company law (Law No. 26 of 1954 which followed closely the French legal structure of corporations) with mixed ownership for shares by the government and general public. Government participation in the capital of these new enterprises was intended to supplement the finance made available by selling shares issued on - 214 - the Stock Exchange. Machinery and knowhow were purchased from firms based in the West and managers enjoyed full autonomy as typical of other private corporations (e.g. the Bank Misr group of enterprises). The Suez War of 1956 and related developments triggered a first shift in the mix of economic policies. Following the war, the government proceeded to sequestrate all of the substantial French and British interests in Egypt. A semi-government holding company - the Economic Organization - was established to supervise these newly acquired enterprises, the majority of which were in banking and insurance. The Economic Organization was soon made responsible for also initiating new projects within the framework of the first Five Year Plan for Industry which began in 1957, a year which saw the creation of the first Ministry for Industry. Some large enterprises in the the private sector began to be nationalized little by little between 1956 and 1961, as government investment expanded in an environment of increasing government control. In 1960, the Bank Misr Group, which owned some of the largest enterprises in industry, was nationalized. The government increased its control of a significant number of vital concerns and it created another two holding companies - "El Nasr" and "Misr" organizations - to supervise what eventually became the nucleus of the dominant nationalized enterprise sector. However, it is worth emphasizing in this context that many public sector managers today remember the benign influence and control of these first three state holding companies over their enterprises. They claim that interference was minimal and that holding companies limited their role to securing finance for individual firms and to acting as mediators whenever problems emerged between the enterprise and the state. There was still emphasis on private sector development and the economy was operating as a market economy quite open to foreign trade. Foreign investment was not only sanctioned but was actively encouraged through special legislation by the government during the 1950's and, as late as 1958, three foreign subsidiaries of multinational pharmaceutical firms were approved and established under joint venture arrangements with the participation of private Egyptian shareholders. It is interesting to observe that all of those private enterprises which were established with government approval during that period were not subject to the nationalization of the 1960's. Moreover, to this day, the ownership of shares by private individuals in the 33 joint stoc:k companies formed with government participation in the 1950's has continued, the shares being traded on the Stock Exchange, which is now much more limited in size. The early nationalizations of private ownership reflected government efforts to stimulate industrial production in light of the weak performance of the private sector in the prerevolutionary period rather than an ideological opposition to private sector activity. The breakdown of relations with Britain and France that triggered the nationalization of the Suez Canal and ended with the confiscation of most foreign investment had an influence on the government's attitude toward domestic private business. But throughout the - 215 - 1950's the increasing trend toward nationalization stemmed more from attempts to assure domestic production in view of Egypt's rather sudden isolation from traditional (Western) political allies rather than from a sudden ideological shift toward Arab Socialism. Socialism and Centralization The ideological shift did eventually occur in the 1960's and the next decade witnessed radical changes in the government's economic policy away from the free enterprise orientation it had advocated and had even made explicit when preparing the first overall Five Year Plan for 1960-1965. In parallel with major changes in foreign policy a large scale wave of nationalizations was undertaken between 1961 and 1963 whereby the majority of medium sized and all of the large scale manufacturing enterprises were first partly-owned and lgter fully absorbed into state controlled and state owned enterprises. The smaller factories were merged into the larger establishments. In the pharmaceutical sector, for example, 50 plants and laborataories were amalgamated into seven large public sector firms. The process of mergers and consolidations was followed by bringing firms operating in the same branch of industry into a single group of enterprises headed by a sectoral general organization called "Moassassa Ama". A total of approximately 160 joint stock manufacturing companies was thus formed and grouped under 11 general organizations. A three-tier organizational structure emerged: the Ministry at the top, the "Moassassa" at the middle level, and the enterprise at the bottom. By 1963, nationalizations and punitive sequestrations had eliminated most forms of private ownership. Surviving private ownership was concentrated in agriculture, urban real estate and small (mostly traditional) businesses. A shift in trade from western markets to mostly bilateral agreements with eastern bloc countries implied further reductions in potential domestic private investment. A gradual but deliberate process of socialism and centralization was adopted by Egypt's policymakers with the enactment of one decree after another supplementing and sometimes supplanting the existing set of rules governing the relationship between state, enterprise, worker and consumer. Although the impetus toward nationalizing the private sector had originated from considerations of national security, the desire to centralize economic and political control also reduced the role of private enterprise. Moreover, redistribution of income and social change became primary objectives of policy. By the end of the 1960s, Egypt was committed to a kind of "welfare state", and the adoption of Arab Socialism meant that the government assumed responsibility for providing a minimum standard of living and many basic services. Consumers were given immediate advantages from nationalization in the form of significant price reductions on essential goods like medicine. Workers were given new privileges in both public and private firms with the enforcement of higher minimum wages and a shorter working week. There was also a massive employment drive with hundreds of thousands of workers absorbed in the public sector, without much regard for the implications in terms of productivity or profitability. - 216 - For all joint-stock companies, the company law of 1954 was especially amended to give workers what were perceived as the most significant gains from socialism: profit sharing and participation in management. The workers' share in profits was instituted at 25% of distributed profits with a ceiling of LE 50 per worker per year (increased to LE 75 in 1977). Four representatives of workers and salaried employees were to be elected by the labor force as members of the Board of Directors of the enterprise whose total membership would range from 7 to 11 members. The complete reorganization of the now dominant public enterprise sector was achieved by 1966, although many of the implementation rules (executive decrees) were delayed until the early 1970's because of the government's preoccupation with the war of 1967 and its aftermath. The three state holding companies were dismantled and replaced by 38 general organizations which were established along sectoral lines in all industries and services unlike their predecessors which had held interests across sectors. The general organizations were given a much wider scope of responsibility and authority over more than 350 enterprises in manufacturing, transport, construction and finance. Each general organization was in turn answerable to the competent Minister who chaired its own Board of Directors. The majority of industrial firms (approximately 160) were assigned to the Ministry of Industry, but specific sectors such as pharmaceuticals, building materials, and defence were placed under the Ministries of Health, Housing and Military Production respectively. For managers of the public sector enterprises, most of which had existed earlier under private ownership, it was essential to adjust to a new code of conduct with respect to the many new layers of authority placed above the enterprise, and to a far more demanding workforce within the enterprise. The old class of managers and owners was almost invariably invited to remain with the enterprise, and in many cases senior and middle management was preserved while engineers and other professionals were recruited from the army ranks and civil service to replace the owners and directors who preferred to move away. Meeting with the new set of objectives assigned to the state enterprise was never an easy task. On the one hand, output targets were planned and budgeted for each firm, with profit and productivity maintained as criteria for measuring efficiency, while the government's massive employment drive and mandatory price fixing for the majority of goods produced by the firm meant the inevitable deterioration in the very indicators (productivity and profits) which the enterprise was asked to maximize. The delicate balance between these conflicting goals was further aggravated by the behavior of the general organizations, which often overstepped their role of monitoring the performance of the firm and slowed down everyday operations with growing interference and bureaucracy. Despite these problems however, the early 1960's were a period of enthusiasm and hope, and there appeared to be a spirit of national purpose and direction. More than 25 percent of GDP was invested and there was rapid overall growth and particularly rapid expansion of industrial output. 1/ 1/ For more details and quantitative indicators see Mabro and Radwan (1976) or Ikram (1981). - 217 - The 1967 war and its aftermaLth posed a very difficult challenge to the Egyptian economy. The difficulties that had been inherent in the system became more apparent after the initial period of absorbing excess capacity and expanding employment. The expansion of the defense budget was at the expense of providing adequate finance for investment replacement or even current operations. The period from 1967 to 1973 was, therefore, characterized by extreme stringency in the availability of any but the most pressing foreign exchange requirements of the industrial sector. The growlth momentum was broken and the economy stagnated. In this context the public sector must be credited with having managed to endure the heavy burdens imposed upon it in the inter-war period from 1967 to 1973, and with providing Egypt's basic needs of intermediate and final consumer goods. Despite the breakdown of production operations in all of the Suez Canal cities during the war of attrition, the public enterprises were able to maintain overall production levels. It is partly because of this experience that many Egyptians regard the public industrial sector as an indispensible backbone of Egypt's economy, despite the weaknesses that are now often publicly criticized. Although the increasing share of public sector activity was the overwhelming feature of the 1960's, medium and small scale private firms in industry continued to operate with little direct interference from the state apart from sporadic attempts by the government to keep their selling prices low (e.g. by fixing the profit margin earned on the sales of leather shoes and pharmaceuticals, or by setting a ceiling on the price of food items such as tahina or white cheese). Indirectly of course, these firms suffered from the acute shortage of foreign exchange which begun in 1966 and which hit their operations much more severely than the relatively favored and strategic public sector enterprises. It is interesting to contrast the treatment by the state of small scale traditional enterprises (and for that matter, its treatment of the labor force) in the 1960's with the historical precedent set by Mohamed Ali during his industrialization efforts in the nineteenth century. Mohamed Ali had ordered the complete elimination of traditional workshops and by coercion forced the skilled artisans to join th,e ranks of poorly paid, underfed and badly treated workers in his modern factories. In Nasser's Egypt, the small- scale entrepreneur and traditional artisan were encouraged to survive, with several attempts at providing linkages between public and private producers and with the establishment of marketing cooperatives and training centers for various skills. As a result, the private sector was still responsible for providing 55 percent of total employment in industry in the early 1970's, albeit with a much smaller share in industrial output or value added, since the sector is concentrated in labor intensive activities using very limited capital resources. The "Opening" Egypt's successful military operations in the October war of 1973 marked a crucial turning point not only for foreign policy, but also for domestic economic policies. The strength and popularity gained in October 1973 allowed President Sadat to turn his attention to the domestic economy and to attempt a major reorientation of economic strategy. In tWhe "October Paper" - 218 - he stressed the government's commitment to a new era of liberalization, popularly known as the "Infitah" policy. Legislation was immediately studied and enacted to make the transition to a mixed economy, in parallel with the radical shift in Egypt's political orientation from East to West. The change of strategy announced in the mid 1970's was prompted by a complex set of internal and external, political and economic factors and coincided with a significant change in Egypt's international political position accompanied by new hopes for a lasting peace. When describing the circumstances that led to the redefinition of economic strategy in Egypt two factors deserve special emphasis. The first relates to the external environment. It is difficult to explain "Al-Infitah" without placing it in the context of the oil surpluses that emerged in the Arab World after 1974. Egypt, as a centrally located and traditionally leading Arab country, with a large and relatively skilled population, correctly sensed the opportunity for an important and unique role in a period of booming growth and trade in the oil producing Middle East. The radical change in the external environment called for a substantial redirection of economic strategy towards more open and world market oriented policies. Such a redirection of economic policy was also complementary to Egypt's new choices in foreign policy. Economic and political factors thus pointed in the same direction and the setting was ready for a major shift in development strategy. On the other hand, it is important not to forget the continuity factor characterizing political and economic evolution in Egypt. There was no radical break with the past, but a redefinition of priorities, a shift of emphasis and a series of cumulative changes in policies that finally amounted to a major change, but all within a framework of continuity and, in particular, with a continued commitment to the social achievements of the 1952 Revolution. "Al-Infitah" was not seen as replacing Arab Socialism but as a way of stimulating private foreign and domestic investment while preserving the State's commitment to the welfare of the Egyptian people as a whole. 1/ Liberalization of the domestic economy has consisted of a package of measures designed to reinstate the private sector in all areas of activity including production, distribution, finance and foreign trade. But the more difficult transition to make and perhaps the crucial weakness of the new policy package, was in defining clearly a mechanism whereby a smooth process would be set in motion to shift from a centrally planned system to a mixed market economy. Throughout the 1970's and until today, the government's dilemma has been how to extricate itself from the responsiblity of regulating prices, wages and employment in the overwhelmingly large sector which it controls, without denying the average Egyptian what are perceived as the gains and rights conferred upon him during the socialist era. 1/ For a quantitative macroeconomic analysis of the 1974-1979 period, see World Bank, Arab Republic of Egypt, Domestic Resource Mobilization and Growth Prospects for the 1980's, December 1980. - 219 - The foundations of the Open Door Policy are the investment law (Law 43 of 1974 as amended by Law 32 of 1977), the new trade and exchange control regulations, and the decentralization of government control over the public sector. In terms of consistency, the set of investment laws and regulations governing new projects in the productive and service sectors can be judged as the most successful. The response of foreign direct investment has been concentrated in banking and tourism, with more limited and cautious involvement in manufacturing projects. On the other hand, private Egyptian entrepreneurs have made a significant contribution in providing new capital in industry. These projects are essentially small in size but valuable in terms of their large number which increases the prospects of their introducing new products, new technology, new competition and the flexibility which would allow them to export. Many of these projects were given Law 43 status and all of its accompanying privileges and incentives precisely because of the export pledges made in their application to the Investment Authority. The effective and consistent application of Law 43 is perhaps as important as the legislative document defining the privileges and conditions governing the operation of foreign and domestic investors. It was, therefore, essential to create a powerful organization - "The Authority for Investment of Arab and Foreign Capital" - capable of screening and approving projects on behalf of the government, inspiring confidence in the general environment within which investors would eventually operate, using its discretion in giving additional incentives to high priority projects, responding with speed to applications and their processing, and dealing with the government bureaucracy on behalf of Law 43 investors. The operating efficiency of the Investment Authority was highly praised in the first years of its existence. Subsequently, however, its performance appears to have fluctuated, and there are serious problems of coordination with other Ministries and public authorities. Liberalization of trade and exchange controls has also been pursued consistently during the post-1979 period. The bilateral trade agreements which had comprised the bulk of Egypt's foreign trade were gradually terminated and the exchange regime was very substantially liberalized. But the transition from rigid exchange control to liberalized access to foreign exchange did not proceed without major problems. The own exchange system allowing the private sector direct access to import financed by "own exchange" was first introduced in 1974 but its real impact followed Law 118 of 1975 which allowed the private sector freedom to engage in all import and trading activities including setting up import agencies. The new system was to provide imported intermediate and capital goods to the private sector without straining the limited resources of the official foreign exchange budget by encouraging the inflow of workers' remittances in the form of "own exchange inputs", i.e. imports financed by foreign exchange budget from Egyptian workers abroad at a freely fluctuating rate. Durinig the two years following its establishment, however, the list of items which could be imported via the own exchange system was extended to all commodities except supply commodities. During the same period the official exchange rate itself - 220 - was changed by introducing in 1975 a parallel market rate for all non-traditional transactions such as cash remittances, tourism and crafts exported for which a significantly devalued Egyptian pound was applied. The parallel exchange rate was gradually to encompass more and more transactions. By mid-1976, most imports of capital goods and intermediates by the manufacturing sector were made subject to the parallel rate which by then stood at 75 percent above the official rate. By the first of January 1979, the old official exchange rate of $1 = LE 0.40 was finally abandoned and the parallel rate became the new unified rate of $1 = LE 0.70. Transactions in the own exchange market continued, however, at a significant premium above the new official rate, a premium which has led to a devaluation in 1981 and has become the subject of controversy over appropriate government action as the free market rate continues to fluctuate around the $1 = LE 1.00 value, far above the new official commercial bank rate of $1 = LE 0.84, or the Central Bank rate which remains at = LE 0.70. The process of institutional decentralization - the third important prerequisite for the market mechanism to function - has been advocated by the government ever since 1974, but progress on this front has been very slow. Every new cabinet has pledged to do away with those controls that have exacerbated the problems related to price distortions, imbalances in the labor market and the absence of sufficient autonomy for state-owned enterprises in facing the challenge of competition. Each one of these problems is a legacy from the period of the 1960's and each one has been the subject of long debate over the entire span of time since the adoption of the Infitah. Administered prices for basic consumer goods, intermediates produced by the public sector, together with fixed selling prices for the majority of output of the agricultural sector have persisted at levels which are a small fraction of their real opportunity cost to the economy, while devaluation, and domestic and international inflation have raised the price of uncontrolled commodities at an accelerated pace over the past ten year period. The ultimate beneficiary of price controls is intended to be the low income consumer whose expenditure on basic subsidized goods and services perhaps accounts for 60 percent of his total income. But the cost to the treasury of providing explicit and implicit subsidies is estimated at more than LE 4 billion creating a severe strain on the government budget and on the finance and liquidity position of state enterprises. More important still, the complicated system of fixing prices and compensating producers by providing them with subsidized inputs has itself run out of control so that a significant proportion of the overall subsidy is in fact being channelled to richer consumers or middlemen, or wasted though misallocation to endorsers. In the manufacturing industry, the main victims of price distortions are the public sector enterprises for which more than 40 percent of output value consists of controlled price commodities, ranging from building materials, fertilizer and food and textile products to cigarettes and soft drinks. To compensate the companies for their losses, the government in turn provides them with low priced domestically produced intermediates and annually allocates some firms a production subsidy calculated as the difference between - 221 - production cost and exfactory selling price. The productLion subsidies and cheap intermediates are in no way consistent with the objective of operating manufacturing enterprises on the basis of efficiency and competition. Enterprises are receiving distorted price signals and are, therefore, inclined to make incorrect output and investment decisions. Measures of productivity and profitability using distorted prices are quite meaningless, and it is difficult for the control authorities to separate good performance from bad management. State owned enterprises were, in principle, given increased autonomy in their day-to-day decision making when all of the general organizations were abolished in 1976, and the Boards of Directors of the enterprises were given discretion in all areas pertaining to employment, wage payment and pricing. But this was only established on paper and in practice the' state companies have continued to be subject to general controls on all of the vital issues. Exceptions were made in selective areas such as banking, contracting, and even the Railways Authority more recently, so that each of the state owned corporations in these sectors has been allowed to assume full control of its employment and wage policy and each has, in fact, undertaken a complete reform of its basic wage and salary scale structure. Ironically, it is the industrial firms which have been left behind. It is also important to note that the two state corporations which have always enjoyed complete autonomy and independence from the Central Administration - the Suez Canal Authority and the Egyptian Petroleum Organization - are also the most: efficiently run enterprises by international standards, Labor market inconsistencies abound in the Egyptian economy and can be traced to government policy. While the employment drive of the 1960's has been abandoned in the first half of the! 1970's, the legacy remains evident in the existing patterns of employment ancL a small number of state owned manufacturing enterprises still complain of being pressured into taking on new workers or employees. There is also general consensus that what industrial firms need urgently is the right to reform their basic wage and salary structure, and their system of recruitment, and to shift to a system of promotion based on merit, qualifications and the specific needs of the enterprise rather than seniority, which has been the rule. About one half of the labor force is engaged in agriculture where rising wages reflect accurately the demand and supply conditions. Another 12 percent of the labor force is in construction where wages are again determined according to market forces for both skilled and unskilled categories. In the private manufacturing and service sectors, wages and salaries have also been rising rapidly in response to increased economic activity at home and to significant labor emigration throughout the period of the 1970's. This leaves an estimated 38 percent of the labor force employed in government administration, public utilities and public sector enterprises. The most conservative estimate of surplus government and public sector employees stands at 20 percent and the problem will continue to grow as long as the government persists in providing jobs to all university graduates and army leavers. The magnitude of resources wasted by the economy as a result of excess labor is large and can be gauged at two levels: in money terms, it can be estimated at several hundred millions of Egyptian pound directly and indirectly weighing on - 222 - the government budget; in welfare terms, the transfer of wage income to a redundant work force is made at the cost of foregoing real income from productive employment. At a time when open unemployment is insignificant in Egypt and when labor scarcities are being felt in most commodity sectors, the existing employment policy are very costly to the economy. While the subsidy bill can be viewed as a transfer of real income from government to final consumers, the overinflated wage bill is transferring resources from the government and public sector to a limited group of citizens whose services could often be better used in producing real income elsewhere in the economy. The burden of surplus labor in the public sector industry is the result of the cumulative increase in workers and employees forced upon its enterprises during the 1960's. The majority of firms claim that they could operate with as much as 30 percent reduction in their work force without any reduction in output. The same firms insist that they would like to offer higher salaries and wages to attract skilled workers and to retain the vital elements of technical and managerial talents on which the efficiency and competitiveness of their enterprises depends. One of the many problems met by these firms as a result of excess labor is that entering into joint-venture arrangements with international firms has been constrained. In many cases the public sector firm has resorted to splitting its manufacturing complex into two, and that part of concern going into the joint venture has absorbed only the needed workers while the remaining entity has seen its labor problem multiplied. The result of "Infitah" policies combined with the inheritance of the 1960's and the government's continuing commitment to supplying the economy with basic commodities at subsidized prices, has been the emergence of a very pronounced form of "economic dualism", with some parts of the Egyptian economy characterized by low and fixed prices, low productivity and low incomes, and other parts characterized by higher and flexible prices, high profits and higher productivity. It is almost as if there were now two economies, coexisting, trading, even sharing labor, but with very different factor ratios and factor productivities. Viewed against this background, the multiple exchange rate system seems almost inevitable. The high and flexible "free market" rate reflects the income level and functioning of the modern private and joint-venture sector. The fixed central bank and commercial bank rates reflect the much lower income level and the price rigidities characterizing the remaining parts of the economy. This extreme form of economic dualism that cuts across industries and geographical location has become an important political problem, in addition to making economic management a very difficult task. Major reforms are required to allow resources to flow into their most productive use and to create an institutional framework which would allow the economy to yield its full potential. But the debate on the most appropriate reforms cannot just be conducted in institutional or organizational terms. It is of vital importance to understand the existing distortions and their effect on factor productivity, trade performance and product mix, when trying to design reform measures or guide investment planning. Industrial strategy is in need of a quantitative economic framework within which policy choices and investment decisions can be made. Without some concrete quantitative knowledge, it is - 223 - difficult for the policymakers to focus on the most important problem areas and design the right mix of policies. The next two chapters of the Report attempt to provide some of the elements of a quantitative analysis of Egyptian industry. The study does not attempt to be comprehensive or exhaustive. Data, time and resource constraints have forced us to be selective in what could be researched and analysed. Nevertheless, in collaboration with the Ministry of Industry, much ground has been covered. The picture that appears is a very complex one, revealing an industry with many problems, suffering from many constraints, but also showing surprising strength and efficiency in some sectors and subsectors, with enough potential to warrant an ambitious and confident approach to the difficult challenges of the future. 10/27/82 (577J) - 224 - Chapter 8 Productivity Growth in Egyptian Public Sector Industry 1973-1979 8.1 The Meaning and Measurement of Total Factor Productivity The purpose of this chapter and the next is to provide an assessment of the progress made by Egyptian industry and its performance in the period following the liberalization efforts outlined in Chapter 7. This chapter focuses on the measurement and explanation of changes in total factor productivity in the public industrial sector between 1973 and 1979. Chapter 9 focuses on the relative efficiency of individual firms and industrial sectors in public and private industry when measured at shadow (economic) prices, and on the structure of economic incentives provided by the price system and the policy environment. The two approaches are complementary; one attempts to document and explain changes in the efficiency with which resources are employed over time, given the incentives confronted by firms; the other asks to what extent these incentives adequately reflect performance when resources are priced at their actual opportunity costs to the economy. Even firms which are judged inefficient at shadow prices can improve their economic performance through improvements in total factor productivity, and indeed, much of the rationale for early protection and other forms of support for industry in a country such as Egypt derives from the belief that eventually gains in total factor productivity will be sufficient to make the industry competitive without further protection. Efficiency and comparative advantage must be seen in a dynamic and global context, not just in terms of static measures taken at a particular time. In this chapter we provide estimates of the rates of change in total factor productivity which have occurred in fourteen industrial groups in the public sector between 1973 and 1979. Total factor productivity change measures the changes over time in output per unit of total factor inputs combined. Since the Egyptian economy can only grow as fast as the rate of expansion of its factor inputs plus the rate of productivity change of these inputs, it is important to know how large a rate of productivity growth has been achieved under a given policy regime and to set this rate of growth in context by comparison with evidence from other countries. This is the first major subject of our empirical work. The second focus is to attempt to explain the factors which underlay Egypt's productivity performance in the recent past, both as a guide to future policy and in an effort to understand the consequences of past policy actions for the rate and direction of productivity change. Previous studies of total factor productivity change in Egypt suggest that average rates of productivity growth in the industrial sector were positive and comparable to those encountered in other countries at similar levels of development between 1945 and 1962. 1/ Between 1962 and 1973, however, Egypt appears to have experienced largely negative average rates of 1/ Mabro and Radwan (1976), pp. 185-86. -- 225 - measured total factor productivity change. Movements in the rates of total factor productivity growth coupled with largely anecdotal, evidence concerning the organization and management of individual enterprises have been used to suggest that the productivity performance of Egyptian industry began to deteriorate around 1962-64. It was partly in response to these indicators of declining industrial performance thal: the policy reforms collectively known as "Al Infitah" (the Opening), were undertaken beginning in 1973. In an economy at any given time, goods and services are produced by combining factor inputs with some technical knowledge. The store of technical knowledge employed in production takes a multitude of forms, from the information contained in a farmer's almanac to some specific chemical formula, or from managerial skills and efficient organization of a large corporation to scientific advances in electronic engineering. The concept of technology represents the ability to transform observable units of factor inputs (capital, labor and materials) into output. With a level of technology given in the production of an output, there must be a maximum amount of the output that can be produced with a given amount of inputs (Production of the output above that maximum is technologically infeasible.) In fact, a given level of technology must imply a series of such maximum output levels, each corresponding to a different level of inputs. Technology is therefore conceived as the technically feasible limit of production possibilities. A given level of technology implies that more output cannot be produced without more inputs and that inputs cannot be reduced without producing less output. Economists have traditionally summarized the relationship between inputs and output in terms of the production function--the set of technical relationships which govern the maximum quantity of measurable output that can be obtained from a given set of measured inputs. The methodology of total factor productivity (TFP) analysis is based on the economic theory of production. In Figure 8-1 one possible production function relationship is represented between a single output and a single input. The production function is shown to have shifted upward between periods one and two, implying that in period two a greater maximum output can be obtained from any positive quantity of input than in period one. In short the shift in the production function summarizes the effect of total factor productivityr change. The major empirical question is how one is to measure this increase iin total factor productivity. Consider a firm such as that located at point A in period one and at point B in period two. Two things have happened in the transition from point A to point B--the firm has added to the volume of inputs it uses in production, thus increasing its maximum potential output along the production function, and it has experienced a change in total factor productivity. The issue is to separate these sources of output growth so that the index we obtain from our measurement of total factor productivity change reflects only the contribution of the increase in the productivity of inputs and not in the - 226 - Figure 8.1 Total Factor Productivity Change in a Single Output/ Single Input Production Function Output B F~~~2 Input volume of inputs applied to production. There are two possible empirical approaches to this problem. One procedure is to define the level of total factor productivity in period two relative to that in period one. This involves finding the factor of increase which expands output to the projected period two level, A', given the period one level of inputs. The alternative procedure is to find the factor of reduction which shrinks predicted output to the period one level, given the input level observed in period two. This defines productivity in period one relative to period two, and can be represented by the movement from B to B' in Figure 8.1. A similar type of analysis could be applied to the estimation of differences in productivity levels between firms at any point in time. The two production functions represented in Figure 8.1 would then represent different levels of maximum output obtainable by the two firms for equal levels of inputs. - 227 - The framework of TFP analysis is therefore quite general, but it suffers from a number of limitations. First the two index number approaches are not equivalent and need not give the same estimate of TFP change. Second, either index of TFP requires that we predict the leveL of output which would have occurred in the absence of productivity change in order to derive the scalar measure of relative output levels. In the case of the period one based measure this consists in practice of predicting the movement along F2 from B to A', and in the case of the period two based measure of predicting the movement along Fl from A to B'. In either case we must specify a form for the functional relationship between inputs and output. In practice this means selecting from among the various functional forms of the production function one which may be estimated by econometric techniques and which we believe is a good approximation to the underlying technical relationships involved in production. Having selected a functional form for the production function, the estimation of total factor productivity change is relatively simple. The structure of production implied by the production function requires that the following accounting identity must always apply: Rate of Growth of Inputs Perentage Change Rate of Growth = Multiplied by Elasticity + in Output per Unit of of Output of output with respect to Time holding all inputs Inputs Constant (1) The first term of the right hand side of the identity measures the effect of increasing the quantities of inputs (more labor, more capital, more materials) on the change in output. The second measures the contribution of total factor productivity change. Because this identity is derived from the production function itself, it is possible to estimate directly both of the elements of the right hand side. Alternatively, and more conventionally, it is possible to assume that the elasticity of output with respect to an input is given by its cost share, which would be the case under perfect competition and constant returns to scale, and to estimate the contribution of total factor productivity change to outptut change as the difference between the rate of growth of output and the input contribution. The second major issue of producitivity analysis is the interpretation of the estimated rates of TFP change. The term productivity change is frequently used synonymously with technical change. The origin of this identification of technological change with TFP change is obvious; if the production function relationship in Figure 8.1 truly represents the maximum feasible limits of production, an upward shift in the production function represents an increase in maximum potential output at each level of inputs. This is how economists traditionally have defined technical change. One must be careful in the use of this synonym, however. Technological change always implies productivity change, but productivity change does not always imply technological change. The most obvious example of this is encountered in economies where sectors exhibit negative total factor productivity change. - 228 - Does this really mean that the maximum feasible limits of production are deteriorating over time? Is technological progress running backwards? Probabaly not. How then are we to interpret total factor productivity change? Recall that in measuring TFP change we define, via the production function, a relationship between measured inputs - capital, labor and materials - and output. There are many characteristics of these inputs, their quality, the rate of utilization, the manner in which they are coordinated and combined, which are difficult if not impossible to measure. In addition there are important production inputs, for example management intensity and quality, which are almost universally excluded from the production function. Changes in the characteristics of inputs included in the production function or in the amount or characteristics of excluded inputs will be recorded empirically as TFP change. For example, fuller utilization of capacity will be recorded empirically and an increase in the output of a given stock of productive assets and, hence, as positive TFP change. A sudden disruption of input supplies may result in a fall in output for a given stock of labor and capital, and thus appear as a deterioration in productivity performance. Improvements by management in using given techniques will also result in increased levels of-TFP. Thus, empirical results on total factor productivity change should not be interpreted simply as technical change in the sense of changes in the maximum limits of production. Rather they represent a combination of changes in technique and changes in the productivity with which existing techniques are employed. It is important in examining the evidence on productivity performance in Egyptian industry to keep this qualification in mind. The short run productivity changes which we observe between 1973 and 1979 may owe as much to changes in the efficiency with which the existing techniques in the public sector are operated as they do to the force of technological progress expanding the limits of production. 8.2 Output Growth and Productivity Change in Public Sector Industry In the analysis below the 110 firms currently under the authority of the Ministry of Industries and Mineral Wealth have been grouped into fifteen sectors producing relatively homogenous types of output. The rationale for doing this is simply that, since the estimates of productivity change are based on a production function, the technology employed by each firm in an industry should be roughly similar, so that the production function which we estimate represents a relatively good approximation to the technological relationship between inputs and output. Empirical implementation of the methodology of TFP analysis requires that we specify an explicit functional form for the production function in order to predict levels of output. Obviously, the fewer restrictions which we are required to impose on the structure of production the better. The family of functional forms called flexible functional forms is therefore very attractive from this point of view since it imposes no more than what are considered the minimum necessary properties for a production function in -- 229 - economic analysis. One member of this family, the transcendental logarithmic form, translog, has gained popularity in recent years because of its relative ease in empirical estimation. In addition the translog form has the property that the index numbers of TFP change generated by its use are precisely equal to the geometric mean of the two approaches to TFP measurement outlined above. Thus it avoids the problem of getting two different measures of TFP change. We have specified a translog production function with three factor inputs, capital, labor and materials. Time is entered explicitly in the production function and, therefore, one of the parameter estimates generated by our estimation procedure is the raite of movement of the production function over time. The mathematical specification of the frontier and some notes on its estimation are contained in Apperndix A-8. The production function was estimated for each of the fifteen industrial groups in Egypt's public sector. Output is value of gross output and factor inputs are capital, labor, and materials. The gross output and material input series are in constant 1972 producer prices. The capital input series represents an estimate of net capital stocks at replacement cost in constant 1972 prices, and the labor input index is number of workers employed. For each of the sectors the panel of data consists of individual firm level observations for the period 1973-1979. Table 8.1 presents average annual growth rates of output, inputs, and TFP change for the average firm in each of the fifteen industrial sectors in our study. The table also gives the percent contribution to growth of each input, and the contribution of TFP change to growth. By the average firm we mean a hypothetical enterprise which has the geometric mean level of inputs and output for the sample of firms in each industry. Average productivity change may be thought of as reflecting the performance of the representative firm in each industry, where some firns are doing better and some worse than the average. Table 8.1 also provides information on average annual changes in the capital-labor ratio for the representative firm and average annual changes in the output-capital ratio, output-labor ratio, and output-material ratio, which are the average productivities of each respective input. Most public sector industries in Egypt experienced rapid rates of growth in output during the period 1973-1979. In seven of the fifteen industrial sectors, rates of output growth for the representative firm exceeded ten percent per year, and in an additional three sectors the output growth rate was more than five percent: per year. The most rapid rate of output growth was recorded in the fertilizer industry where two major new investments made late in the 1970's came on stream and substantially increased the capacity of the sector in 1978 ancl 1979. This expansion of output in fertilizer is the major contributing factor to the rapid expansion of output in the basic chemicals industry in which it is also included. Edible oils, beverages and tobacco, rubber and plastic, transportation equipment, and electrical machinery also experienced very rapid expansion of output during the period. Table 8.1 Sources of Growth in Egyptian Public Sector Industries, 1973-1979 FOOD TEXTILES CHEMICALS METAL PRODUCTS AND ENGINEERING Fabri- Beverage Rubber Light Iron cated China Edible & Mfg. Cotton a/ . Other Basic & Cons. & Transp. Metals Elect. & oils Tobacco Food Products Textiles Paper Chem. Fert. Plastic Goods Steel Equip. & Mach. Mach. Glass Growth Rate of: Gross Output 13.6 11.7 9.2 0.5 (3.2) 3.2 9.3 14.9 23.8 12.9 -2.2 5.8 12.1 3.4 17.0 3.4 Capital Input 4.6 7.8 5.3 3.8 (3.8) 1.4 8.2 4.4 3.5 4.9 3.8 7.2 1.5 5.2 5.2 3.5 Labor Input 0.6 2.4 3.7 0.6 (0.6) 2.3 2.3 7.0 98.1 2.8 -0.2 5.7 1.6 1.0 4.2 -1.2 Material Input 7.3 5.9 7.2 -0.6 (3.9) 1.8 9.4 14.7 17.7 15.3 -3.6 3.9 10.0 4.1 16.4 3.6 Total Factor Productivity Change 7.6 6.0 3.5 -2.0 (-0.2) 1.4 2.3 3.0 13.2 -1.6 -1.3 0.7 4.5 0.5 3.8 -0.2 L Contribution to Growth by: b/ Capital Input 8.5 0.0 15.4 253.9 (57.3) 9.4 29.8 4.3 6.9 2.1 -33.9 19.6 1.0 39.4 0.8 26.9 Labor Input 0.7 0.7 13.8 44.5 (0.3) 0.0 7.6 8.7 0.0 0.0 2.2 23.3 4.6 9.8 5.2 0.0 Material Input 34.8 48.6 33.0 216.5 (46.6) 47.3 37.4 66.5 37.9 110.0 70.2 46.0 57.0 37.3 71.6 77.7 Total factor productivity change 56.0 50.6 37.8 -414.9 (-4.2) 43.2 25.2 20.5 55.3 -12.2 61.4 11.2 37.4 13.5 22.5 -4.5 Growth Rate of: Capital-Labor Ratio 4.3 5.4 1.6 3.2 (3.2) -0.9 6.5 -2.6 -4.7 2.1 3.9 1.5 -0.1 4.2 1.0 4.6 Output-Capital Ratio (Capital Productivity) 8.8 4.0 3.9 -3.3 (-0.6) 1.8 0.5 10.4 20.4 8.0 -5.9 -1.4 10.6 -1.8 11.8 -0.1 Output-Labor Ratio (Labor Productivity) 13.0 9.4 5.5 -0.1 (2.6) 1.0 7.0 7.8 15.7 10.1 -2.0 0.2 10.5 2.4 12.8 4.6 Output-Material Ratio (Material Productivity) 6.3 5.9 2.0 -2.8 (-0.7) 1.4 -0.1 0.1 6.1 -2.4 1.4 1.9 2.1 -0.7 0.5 -0.2 a/ Entries in parentheses pertain to the physical input and output series. b/ Effective growth rates of inputs divided by gross output growth rate. - 231 - Of the remaining five sectors, one, light consumer goods, experienced negative rates of output growth, and three, other textiles, fabricated metals and machinery, and china and glass, had rates of output growth of approximately three percent per year. The remaining sector, cotton textiles, poses a particular problem. The constant price output series derived from individual firm data on production and prices indicates that the real value of output increased between 1973 and 1979 at an annual average rate of 0.5 percent. Physical output measures compiled by the General Organization for Textiles on the other hand indicate that the volume of cloth and yarn production increased over the same period at a rate of approximately 3 percent per annum. These data are not inconsistent if there is evidence of down-grading of product quality or other price changes which would result in a decline in constant price unit values over the period. Unfortunately, our evidence in this regard is incomplete. Abrogation of the bilaterial trade agreements which affected much of the exported output from the sector did result in a shift in capacity from higher unit value exported cloth to lower value,outputs produced for the domestic market. In addition, there is some indication that increases in the allocation of capacity to the production of rationed cloth may also have contributed to a decline in unit values. We are, however, unable to quantify the impact of these changes either at the firm or the industry level, and we have therefore chosen to present both the constant price and physical output series results in Table 8.1. In contrasting output growth rates for the representative firm with rates of factor input growth one striking feature immediately emerges. Employment growth generally fails to kceep pace with output growth. The consequence of this result is that in thirteen of the fifteen sectors labor productivity increases, often at a very rapid rate. Declines in labor productivity occur only in cotton textiles (using the constant price series) and light consumer goods. Rapid rates of growth in output with relatively little employment growth are consistent with the view advanced by many commentators that public sector firms in Egypt began the 1970's with employment levels much in excess of the optimum economic level. Firms confronted with a substantial number of workers whose wage exceeds their marginal value product can respond by some combination of changes in techniques to raise the productivity of workers via substitution of other factors of production for labor and increases in total factor productivity which will raise labor productivity along with that of all other factors. In an expanding enterprise these two phenomena should be reflected in rising capital-labor (and possibly material-labor) ratios due to capital deepening and in increasing productivity of all inputs due to total factor productivity change. Eleven of the fifteen sectors in our sample experienced capital deepening at rates ranging from 6.5 percent per year for paper products to one percent per year in electrical machinery. Basic chemicals (including fertilizer), non-cotton textiles, and transportation equipment were the only sectors in which the capital labor ratio declined over the period. These were also three of the four sectors with the lowest rates of investment. The materials-labor ratio increased in tweLve of the fifteen sectors; the only - 232 - exceptions were in iron and steel, light consumer goods and other textile products. In sum in a great many sectors output, capital and materials all grew relative to labor input. Total factor productivity increased in eleven of the fifteen sectors of our sample. Rates of productivity change varied from a high of 13 percent in fertilizer to a low of -2 percent in cotton textiles (using the constant price series). There does not appear to be an obvious common link among the industries which have negative total factor productivity growth. The light consumer goods industries grouped together in the chemicals sector are relatively mature industries, while rubber and plastic, and china and glass are more recent import substitutes. In light consumer goods declining output was accompanied by declining total factor productivity. In the cotton textile, rubber and plastic and china and glass industries output growth was accompanied by deteriorations in total factor productivity. The sources of growth calculations in Table 8.1 reveal that in most Egyptian industries total factor productivity growth is a major contributor to output growth. The percentage contribution to output growth by TFP change ranges from a high of approximately 55 percent in edible oils and fertilizer production to 11 percent in iron and steel manufacturing. The contribution of TFP change to growth in Egypt is compared with similar estimates from five different countries in Table 8.2. This international comparison shows that the contribution of TFP change to growth among Egyptian industries was exceedingly high relative to that of other countries. In as many as eight out of fifteen industries in Egypt, more than one-third of growth can be attributed to TFP change, while in other countries, the USA is the only country that has any high concentration of industries with such contributions by TFP growth. In studies of Japan, Korea, Turkey, and Yugoslavia, the average contribution of TFP change to growth has been found to be somewhere between 10 to 20 percent of the growth rate of output. In the growth process of industrial activities, the percentage contribution of material input to gross output growth is usually high regardless of countries or industries. The trade-off, therefore, is between TFP growth on the one hand, and capital and labor input growth on the other. The importance of TFP change in Egypt implies relatively less importance attached to the contribution of capital and labor input to growth as one can observe in Table 8.1. In fact, one revealing feature of the industrial growth process in Egypt's public sector seems to be that it occurred with somewhat lower rates of capital deepening compared with other countries. Table 8.3 presents the average annual growth rates of the capital-labor ratio in broadly comparable industries in five countries in contrast to Egypt. Egypt's rates of capital deepening are on average more similar to those of the USA, which has the slowest growth in industrial output of any country in our sample. They differ significantly from those of Japan, Korea, and Turkey with whom Egypt shares similar growth rates of industrial output. In sum total factor productivity change was an extremely important element of the rapid rate of industrial growth enjoyed by the Egyptian public sector between 1973 and 1979. Output in most industries grew far more rapidly than the effective contribution of factor inputs, and in particular more rapidly than the effective contribution of capital and labor. Table 8.2 CONTRIBUTION OF TFP CHANGE TO GROWTH, AN INTERNATIONAL COMPARISON (in percent per year) Egyptian EGYPT JAPAN KOREA TURKEY USA YUGOSLAVIA Non-Egyptian Industries l973-7T9) (Ti-3 53) (T6i 77) (1963-76) (19ZW-*73) (1965-78) Industries FOOD 23.5 32.6 22.6 37.2 -9.0 Food Edible Oils 55.95 Beverages and Tobacco 50.63 72.0 -29.8 Tobacco Mfg. Food 37.82 TEXTILES 22.6 23.8 15.2 35.3 Textile Hill Products 15.5 6.9 14.9 45.1 -1.7 Apparel Cotton Products -414.9 Other Textiles 43.22 CHEMICALS Paper 25.22 14.4 23.3 10.4 21.0 0.6 Paper Basic Chemicals 20.45 20.4 21.0 18.8 42.2 0.8 Chemicals (of which Fertilizer) 55.27 Rubber and Plastic -12.18 -12.4 28.1 30.2 25.4 17.7 Rubber and Plastic (A Light Consumer Goods 61.42 bJ METAL PRODUCTS AND ENGINEERING Iron and Steel 11.20 7.9 7.2 5.8 -32.2 -10.4 Basic Metals a/ Tranap. Equipment 37.42 15.1 17.7 17.0 21.4 Transp. Equipmentb/ 5.8 27.0 19.9 27.1 4.8 Fabricated Metals Fab. Metala 6 Machinery 13154 19.7 24.9 7.5 27.3 Machinery Electrical Machinery 22.45 24.2 20.1 9.4 40.3 -1.5 Electrical Machinery China and Glass -4.49 13.9 23.9 2.0 26.4 19.3 Stone, Clay, Glasa Notes: a/ Includes non-ferrous metals for Japan, Korea, Turkey, and USA. b/ Motor vehicles only for USA. Source: The estimates for Japan, Korea, and Turkey are from Nishimizu and Robinson (1982), "Sectoral Productivity Growth: A Comparative Analysis of Four Countries," Development Research Department, The World Bank. The estimates for Yugoslavia are from Nishimizu and Page (1982); see Table 6. The estimates for USA are from Gollop and Jorgenson (1980), "US Productivity Growth by Industry" in J. W. Kendrick and B. N. Vaccara (eds.) New Developments in Productivity Measurement and Analysis, NBER Series in Income and Wealth, Vol. 44, Chicago: The University of Chicago Press. Table 8.3 INTERNATIONAL COMPARISON OF THE RATE OF CAPITAL DEEPENING (in percent per year) Egyptian EGYPT JAPAN KOREA TURKEY USA YUGOSLAVIA Non-Egyptian Industries (1973-79) (1955-73) (1960-77) (1963-76) (1966-73) (1965-78) Industries FOOD 6.74 4.01 4.91 2.48 2.73 Food Edible Oils 4.25 Beverages and Tobacco 5.40 0.88 9.51 Tobacco Mfg. Food 1.59 TEXTILES 4.56 6.41 7.53 3.67 Textile Mill Products 9.75 9.36 6.34 5.05 4.28 Apparel Cotton Products 3.19 Other Textiles -0.88 CHEMICALS Paper 6.54 5.79 -0.88 8.10 3.14 3.54 Paper Basic-Chemicals -2.59 8.48 8.49 4,48 3.22 4.04 Chemicals (of which Fertilizer) -4.67 Rubber and Plastic 2.09 8.94 5.78 9.70 3.07 5.38 Rubber and Plastic Light Consumer Goods 3.93 METAL PRODUCTS AND ENGINEERING Iron and Steel 1.51 8.58 20.68 3.11 2.61 6.48 Basic Metals a/ b Tranap. Equipment -0.13 7.02 4.98 8.54 1.41 Transp. Equipment - 9.05 2.32 10.56 2.54 3.17 Fabricated Metals Fab. Metals & Machinery 4.22 7.75 5.43 -0.33 4.17 Machinery Electrical Machinery 1.00 4.52 8.39 8.45 4.88 6.50 Electrical Machinery China and Glass 4.63 8.92 3.92 6.86 1.19 4.91 Stone, Clay, Glass Notes: a/ Includes non-ferrous metals for Japan, Korea, Turkey, and USA. h/ Motor vehicles only for USA. Source: The estimates for Japan. Korea, and Turkey are from Nishimizu and Robinson (1982), The estimates for Yugoslavia are from Nishimizu and Page (1982); see Table 6. The estimates for USA are from Gollop and Jorgenson (1980). Table 8.4 AN INTERNATIONAL COMPARISON OF TOTAL FACTOR PRODUCTIVITY CHANGE (in percent per year) Egyptian EGYPT JAPAN KOREA TURKEY USA YUGOSLAVIA Non-Egyptian Industries (197 3-79) (955-73) (1T60-77) Ti-96-76) (1966-73) (1965-78) Industries FOOD 2.21 5.26 1.91 1.23 -0.57 Food Edible Oile 7.61 Beverages and Tobacco 5.95 0.85 -1.60 Tobacco Mfg. Food 3.48 TEXTILES 1.70 4.51 1.44 2.25 -0.17 Textile Hill Products 1.94 1.62 2.74 1.83 Apparel Cotton Products -. Other Textiles 1.40 CHEMICALS Paper 2.34 1.62 4.52 1.41 0.94 0.48 Paper w Basic Chemicals 3.04 2.50 4.49 1.62 2.67 0.10 Chemicals (of which Fertilizer) (13.17) Rubber and Plastic -1.57 -1.22 5.88 5.80 1.87 4.70 Rubber and Plastic Light Consumer Goods -1.32 METAL PRODUCTS AND ENGINEERING Iron and Steel 0.65 0.96 1.87 0.87 -0.46 -0.19 Basic Metals a/ Transp. Equipment 4.52 2.53 5.10 3.33 1.04 Tranap. Eqatupment - 0.84 6.01 1.51 0.90 0.54 Fabricated Metals Fab. Metals & Machinery 0.46 3.14 5.73 1.33 1.05 Machinery Electrical Machinery 3.81 4.42 7.25 1.83 1.60 0.25 Electrical Machinery China and Glass -0.46 1.73 4.53 0.26 0.70 2.20 Stone, Clay, Glass Notes: a/ Includes non-ferrous metals for Japan, Korea, Turkey, and USA. _/ motor vehicles only for USA Source: The estimates for Japan, Korea, and Turkey are from Nishimizu and Robinson (1982), The estimates for Yugoslavia are from Nishimizu and Page (1982); see Table 6. The estimates for USA are from Gollop and Jorgenson (1980). - 236 - Some additional insights into the nature of Egyptian productivity performance can be gained by contrasting our average TFP estimates with available estimates for comparable industries from other countries. Table 8.4 presents these estimates for Japan, USA, Korea, Turkey and Yugoslavia in addition to our estimates for Egypt. TFP growth for mature industrialized economies over a sufficiently long period of time can be thought to approximate rates of technological change, since these economies usually define the production frontier internationally. The stylized facts accumulated in the productivity literature show that one can expect these long-run rates to cluster closely around 1 to 2 percent per year, and this can be observed in the productivity growth estimates for Japan and the USA given in Table 8.4. TFP growth for developing countries, on the other hand, is often influenced significantly by factors other than technological change (such as changes in capacity utilization rates or investment gestation lags), especially when important changes occur in demand conditions, production constraints, and trade and industrial policies. Thus, productivity estimates for developing countries tend to be distributed more widely around the long- run rates of 1 to 2 percent; and this can also be observed in the estimates for Korea and Yugoslavia as well as in our estimates for Egypt. The estimates for Turkey resemble those of Japan and the USA, but this probably reflects the impact of supply side constraints imposed by a strong import substitution policy regime in that country. The fact that average rates of total factor productivity change most sectors exceed international levels suggests that total factor productivity change in Egypt does not reflect long term trends in technological progress. Rather it reflects a process of "catching-up" after the productivity deterioration which is widely believed to have taken place in the 1960's. 8.3 The Nature of Productivity Change in Egyptian Industry The international comparisons in the preceeding section indicate that both the rate of average total factor productivity change and the contribution of TFP change to output growth are high in Egypt by all international standards. In this section we examine the characteristics of this rapid growth in productivity. We begin by decomposing TFP change into changes in best practice total factor productivity and changes in technical efficiency. We then examine the structure of TFP change of each of these components with a view to explaining the sources of Egypt's rapid rates of total factor productivity growth. Decomposing TFP Change In discussing the interpretation of productivity change we argued that it is not correct to view TFP change wholly as changes in techniques of production. The efficiency with which existing techniques are used may also change over time, for example, as a result of improvements in management or increases in capacity utilization. These improvements will also be recorded as changes in total factor productivity. It is the concept of the production - 237 - function as defining the maximum potential output for a given set of inputs which makes this distinction relevant. In practice, not all firms achieve their maximum potential output; they therefore operate at a point like C in Figure 8.1, below the production function. If, by improvements in their use of existing techniques, they are able to reach their maximum potential output, in this case at A, the increase in output for a given set of inputs will be recorded as an improvement in total factor productivity. This type of TFP change, which is not due to a change in techniques of production is called technical efficiency change. Observed TFP change for any firm, say the movement from C to B, can be thought of as the combination of technical efficiency change (C to A) and changes in techniques (A to B). In studying the productivity performance of Egypt's public sector the distinction between changes in techniques of production and changes in the efficiency with which known techniques are employed is particularly relevant. A number of sector studies undertaken in the 1970's expressed concern over the levels of technical efficiency--the efficiency with which existing techniques of production were employed--encountered in Egypt's public enterprises. Changes in technical efficiency may occur even in the absence of technological change and as we explained in Section 8.1 the gains (or losses) from such changes are also recorded as TFP change. Since the magnitude of the productivity gains from technical efficiency change may oultweigh those from technological change, it is important to know the level of efficiency with which known techniques are employed and the rate at which this level is changing over time. In order to define technical efficiency and distinguish it from technological progress we must have a standard against whic:h the productivity performance of any enterprise is measured. One possible standard is the frontier or "best practice" production function, which establishes for any set of firms or production units the outer boundary of all observed input-output combinations. The production frontier, therefore, defines for a given set of techniques of production and a given production environment the maximum output level which can be obtained from any level of inputs. In Egypt, for example, the production frontier would reflect the best practice levels of productivity actually encountered among Egyptian firms. Many, and perhaps most firms, will fail to achieve best practice levels of productivity. The level of output which they can achieve will be less than that predicted by the best practice production function. Note that the best practice frontier is defined relative to the actual performance of firms in the sample. It shows the maximum amount of output actually achieved over all of the input combinations actually observed. This best practice level of productivity may not represent the maximum output attainable internationally in the same production process, and, indeed, for the reasons which we discussed above, it may not even represent the maximum technological capabilities of the production process in place. It does however define the maximum limits to productivity beyond which no operating firm is observed. The frontier production function provides information on the subset of firms which define the technological state of the art. - 238 - The production function which we employed in our analysis of average TFP change was a frontier production function. Because time was entered explicitly in the estimation procedure we have a direct estimate of the rate of best practice productivity change. In Appendix A-9 we show that average TFP change can be decomposed into the sum of best practice TFP change and changes in technical efficiency. We can therefore rewrite expression (1) in the following manner: Average Rate of Rate of TFP Change of + Rate of Change of (2) TFP Change Best Practice Frontier Technical Efficiency Our procedure therefore allows us to examine separately the characteristics of productivity change in firms employing best practice and those of average firms in each sector. From this analysis we can learn how rapidly best practice firms have improved their total factor productivity and whether the average firm has been moving closer to best practice productivity of further away. This assists us in determining the extent to which TFP growth in Egypt since 1973 has been due to technological change or to changes in the productivity with which known techniques are employed. When technical efficiency change is positive, it indicates that firms are "catching up" on average with the best-practice productivity performance of the industry. When the rate of technical efficiency change is negative, it indicates that the average performance of firms is falling behind that of best--practice. TFP change of a representative firm can be computed as the sum of the best-practice TFP change and technical efficiency change. It is importanmt to keep in mind that declines in technical efficiency are compatable with overall improvements in total factor productivity. When best practice productivity change is very rapid, as for example when an industry is experiencing high rates of technological progress, the average or representative firm may not fully incorporate all of the changes undertaken by those employing best practice. Nevertheless, it is possible for the representative firm to experience positive productivity growth if the rate at which its production possibilities are shifting outward exceeds the rate by which it is falling behind the best practice technology. Conversely, in sectors where best practice firms are experiencing little or no growth in total factor productivity the representative firm may achieve high rates of productivity growth simply by improving the efficiency with which the static technology is used. Estimates of average annual rates of TFP change, best-practice TFP change, and technical efficiency change are presented for the representative firm in each industry in Table 8.5. We can predict best-practice TFP change for the representative firm in each industry by combining average input levels with the estimated frontier parameters in each year and taking simple averages of consecutive time periods. The actual TFP level of the representative firm relative to the potential best-practice level is equal to the observed average output level relative to the potential output level of the representative firm. The difference in the rate of best-practice TFP change and average TFP change can be obtained by taking the log differences of this ratio in successive time periods. This is what we have termed technical efficiency change. - 239 - Three aspects of these estimates are immediately striking. First, we observe average firms to be catching up with the best-practice in only three industries. They are beverages and tobacco, manufactured food, and fertilizer. The rest of the industries exhibit negative technical efficiency change, indicating a widening gap between average performance and best-practice over time. The second point we can note, however, is that these negative technical efficiency changes are smaller in their absolute magnitude than the corresponding best-practice rate of TFP change in all but four industries. This indicates that the average firm was experiencing procluctivity improvement, but at a rate slower than the best-practice potential rate. The four industries which are the exception to this are cottorl textiles, rubber and plastics, light consumer goods, and china and glass, where one observes deteriorating average TFP levels over time. Third, the rates of best practice TFP change are very high in comparison with long term trends in total factor productivity in more developed countries. In Section 8.2 we argued that long term rates of total factor productivity change in such developed countries as Japan and the United States approximate rates of technological change. These economies define the international state of the art in most production processes and their rates of change in total factor productivity can be thought to approximate maximum sustainable rates of best practice TFP change. The very rapid rates of best practice TFP change encountered in Egypt, particularly in such industries as edible oils, paper,;transportation equipment, fabricated m.etals and electrical machinery, are most likely to be indicative of a process of short run adjustment by best practice firms rather than of the effects of technological progress in expanding production possibilities. The Structure of "Best-Practice" TFP Change The estimated parameters of the frontier translog production function provide substantial information about the nature of productivity change of best practice firms in each of our 15 industrial sectors. Recall from our earlier discussions that these frontier functions are defined by firms that perform best, within each industry, in terms of the output level achieved for a given level of inputs. Although not every firm is on the frontier, the estimated frontier production function can be thought to describe the "best-practice" potential of each firm. Therefore, not only for the purpose of understanding the productivity performlance of best-practice firms, but also for the objective of evaluating actual productivity performance of firms relative to best-practice, it is important to study our empirical results of the frontier functions. The parameter estimates are summarized in Table A9-1 in the Appendix to the Chapter. The estimated coefficients of interest to us here are those which characterize the shift of the frontier with respect to time, since they describe the "best-practice" TFP change of each industry. There are five such parameters. These are the parameters which appear in rows (2) - (3) and (13) - (15) of the table. - Z40 - Table 8.5 AVERAGE TOTAL FACTOR PRODUJCTIVITY CHANGE, BEST-PRACTICE TFP CH.ANGE, AND TECHNICAL EFFICIENCY C'HANGE IN EGYPTIAN PUBLIC SECTOR (in percent per year) Best-practice Technical TFP Efficiency Average TFP Industries Change Change Change FOOD- Edible Oils 9.45 -1.84 7.61 Beverages and Tobacco 2.21 3.74 5.95 Mfg. Food 2.50 0.97 3.48 TEXTILES Cotton Products 0.00 -2.00 -2.00 Other Textiles 2.96 -1.56 1.40 CHEMICALS Paper 7.71 -5.36 2.34 Basic Chemicals 3.25 -0.21 3.04 (of which Fertilizer) (1.66) (11.51) (13.17) Rubber and Plastic 1.92 -3.49 -1.57 Light Consumer Goods 4.43 -5.75 -1.32 METAL PRODUCTS AND ENGINEERING Iron and Steel 3.16 -2.51 0.65 Transp. Equipment 8.18 -3.66 4.52 Fabricated Metals and Machinery 5.68 -5.22 0.46 Electrical Machinery 9.03 -5.22 3.81 China and Glass 0.31 -0.46 -0.15 - 241 - Two parameters (at and %tt) describe the "best-practice" TFP change of an "average"firm at the mid-point of the estimated time period. When Stt is positive, it indicates that the upward shift of the best-practice frontier is accelerating at a constant rate over time. When tt is negative, it indicates deceleration, and when zero it implies a stable rate of movement of the frontier over time. Table 8.6 summarizes the estimation results for at and Xtt for our sample. The distribution of best practice rates of TFP change at the midpoint of the sample are very similar to those presented in Table 8.5 (Indeed the only difference between the two estimates is that the results in Table 8.5 are averages of year to year rates over the whole sample period while the estimate of at in Table 8.6 is a point estimate at the mid-point in time of the sample.) What is of interest, however, is the great number of best practice production functions which are registering accelerating TFP growth. Traditionally, economists have viewed technical progress as occurring at a constant or decreasing rate, that is we would predict that Ott should be less than or equal to zero. Seven out of fifteen industries in Egypt show accelerating TFP change at the frontier. Only one industry (cotton products) shows a stationary frontier, and the rest of the industries are distributed equally bet:ween accelerating and decelerating TFP change. One very remarkable result of the production function estimates is that the three sectors exhibiting the highest rates of TFP change at the frontier--edible oils, transportation equipment, and electrical machinery--all exhibit accelerating rates of TFP change. This implies that best practice firms in these industries not only increased their total factor productivity at a rapid rate but that they increased this rate of productivity change over the period 1973-1979. It is unlikely that such a pattern of productivity performance is consistent with the view that technological change alone, was driving best practice TFP growth. Best practice firms in these industries appear to have been altering the existing structure of production and adjusting to changes in the productiona environment as well as innovating or adopting new techniques from abroad. The remaining three parameters ( 6Kt, SLt, and XMt ) can be interpreted as the rates of bias of best-practice TFP change with respect to capital, labor, and material inputs. When SLt is positive, for example, best-practice TFP change is labor-using, i.e. it is biased towards employing more labor for a given level of other inputs over time. Labor-using bias implies that increasing employment of labor raises the rate of TFP growth for a given level of other inputs. It also implies that the output elasticity of labor increases over time given a level of other inputs, so that if workers are paid the value of marginal product: then their income share in total factor cost increases over time. When SLt is negative, TFP change is labor-saving; and when it is zero, TFIP change is neutral with respect to labor. - 242 - Table 8.6 Number of Industries Industries DISTRIBUTION OF AVERAGE RATES OF BEST-PRACTICE TFP CHANGE ( a ) Percerit Intervals 0%v 1 Cotton Products O - 1% 1 China and Glass 1 - 2% 2 Fertilizer, Rubber and Plastic 2 3 3% 3 Beverages and Tobacco, Manufactured Food, Other Textiles 3 - 4% 3 Basic Chemiicals, Light Consumer Chemicals, Iron and Steel 4 - 6X 1 Fabricated Metals and MIachinery 6 - 8/ 1 Paper 8 - 10% 3 Edible Oils, Transportation Equipment, Electrical Machinery RATES OF CHANGE OF BEST-PRACTICE TFP CH.ANGE (St ) Accelerating 7 Edible Oils, Fertilizer TFP Change Rubber and Plastic, Light Consumer Chemicals (b > 0) Iron and Steel, Transoortatiorn Equipment tt Electrical Machinery Constant TFP Change 1 Cotton Products (b t 0) Decelerating 7 Beverages and Tobacco, Manufactured Food, TFP Change Other Textiles, Paper, Basic Chemicals (btt < 0) Fabricated Mletals and Miachinery, China Glass -- 243 - Table 8.7 provides a summary of these results. Egyptian industries show a high proportion of sectors with biases in capital input and material input use. There are very few industries that exhibit capital-neutral or material-neutral tendencies in best-practice TFP change. This is not surprising since Egypt's best-practice TFP change is on average far more rapid than international levels. It is probably the case that faster TFP change can be generated by bias in factor use. Table 8.7 also points out that the bias of factor use with respect to capitaL and material input is more or less split equally between using bias and saving bias. Mixed results with respect to the nature of bias in capital and material inputs are consistent it other studies of the structure of TFP change in industry. Only three out of fifteen industries, however, show labor-using bias. Of the remaining twelve industries, four show no bias and eight show labor-saving bias. This result implies that over half of the industries in Egypt's public sector are biased towards employing less labor for a given level of other inputs over time. Decreasing employment of labor relative to other inputs increases the rate of best-practice TFP change, and accordingly the labor income share in total factor cost should decrease over time if workers are paid their marginal value product in these industries. How are we to interpret this relatively high incidence of labor saving bias in the total factor productivity change of best practice firms in Egypt? An immediate temptation is to attempt to view best practice TFP change as a response to the often discussed compulsory employment practices imposed on public sector firms in the 1960's and early 1970's. The relatively high concentration of industries with labor-saving bias may in fact reflect the consequences of employment policies in Egypt which require compulsory addition of workers to the labor force of public sector firms in varying degrees beyond the optimum level. If firms are forced to employ labor beyond its optimum level, one might expect them to undertake labor-using bias in TFP change, because for given levels of other inputs labor using innovations would increase the output elasticity of workers and raise the overall TFP level over time. This, however, is true only if implementation of such labor-using bias in concrete terms in each industrial activity is "'cheaper"' than some other alternative. Modifying production processes towards gainful employment of relatively more workers may be costly in real resources, either in terms of explicit financial costs to the enterprise or as a result of more intensive use of existing factors such as management and supervision. "Surplus labor" may also occur in certain categories of workers whose tasks cannot be easily changed, such as clerical and administrative workers (which in fact is a case in point in Egypt). In these instances, then, a "cheaper" alternative may be to attempt to avoid the enforcement of compulsory employment if possible. If some firms are more successful in doing this relative to others, these "best- practice" firms would tend to show labor-saving bias in their productivity change. We are inclined to view the structure of best practice TFP change as reflecting, at least in part, the greater ability of best practice firms to avoid the incidence of compulsory employment programs. One must be careful, however, in the interpretation of our labor-saving result with respect to Egypt's employment policies, since a somewhat different picture emerges when one combines all the patterns of biases, withrespect to capital, labor, and material input,, for each industry. - 244 - Table 8.7 INDUSTRY DISTRIBUTION OF THE RATES OF BIAS OF BEST-PRACTICE TFP CHANGE (6Kt' SLt, Mt OF EGYPT (1973-1979) Number of Bias Industries Industries Capital-using 6 Edible Oils, Other Textiles, Fertilizer, Iron and Steel, Fabricated Metals and Machinery, China and Glass Capital-neutral 2 Beverages and Tobacco, Cotton Products Capital-saving 7 Manufactured Food, Paper, Basic Chemicals, Rubber and Plastic, Light Consumer Chemicals, Transportation Equipment, Electrical Machinery Labour-using 3 Beverages and Tobacco, Basic Chemicals, Electrical Machinery Labour-neutral 4 Cotton Products, Other Textiles, Fertilzer, China and Glass Labour-saving 8 Edible Oils, Other Food, Paper, Rubber and Plastic, Light Consumer Chemicals, Iron and Steel, Transportation Equipment, Fabricated Metals and Machinery Material-using 6 Other Food, Paper, Rubber and Plastic, Light Consumer Chemicals, Transportation Equipment Fabricated Metals and Machinery Material-neutral 1 Cotton Products Material-saving 8 Edible Oils, Beverages and Tobacco, Other Textiles, Basic Chemicals, Fertilizer, Iron and Steel, Electrical Machinery, China and Glass - 245 - The distribution of these three biases are summarized in Table 8.8. It shows that five out of eight industries with labor-saving bias have a capital-saving, labor-saving, and material using bias combination. This combination has the highest frequency of occurrence of all the possible combinations. One way in which we can interpret this result is that best-practice firms in these industries are increasing their outputs by greater utilization of the existing stock of capital and labor combined with increasing levels of material inputs. Given the production environment of the "opening", and rapidly increasing demand during the estimation period, 1973-1979, this pattern of biases would be consistent with the view that best-practice firms were those with rapidly increasing levels of capacity utilization. There is nothing inconsistent in these two views of the structure of best practice TFP change in Egypt. Best practice firms may have been those enterprises which were most successful in adapting to the rapidly liberalizing economic environment, both by making fuller use of their existing stocks of capital and labor as aggregate demand in the economy increased and supply side constraints were removed, and by having greater success than similar enterprises in avoiding the addition of workers under mandated employment schemes. Patterns of Technical Efficiency Change The rapid growth of best practice total factor productivity has as its counterpart a "falling behind" in levels of technical efficiency for the average firm in Egypt's public sector. Twelve of the fifteen industrial sectors in our sample had negative technical efficiency change on average between 1973 and 1979. This means in short that the representative firm in the great majority of of industries was failing to maintain its level of productivity relative to the best practice firm. It is important to recall that this does not mean that the average firm has experienced an absolute decline in its productivity performance; rather declining technical efficiency simply indicates that the average firm has failed to keep pace with the rapid productivity growth of those performing best practice. Figures 8.2 through 8.5 trace the year to year level of the index of technical efficiency, the ratio of actual output to predicted output, over the sample period for industries in each of the four major sec:toral groupings, food products, textiles, chemical products, and metals and engineering. These charts provide a graphical representation of the pattern of technical efficiency change in each sector. In addition the average level of technical efficiency is reported on a sectoral basis in Table 8.9. The overall patterns of technical efficiency change show some common threads across all of the sectors as well as some interesting variations among industries. For most of the sectors 10 of 15) rather sharp deteriorations occur in the ratio of actual to potential output between 1973 and 1976. This is then followed by a period of relative stability between 1976 and 1979. The major exceptions to this general trend occur in the fertilizer industry (and, therefore, in basic chemicals of which it is a component) and in transportation equipment. The index of technical efficiency in fertilizer Table 8.8 SUMTMARY DISTRIBUTION OF TIIE RATES OF BIAS OF BEST-PRACTICE TFP CHTANGE ( Kt, Lt, ) IN COMPARABLE INDUSTRIES OF EGYPT (1973-1979) LABOUR _Jsing Neutral Saving Row Total IUsing 0 3:M- 2:M- 6 (40%) (20%) (20%) CAPITAL Neutral 1:M- 1: MO 0 2 (13%) (.7%) (7%) Saving 2:M- 0 5:M+ 7 (47%) > (13%) (33%) Column Total 3 (20%) 4 (27%) 8 (53%) 15 Industries (100%) Key: M+ : Material-using MO : M4aterial-neutral H- : Material-saving - 247 - TaLble 8.9 FARRELL INDEX OF TECHNICAL EFFICIENCY LEVEL, EGYPTIAN PUBLIC SECTOR INDUSTRIES, 1973-79 Mean Index Minimum Index Representative Firm Individual Firm FOOD Edible Olls .880 .644 Beverages and Tobacco .474 .201 Mfg,. Food .794 .510 TEXTILES Cotton Products .622 .304 Other Textiles .673 .295 CHEMICALS Paper .728 .462 Basic Che-micals .572 .059 (of which Fertilizer) (.669) (.065) Rubber and Plastic .804 .558 Light Consumer Goods .667 .344 METAL PRODUCTS AND ENGINEERING Iron and Steel .744 .430 Transportation Equipment .624 .408 Fabricated Metals and Machinery .739 .468 Electrical Machinery .759 .295 China and Glass .891 .617 - 248 - production increases rapidly between 1973 and 1976 and remains relatively stable thereafter. This presumably reflects the reinstallation of capacity moved from Suez following the 1973 war and the process of adjustment of the petrochemical complex from war to peacetime production. In transportation equipment on the other hand, the relative technical efficiency of the representative firm remains constant between 1973 and 1977 after which it suffers a sharp decline. The industry is dominated by the car manufacturing complex which suffered a sharp decline in technical efficiency in 1978-1979, a result which is quite clearly reflected in the behavior of the representative firm. The index of technical efficiency in 1973 for most industries in Egypt is also quite high by international standards. Eleven of the fifteen sectors begin the period with ratios of actual to predicted output for the representative firm exceeding 70 percent. This compares quite favorably with studies of technical efficiency in other economies where the average index of technical efficiency is frequently in the range of 40 to 50 percent of potential best practice output. The major exceptions to this pattern of relatively high average levels of technical efficiency are alcohol, beverages, and tobacco, in the food sector and fertilizer (and therefore basic chemicals) in the chemical sector, which have indices of technical efficiency of about .40 in 1973. The high indices of technical efficiency for the representative firm in 1973 indicate that most firms in Egypts public sector were relatively close to the best practice performance observed in the Egyptian economy. By 1979 the dispersion of firms relative to the best practice frontier had become much greater and the representative firm had failed to keep pace on average with the best practice performers. One possible interpretation of these results is that diffusion of productivity increasing innovations deteriorated in Egypt between 1973 and 1979, with the result that best practice innovators were able to appropriate more of the gains from TFP change by the end of the period. We have argued, however, that the rates of best practice TFP change observed in Egypt are too high to be fully credited to technological change. This coincidence of rapid TFP change at the frontier, reflecting a process of catching up by best practice firms from relatively low levels of total factor productivity, and increasing variance in the relative total factor productivity of firms suggests an alternative explanation. The policy reforms of the opening increased the autonomy of individual firms substantially, relative to the levels which had prevailed in the 1960's. With increased autonomy of enterprises, some firms were able to make more rapid adjustments to the changes in the production environment implicit in the policy reforms of the opening than others. These enterprises quickly moved to define best practice based on the techniques in place, and it is their process of adjustment that we observe as best practice total factor productivity growth. In short central direction of firms in each sector kept total factor productivity growth low or negative in the 1960's but also resulted in very little dispersion of firms in terms of their relative TFP levels. The 1970's in contrast was a period of rapid productivity gains, but of increasing variance in TFP levels as firms with greater freedom of action adjusted at varying speeds to the liberalization efforts. - 249 - Figure 8.2 INDEX OF TECHNICAL EFFICIENCY TEXTILE SECTOR -N- IXI5lH alLES 0 Om--- OER TEXTILES O OD C Z~~~~~~~~~~~~ H Lr) U) - N., N. r - *,... I V) \ f)," t I[l*10 % o ]0 CD~~~~~~~~~~~ X °- 9\ 0~~~~~~~~~~~~~~~~~~~~~~~( O s ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~a 0~~~~~~~~~~~ H~~~~~~~~~~~~~~~~~ . U)S 1973 1974 1975 1976 1977 197 1979 YEARR - 250 - In the longer run deteriorating technical efficiency in industry would be a subject of substantial concern. For the short period for which we have observations however, it may be viewed as a part of the adjustment process to the new set of rules under which public sector companies were expected to operate. There is even at present an important exception to this rather optimistic view regarding the deterioration in technical efficiency in most sectors. This is in those sectors in which negative technical efficiency change outweights the gain from best practice TFP change - cotton products, rubber and plastic, light consumer goods, and ceramics and glass. These activities are not characterized (with the exception of light consumer goods) by rapid movement of the production frontier. Thus deteriorating technical efficiency probably reveals major problems with maintaining productivity at existing levels, rather than adjustment to higher levels of productivity at varying speeds. The most important single exception to the generally high rates of observed total factor productivity change in Egyptian industry occurs in cotton textile manufacturing, which produced 19 percent of total output in public sector industry and employed 45 percent of public sector workers. Cotton textiles is the only sector in which we observe no perceptable movement of the best practice production frontier between 1973 and 1979. Moreover, the level of technical efficiency of the representative firm deteriorated between 1973 and 1979 at an average rate of 2.0 percent per year. Figure 8.4 reveals that the technical efficiency of the average enterprise deteriorated rapidly between 1973 and 1975 and remained relatively stable thereafter. In an economy in which most enterprises were enjoying positive levels of productivity change this deterioration in the productivity performance of a relatively large and mature sector is quite striking. Of all of the sectors in our study the cotton textile sector was the one which was most strongly outward oriented; it was the principal manufactured export activity throughout the period. In addition the sector was operating at relatively high rates of capacity utilization throughout the 1960's and early 1970's. The policy reforms of the opening and the subsequent shift of export markets from bilateral to convertible currency areas had a particularly severe impact on the export performance of the cotton textile industry. We have interpreted the difference between the physical output series and the constant price value series as reflecting a decline in unit values of cotton output. The change in the constant price value of output will show up as a decline in technical efficiency if declines in unit values are not accompanied by corresponding reductions in factor inputs. This would be the case for example if formerly exported cloth were to be sold on the rationed domestic market. To the extent that the lower controlled price does not reflect a downgrading of product quality, the decline in unit values will not be accompanied by a corresponding reduction in unit costs. The loss of export markets from relatively high initial levels of capacity utilization, coupled with the resource costs of entering new market areas, must be partly responsible for the deteriorating total factor productivity performance of the representative firm. In addition, there is some evidence to suggest that the mandated employment of military veterans may have had a particularly severe impact on the textile industry. In the period following the 1973 war a substantial number of veterans had to be absorbed by the public sector, and a large number of these new employees were presumably accomodated in the textile - 251 - industry. Adjustment to the addition of these workers would lower the total factor productivity of firms in the short run, since there is evidence to indicate that most enterprises in the cotton textiles sector were overstaffed at the beginning of the period. Short run adjustment problems are not wholly responsible for the declining total factor productivity of the industry, however. There is also evidence to suggest that by 1979 relatively poor maintenan,-e practices coupled with the increasing age of the capital stock in the sector had resulted in declining plant level productivity in many textile firms. Thus technological factors at the enterprise level and problems of adjustment to changes in the economic environment beyond the control of individual firm combined to reduce the level of total factor productivity of the average enterprise from approximately 70 percent of best practice to 56 percent of best practice in seven years. We are therefore inclined to interpret the TFP results for cotton textiles in the following way. The modest declines in TFP recorded for the output and input volume series probably reflect a deteriorating competitive position for the industry resulting from limited technical progress during the period and from the costs of adjustment imposed on firms by the closure of export markets in the bilaterial currency areas and by the shift to higher mandated levels of rationed cloth production. The more dramatic decline in TFP levels recorded for the constant price output series probably reflects the impact of declining unit values of output. The pattern of technical efficiency change of firns in the non-cotton textiles sector is strikingly similar to that encountered -in cotton textiles. In this case, however, best practice productivity change is positive and exceeds the negative rate of technical efficiency change. Thus although the representative firm was falling away from the best practice frontier in a very similar pattern to the representative firm in cotton textiles, overall productivity change for the sector was positive. This is consistent with the view that the non-cotton textiles sector which produces mainly for import substitution was less severely impacted by the shift in export markets than was the cotton textile industry, but that both sectors sufiered from deteriorations in plant level efficiency. In the rubber and plastics industry the major cause of the deterioration in technical efficiency of the representative firm was the poor productivity performance of the rubber manufacturing firms in the sample. We have no satisfactory explanation for the rapid deterioration in firm level productivity among rubber producers. Short run adjustment problems would not appear to be the explanation, since output growth in the sector was relatively high. Material input growth was quite rapid, however, and the decline in TFP and technical efficiency may reflect increasing wastage in the production process. Figure 8-3 traces the time trend of the index of technical efficiency for the three food manufacturing industries in our sample. These activities are of particular interest both because taken together they exhibit the - 252 - Figure 8. 3 INDEX OF TECHNICAL EFFICIENCY FOOD SECTOR CDIBLC OILS a------MFG. FOOD ------ FUCOHOL,MEVMES & TUSA= | oq 0 C O) 0; 4 ZL olr C)______w 5.. t L--- C- -^ .-e C.) Li.] 1973 co417 17 97 8 17 - YR * a 1i. 73 1o417 ~ 197 198 I& Li..] - -YEA - 253 - Fitre 8 _.4 INDEX OF TFCHNT FFJCIENCY CHEMI CAL, SECTO R . - Prlrt -- --- BS]IC ICHlMLS --- fERl'ILIZER RueEiR s. PlusT C - LICIT CCRI G o o L-4 0~~~~~~~~ z La 1 \* a ~~- us1 Y ,/ ° XL *- *< <_ LLI~~~~~~~~~~~~~~~~~ I It~~~~~~ IV~~~~~~~~~~~~~ C_.o e" * 'I 1- - 1973 1974 1975 1 76 1977 197EI 1979 YEAR - 254 - highest rates of total factor productivity change of any industrial group and because their pattern of technical efficiency change is quite distinct. In beverage and tobacco production and in miscellaneous food manufacturing the representative firm is moving closer to best practice productivity levels, nothwithstanding the fact that the production frontier is itself shifting out at a rate of more than two percent per year. In the edible oils sector the representative firm was falling away from the frontier at a relatively modest rate of 1.8 percent per annum, but the frontier was moving very rapidly; best practice productivity change was approximately 9.5 percent per year. In both edible oils manufacturing and in other food processing the gains in technical efficiency may reflect improvements in the availability and reliability of supply of agricultural inputs. Capacity utilization in these sectors is particularly sensitive to the timely availability of agricultural commodities. Liberalization presumably reduced the dependence of many firms in the sector on locally provided inputs and increased their flexibility in responding to shortfalls in domestic agricultural supplies. In the edible oils sector there is also some evidence to indicate that firms shifted existing capacity from production of relatively low quality, low price items to higher price products during the period. This process of product upgrading will be recorded as TFP change and may help to explain both the high overall rate of TFP change in the industry and the slight deterioration in the technical efficiency level of the average firm. Both may be the result of high rates of product upgrading by best practice firms followed with a lag by other firms in the industry. The beverages and tobacco industry is sufficiently heterogenous that it is difficult to interpret both the average level of technical efficiency in the sector and the nature of its technical efficiency change. The major improvements in the ratio of actual to predicted output are recorded among beverage manufacturing firms which experienced relatively rapid output growth during the period. Technical efficiency change in these enterprises may, therefore, reflect gains due to economies of scale. In the chemicals sector both paper products and light consumer goods show continuous deteriorations in the technical efficiency level of the representative firm. In both of these industries the rate of TFP growth of best practice firms is quite rapid; hence, the deterioration in the technical efficiency level of the representative firm reflects the inability of other firms in the sector to keep pace with those employing best practice. As we have noted above, the heterogeneity of the light consumer goods industry makes an interpretation of the results difficult. Major deteriorations occur in the technical efficiency of leather manufacturing and wood products firms. This may indicate that in these activities loss of export markets (leather) coupled with increased import competition (wood) impacted firms in the industry unevenly, benefitting frontier firms while penalizing other firms. In paper and paper products the uneven impact of trade liberalization is almost certainly a partial source of the observed pattern of productivity change. The liberalized trade policy as it affected the paper and paper products sector increased import competition for some firms, while it relieved - 255 - input bottlenecks and allowed other firms to shift to lower cost foreign supplies of inputs. Thus some firms benefitted more than proporationately from the liberalization of the trade regime, while others were more than proportionately hurt by the increased import competition. In paper products this adjustment process was particularly dramatic because of the stratification of firms along product lines. Basic paper manufacturers probably suffered reductions in capacity utilization as a result of increased import competition, while paper products manufacturers benefitted on the whole from improved levels of capacity utilization due to increased availability of inputs. In the metals and engineering sector, the iron and steel industry shows a somewhat unusual pattern of technical efficiency ,-hange; a sharp reduction in technical efficiency between 1973 and 1975 is followed by a substantial recovery between 1975 and 1978. The industry is dominated by the iropi and steel complex which strongly influences the behavior of the representative firm. Technical efficiency change in the sector closely follows the operational learning periods of the two expansions of the iron and steel complex. The Phase I learning period between 1974 and 1977 is clearly reflected in Figure 8.5, and the learning period of the Phase II expansion which began in 1978 may be reflected in the slight decline in the index of technical efficiency between 1978 and 1979. In the electrical machinery sector the representative firm fails to keep pace with the rapid rate of total factor productivity change experienced by best practice firms throughout the period. The result is a major decline in the index of technical efficiency from near .9 to about: .65. Relative performance in the sector does not appear to be realted to the type of output produced; thus, we do not view this increase in the variance of TFP levels among firms as related to the uneven impact of import liberalization. Rather it appears to reflect the inability of some firms in the sector to maintain the rates of productivity growth exhibited by best practice firms. In sum our results indicate that firms in most Egyptian public sector industries experienced relatively high and positive rates of TFP change during the period 1973-1979. In many of these industries, however, if the average firm had performed best practice, relative to its peers within Egypt, the rates of productivity change would have been even higher. We can compute the total potential output level of Egypt''s public sector by aggregating over the potential output levels of individual firms estimated from the frontier production function of each industry. We can contrast this estimated total potential output with the actual total output level observed for the public sector as a whole. The difference between the two can be thought of as a crude indicator for the loss to the society incurred by "technical inefficiency" of various firms in the public sector. Figure 8.5a presents this contrast, and plots the difference between potential output and actual output levels for Egypt's public sector for 1973-1979. The cost of "technical inefficiency" in terms of the foregone output (in 1972 prices) was approximately LE 250 million in 1973 and slightly above LE 500 million in 1979. - 256 - Figure 8.5 INDEX OF TECHNICAL EFFICIENCY METAL & ENGINEER ING SECTOR IRON & sEL ---- TRfNSORTHTION EDUIPMENT --- FRBRI CR METAL PRODUCTS ELECTRICL MACIINERY -C HINA & tS CD L-I _ A CO ~ ~ ~ ~ ~ ~ ~ ~ 0~~~~~~~~~ F--i U-) E-4 CD 7',t_ LL]CDl 1973 1974 1975 1976 1977 1978 1979 YEAR Figure 8.5a ACTUAL VS. POTENTIAL GROSS OUTPUT EGYPT PUBLIC SECTOR o M o C) 0 O-l ..-"F,TENIA OUPT N _L ) CW ~~~j0U ~~~~~~~0 _t~~~~~~~~~~~~~~~~~~~~~~~C .)o,,,,*&POTENTIA OUTPUT J ................... 0 0Ca E-i ° _ 3-4 a C)a (n o o--- 0~~~ Q CD ____________, POTENTIAL LESS ACTUAL L 0--' ~~~~~~~~~~~~~~~~~~~~~~~~OUTP'UT I O g ~ ~~~~ I - , . I __ 1973 1974 1975 1976 1977 1978 1979 YEAR - 258 - 8.4 Capacity Utilization and TFP Change The period 1973-1979 in Egypt's public sector cannot in general be characterized as an era during which new lines of industrial activities or new firms came on stream to add to the productive capacity of the sector. Rather, much of the capacity in terms of technology, plants and equipment, and labor force was in place prior to 1973. The period 1973-1979 was, however, an era of rapid growth in aggregate demand, and most importantly, the period during which the policy reforms collectively known as "the opening" were implemented. These reforms liberalized various supply-side constraints that had plagued the public sector and to some extent increased the autonomy of firms. In our discussions above, we have noted several patterns which suggest increasing utilization of capacity was a major force behind the high total growth observed in many of Egypt's public sector industries. We shall test this hypothesis in this section. Analytically, TFP change measures shifts in the production function. If all firms are utilizing their factor inputs most effectively in production, measured TFP change should represent technological progress in the sense of an increase in the technically feasible maximum limits of production. If this is the case, all variations in output growth among different firms should be accounted for by variations in input growth, and there should be no systematic correlation between TFP growth and input growth or output growth. These arguments can be represented in terms of the fol'lowing three relationships: (1) Output Growth = al + b1 Input Growth, (2) TFP Growth = a2 + b2 Input Growth, and (3) TFP Growth = a3 + b3 Output Growth. We expect high correlation in relationship (1). Since output growth is always the sum of TFP growth and input growth, one should expect al to equal the average rate of TFP growth and bl to equal unity in relationship (1). We should also expect no correlation in relationship (2) or (3), and b2 and b3 to be zero. 1/ Since we have estimated the frontier production function in each of the Egyptian industries, we can generate a "predicted" data base where each firm is producing its potential output by combining inputs with the best- practice effectiveness in terms of frontier output elasticities, and demonstrating best-practice TFP growth. Such a predicted data base should confirm the expected relationships discussed above, if best practice firms are experiencing technological change as the only element of their total factor productivity change. If on the other hand best practice firms in Egypt are also adjusting to the liberalization of the economy by expanding their own levels of capacity utilization, we may expect to see some correlation between output growth and total factor productivity growth in relationship (3). 1/ Given that output growth is the sum of TFP growth and input growth, a2 = a1 and b2 = bl-l. - 259 - Suppose, on the other hand, that a substantial number of firms in each industry is not utilizing inputs optimally. These firms are situated somewhere "off" the production frontier, and therefore are in the position to be able to increase output without any increase in factor inputs even in the absence of technological progress. The measured TFP growth for these firms is due entirely to an increased rate of utilization of fixed inputs, i.e. capacity utilization. If this is the case, then there is no reason to expect that all variation in output growth among different firms to be accounted for by variation in their input growth. Neither should there be any systematic correlation between TFP growth and input growth variations among firms. There is, however, a very good reason to expect that a substantial portion of variation in TFP growth among firms to be accounted for by the variation in their output growth rates. Of course, no firm could possibly derive all of its TFP change from increases in capacity utilization over time. There is some input growth, some technological progress, and some change in capacity utilization. If indeed it is true that a substantial portion of TFP change among Egypt's public sector firms is due to increasing rates of capacity utilization, then we should expect the following in terms of the three relationships we discussed above: We should expect low correlation in relationships (1) and (2), and high correlation in relationship (3). Our measure of TFP change for each firm is derived by applying output elasticities of each factor input estimated from the frontier production function. This assumption provides us with a useful tool of experiment here. If a factor input is in fact underutilized, its marginal product should be less than its optimum. The actual marginal product (which is unobserved) of the underutilized factor must therefore be less than the marginal product implied in the frontier output elasticity we have imposed. By definition, the underutilized factor input must be fixed or growing relatively slowly compared with other inputs. It is likely, then, that we may have over-valued the contribution of those inputs which are growing relatively slowly, and consequently undervalued the contribution of those inputs which are growing relatively more rapidly as capacity utilization expands. W4e should, therefore, expect bl to be significantly less than unity in relationship (1), and, correspondingly, al to be significantly greater than the average rate of measured TFP change. If so, then b2 should be significiantly negative in relationship (2). If capacity utilization is indeed the prime mover of TFP change, then we should expect b3 to be significantly positive. The greater the force of capacity utilization in TFP change, the greater should be the value of b3. Since a3 can be interpreted as the average rate of TFP change net of the capacity utilization factor, the greater the force of capacity utilization, lower should be the value of: a3. We have estimated relationships (1), (2), and (3) using the ordinary least squares method, on the "predicted" data base with estimated frontier potential output growth and best-practice TFP change of each firm, as well as on the actual data base with observed output growth and TFP change measured as discussed in the earlier sections of this paper. Input growth rates are the same between the two data bases. In both cases, we tested the relationships - 260 - on the pooled time series (1973-1979) - cross section (101 firms) observations. The regression results are presented in Table 9.11, which reveals that the estimated coefficients and and the correlation coefficients confirm our expectations. On the "predicted" data base generated using the frontier production functions, we see a very high correlation between potential output growth and input growth as we expected (relationship (1)). The constant term (al) approximates the average annual rate of best-practice TFP change over all industries (see Table 8.10), and the coefficient for input growth (bl) is not significantly different from unity, again as we expected. Best-practice TFP growth shows very low correlation with input growth (relationship (2)), and the coefficient for input growth (b2) is not significantly different from zero confirming our expectation. Best-practice TFP growth also shows litt:Le evidence of correlation with potential output growth (relationship (3)). The magnitude of the coefficient for output growth in relationship (3), however, is contrary to our expected value, since it is significantly different from zero (at the 95 percent level of confidence). This is consistent with the view that increased capacity utilization was one force at work driving the TFP change of best-practice firms in Egypt's public sector. Indeed, this complements our evaluation of the structure of best-practice TFP change in Section 9.4(A). The estimated results on the actual data base are in striking contrast with those on the "predicted" best-practice data base, and once again confirm our expectations. We no longer see a strong correlation between output growth and input growth (relationship (1)). Furthermore, the estimated coefficient for input growth (al) is significantly below unity (at the 99 percent level of confidence), which implies underutilization of factor inputs as we discussed earlier. We also see that the correlation between TFP growth and input growth is very low as one would expect (relationship (2)). Finally, and most importantly, we observe an extremely high degree of correlation between TFP growth and output growth (relationship (3)). The constant term (a3) is significantly negative, and shows that with zero growth in output, TFP would have declined at 5.4 percent per year. The coefficient for output growth (b3) is significantly positive, and indicates that one percent growth in output implies 0.962 percent TFP improvement. The ratio of 0.054 (-a3) to 0.962 (b3) is equal to 0.056, which implies that growth in output of 5.6 percent per year was required in order to keep TFP from declining. These results altogether are consistent with our hypothesis that the major source of the impressive productivity performance among Egypt's public sector firms during the "opening" period was increasing capacity utilization. We have attempted to set our results in international context in Table 8.11 which presents regression results between TFP growth and output growth for manufacturing industries in Japan, Korea, Turkey, and Yugoslavia. The result for Japanese manufacturing industries shows a very low correlation coefficient compared with other countries, presumably reflecting the longer run relationship between TFP change and technical progress in the more deve]Loped countries. The results given in Table 8.11 also reveal a sharp difference between Egypt on the one hand and Korea, Turkey, and Yugoslavia on Table 8. 10 REGRESSION RESULTS ON TFP CHANGE AND CAPACITY UTILIZATION IN EGYPTIAN PUBLIC SECTOR INDUSTRIES (1973-1979) Hypothetical "Best-Practice" Data Actual Observation .~~~~ .2 R D-W RI D-W (1) Output Growth - 0.035 + 1.002 Input Growth Output Growth - 0.098 + 0.425 Input Growth (0.005) (0.002) 0.995 2.038 (0.028) (0.136) 0.016 2.006 H (2) TFP Growth - 0.035 + 0.002 Input Growth TFP Growth - 0.098 - 0.574 Input Growth (0.005) (0.002) 0.001 2.038 (0.028) (0.136) 0.028 2.006 (3) TFP Growth - 0.035 + 0.007 Output Growth TFP Growth - -0.054 + 0.962 Output Growth (0.005) (0.002) 0.010 2.044 (0.008) (0.011) 0.915 2.179 Note: Standard error is presented in parenthesis under each estimated coefficient. D-W is the Durbin-Watson statistic. Sample size is 606 observations (time series - cross section pool of 101 firms). Table 8.11 INTERNATIONAL COMPARISON OF THE RELATIONSHIP BETWEEN TFP GROWTH AND OIJTPIJT GROWTH Country (Estimation Period) TFP Growth = a3 + b3 Output Growth R2 D-W Sample Size Egypt (1973-1979): TFP Growth = -0.054 + 0.962 Output Growth (0.008) (0.011) 0.915 2.179 606 Japan (1955-1973): TFP Growth = -0.004 + 0.158 Output Growth (0.095) (0.036) 0.061 1.859 288 Korea (1960-1977): TFP Growth = -0.025 + 0.355 Output Growth c (0.007) (0.026) 0.394 2.027 272 Turkey (1963-1976): TFP Growth = -0.037 + 0.391 Output Growth (0.007) (0.032) 0.420 2.077 2(8 Yugoslavia (1965-1978): TFP Growth = -0.015 + 0.179 Output Growth (0.002) (0.021) 0.246 1.960 221 Note: Standard error is presented in parenthesis under each estimated coefficient. D-W is the Durbin-Watson Statistic. Estimates for Japan, Korea, Turkey, and Yugoslavia, are based on time series- cross section pool of 16 manufacturing industries (17 industries for Yugoslavia). Source: See Nishimizu and Robinson (1982) for the discussion of thie data base on Japan, Korea, and Turkey. See Nishimizu and Page (1982) for the discussion of the data base on Yugoslavia. - 263 - the other. In these three countries, variations in output: growth rates explain a substantially lower portion of variations in TFP growth rates compared with Egypt. The magnitudes of the intercept tenr as well as the coefficients for output growth are both significiantly smaller than those for Egypt, indicating a much weaker impact of capacity utilization on productivity change in these countries. 8.6 Conclusions In this chapter we have focused on one measure of industrial performance in Egypt, total factor productivity. Our results indicate that between 1973 and 1979, many of Egypt's public sector industries experienced very rapid rates of total factor productivity growth, and that this rapid total factor productivity growth "explained" a substantial proportion of the rapid growth in industrial output which occurred following the opening. Our analysis of the nature of productivity change in fifteen industrial sectors leads us to believe, however, that rather than productivity change driving output growth, as one would expect in the long run where best practice TFP change approximates the rate of technological progress, in Egypt output growth explains much of the observed high level of total factor productivity growth. A causal relationship which runs from rapid increases in output to rapid increases in total factor productivity is consistent with the view that much of productivity change in Egyptian industry during the period after 1973 was due to increased utilization of existing capacity due to easing of supply constraints as well as exceptionally rapid growth of domestic demand. Tests of our empirical results support such a view. Our decomposition of TFP change into best practice total factor productivity change and changes in technical efficiency reveals that in most industries the rates of best practice total factor productivity growth were extremely high relative to long term rates of technological change observed in other countries. These high rates of best-practice TFP growth were offset somewhat by deteriorating technical efficiency. In most industries in Egypt the average firm was suffering from a decline in its level of total factor productivity relative to best practice. This pattern of productivity change is consistent with the view that public sector firms adjusted to the liberalization of the trade regime, increases in effective demand, and the increased autonomy which characterizecd the opening at different rates. Best practice firms were those which were most able to adapt to the changing production environment while other firms in the same sectors adjusted more slowly. It appears that the rapid overall rates of productivity change are indicative of the success of the liberalization efforts undertaken following 1973 and of the increased availability of foreign exchange. The "falling behind" reflected in the increasing gap between best practice and the average levels of technical efficiency and the resulting increased dispersion of relative levels of efficiency which occurred in most sectors is probably an inevitable consequence of the movement from highly centralized direction of public sector enterprises to a somewhat more decentralized environment for production decisions. - 264 - It is important to recall, however, that these results reflect a relatively short run process of adjustment from a low base. In the longer run increased investment and efforts to adopt or create technical innovations will be necessary if industries are to continue positive rates of best practice TFP change, and continued "falling behind" of average firms could have serious consequences for overall levels of total factor productivity. This cautionary tale is already reflected in the performance of one major sector, cotton textiles, and efforts to improve best practice total factor productivity and technical efficiency in that sector could pay important dividends in terms of reduced production costs and improved competitiveness. Subject to these qualifications, it is worth stressing that the results presented in this Chapter indicate that the potential for very good performance exists in the public industrial sector. If "average" firms could get closer to best practice firms it appears that there could be large gains to the Egyptian economy. A more detailed analysis explicitly focused on explaining firm-level performance could yield very useful results and extend our understanding of the process of growth and productivity change in Egyptian industry. - 265 - Chapter 9 Comparative Costs and Incentives in the Industrial Sector: A Selective Overview 9.1 Introduction to the Techniques of Measurement The analysis in the previous chapter tried to provjide a description of growth in the Egyptian public sector during the 1970's. In this chapter we focus on one year, FY80/81, and analyze firm-level data by computing certain measures of economic efficiency, competitiveness and incenlive structures. The analysis is based on a survey carried out jointly with the Ministry of Industry and Mineral Wealth and the information obtained covers 82 firms in the public sector and 24 firms in the private sector. Our objective is to provide a good analytical description of comparative advantage and incentives in Egyptian industry which can form the empirical background and point of departure for further work on policy reforms as well as detailed sectoral investment plans. The measures of economic efficiency and incentives employed for our analysis of Egyptian industry are similar to those used in Chapter 4 for agriculture. At the core of the analysis we have the disti.nction between private and social profitability derived from the distinction between market and economic (shadow) prices. Industrial firms, whether in the public or private sector, naturally tend to make investment decisions and evaluate the success of past activities on the basis of observed or expected market prices and financial profitability. If these prices reflected full economic costs or benefits, the price signals would help ensure that individual decisionmakers acting without central direction would undertake activities most beneficial to the economy. In Egypt, however, actual prices are far from reflecting the underlying economic values. Tariffs, taxes, pervasive price controls and restrictions on foreign trade make prodluct prices and input prices very imperfect measures of economic opportunity costs. In addition, public interventions in the markets for capital and labor introduce further divergences between market and economic prices. These considerations which were addressed in some detail in Section 2.4 of Chapter 2, imply that investments made in response to market incentives may be economically inefficient and consequently reduce social welfare, while activities which improve welfare are insufficiently rewarded. In this chapter we combine the estimates of economic prices and accounting ratios presented in Chapter 2 with micro-economic data from a sample of firms in the Egyptian industrial sector in order to: (i) draw some inferences concerning the relative efficiency and international competitiveness of various branches of industrial activity and, (ii) provide an overview of the incentive policies affecting industrial production and trade. Economic Profitability and the Domestic Resource Cost Criterion An industrial activity is competitive at economic prices if the economic value of its output exceeds the opportunity costs of the commodities and factors of production employed in producing it. If the full time profile - 266 - of inputs and outputs is known and a suitable time discount rate is applied to costs and benefits occuring at different poits in time, the net present value of any project (actual or proposed) at economic prices provides the correct measure of its net contribution to social welfare. In that sense economic activities with positive net present values are efficient. Our data on Egyptian industry, however, are not well adapted to the application of the present value criterion. Although we have highly detailed information on the levels of inputs and outputs for the survey year, historical data on prior years is not available in all cases, and application of the present value criterion would necessarily be somewhat arbitrary. In these circumstances, it is possible to employ a single period efficiency measure based on the annual economic profitability of an industrial activity: B, P. ~~~- n ..m B. = P. _ Ea.j Pi - zf i P (1) J i jIsS] s Unit Economic Economic Economic Economic = Price per - Value of - Value of Profit Unit of Intermediate Primary Output Inputs Inputs The Pj, Pi and Ps are the shadow prices of output, material inputs and factor inputs used in the production of j, and the aij and fsj are the input output coefficients for material inputs and factors of production. The activity is judged efficient in the level of unit economic profit is non-negative. If the investment to be evaluated is in the public sector and all produced inputs and outputs are assumed to be tradable, the interpretation of the unit economic profit criterion is straightforward. The first two terms in expression (1) give the annual "value added at world prices" per unit of output generated by the particular subsector or industrial activity: m VA, = P. - E a .P. (2) j J i=i Ij 1 where VAj represents the annual net addition to national income, evaluated at the opportunity costs established by world prices. The third term in (1) above represents the opportunity cost of factor inputs evaluated at economic prices. When the opportunity cost of factor inputs exceeds the net addition to national income, unit economic profits are negative, and the resources employed could be more efficiently employed in their best alternative use. In evaluating past investments and the success of previous policies, it is useful to have a measure of the relative efficiency of activities producing different outputs. The unit economic profit criterion is unsuited to this purpose because its value varies with the measure of output of each activity. Although it is possible to compare the level of unit economic profits between two activities producing cotton cloth, it is not possible to - 267 - compare the relative efficiency of cloth production with the manufacture of automobiles. Where policy questions focus on the allocation of resources among several industries or sectors, the efficiency criterion chosen must be independent of the type of output. In general, rules for choosing among projects which are to be executed with a limited amount of national resources prescribe calculating the net benefits which they generate per unit of a budgeted factor. For a project using traded inputs and primary factors to produce traded output the addition from the project to national income, measured at economic prices, is given by the level of value added at world prices, which also represents the net (direct and indirect) addition to foreign exchange arising from the investment. If domestically supplied factors of production are evaluated at their opportunity costs, criterion (1) may be rewritten as the ratio of domestic factor costs evaluated at economic prices to value added at world prices: m £ f p Economic Value of DRC. s sj s Primary Inputs P - a p Value Added at J ±l J International Prices The resulting "domestic resource cost ratio" (DRC) measures the amount of "net" foreign exchange that domestic r(esources can generate for the firm in question. If this rate of transformation exeeds one, the opportunity cost of domestic factors of production (in terms of foreign exchange) exceeds the addition to value added at world prices by these factors and the net benefit criterion would turn negative. 1/ Minimizing the domestic resource cost ratio in tradable goods producing activities is equivalent to rnaximizing value added at world prices per unit of domestic resources employed. Thus evaluating firms in terms of their resource cost ratio provides a measure of relative economic efficiency. Firms with DRC's less than or equal to one may be classified as efficient in the sense that the domestic resources which they employ produce as much or more value added at world prices as they would in the activities from which they are drawn. Activities with resource cost ratios greater than unity are termed inefficient in the sense that the resources they use would be more productive in alternative activities. To the extent that the government is able to allocate resources among competing activities, they should be distributed to projects with low resource cost ratios. 1/ Often the DRC criterion is written as the ratio of domestic resource costs in terms of domestic currency to value added at world prices in terms of foreign currency. There is no difference in substance between our measure of the DRC and the alternative. We have simply chosen to express the opportunity of domestic factors in terms of border prices and to compare the resulting ratio with one. - 268 - Ranking of firms by the resource cost ratio provides an index of efficiency among tradable goods producing activities. Firms with the lowest resource cost ratios are more efficient at transforming domestic factor inputs into foreign exchange than those with ratios close to or exceeding unity. High DRC's may arise either from low levels of value added at world prices, as for example, when an import substituting activity uses inputs with low or zero protection to produce a highly protected output, or from high domestic resource costs per unit of value added at world prices, deriving perhaps from low levels of technical efficiency in production. Unlike the unit social profit criterion, the resource cost ratio may be used either to compare the performance of firms within a single industry or to compare the performance of several different industries. Within industries, the intra-marginal ranking of firms provides substantial information concerning the relative levels of economic costs of production across firms. Relative rankings under the DRC criterion are not unambiguous, however. The ordering of firms may shift in response to a change in relative factor or commodity prices. Unless all firms have very similar input-output coefficients, alterations in economic prices will affect unit economic costs differently for each firm. If differences in the level of average economic costs and hence in resource cost ratios are small, changes in economic prices may result in substantial shifts in the rank ordering. But where there is substantial variation in resource cost ratios both across industries and within sectors, the relative rankings provide a sound empirical guide to relative efficiency. Considerable attention in many countries has been focused on the domestic resource cost ratio as a measure of comparative advantage. Comparative advantage exists if the economic opportunity cost of producing a commodity is less than its border price. Hence activities with positive unit economic profits or resource costs ratios less than one are those activities in which the economy has a comparative advantage. In addition, the smaller the DRC of an individual activity within an economy, the greater the scope for efficient expansion of exports or import substitutes. It is important to remember that DRC estimates for existing industries are best thought of as a guide to the consequences of small changes from the existing structure of production. Major policy changes or significant expansion of one or more industrial sectors will probably result in substantial changes in input output coefficients or in shadow prices, and hence in DRCs. For example, an industry which appears to have an acceptable DRC as an import substitute may not be competitive as an export if there is a wide margin between FOB and CIF prices for its output. Thus, some care should be exercised in the interpretation of DRC ratios as indicators of comparative advantage; they provide a snap-shot of potential lines for export expansion or efficient import substitution but the picture may change with the passage of time and with increases in output. Incentives and Protection In addition to the measurement of economic efficiency, a major focus of research has been to measure the structure of incentives to producers. At the core of this analysis is the concept of the effective protective rate - 269 - (ERP), which measures the increase in domestic value added permitted by the structure of trade protection and domestic price controls over the level of value added in the absence of such restrictions. If all commodities are traded, the effective protective rate is given by: m Pd _ a. pd J ai . pd i ValuLe Added at Domestic Prices m P. - z a.. P Value Added at World Prices 1 j J i where Pj and Pi are the domestic market prices of output aind inputs respectively. Thus the effective protective rate is the ratio of value added in domestic prices to value added at world prices. The effective protective rate and the resource cost ratio are closely related. Both have as their denominator value added at international prices and so the only difference is in their respective numeratcirs. That of the ERP shows the scope that domestic prices allow for some combination of domestic resource costs, profits and rents to be incurred in a particular economic activity. The DRC includes in its numerator only domestic resource costs actually incurred. The ERP thus indicates the potential for resource costs and transfers arising from the existing structure of protection; the DRC indicates the extent to which these potential costs are actually incurred. The difference between the two depends on the structure of domestic taxes and subsidies and on the supply functions for domestic primary factors. In the results presented below, we shall consider both the effective rate of protection provided by the overall structure of tariffs, taxes, and subsidies and the protection afforded by trade taxes and the system of price controls considered separately. Thus we shall compute an overall effective protective rate, effective protection due to trade taxes, and effective protection due to price controls and subsidies. Major Assumptions of the Empirical Work Indicators of domestic resource costs, effective rates of protection, and single period rates of return to capital at market and economic prices are given in this chapter for both public and private sector enterprises and for more than 100 individual product lines. Each activity is assumed to have fixed input/output coefficients for intermediate inputs and factors of production based on information supplied for the accounting year 1980/81. Calculations of the indicators are based on a number of common assumptions. The most important of these involve the treatment of non-traded goods, the role of capital as a factor of production, treatment of the private sector, and application of the concept of sunk costs. Non-Traded Goods The techniques of analysis described above were developed initially using the simplifying asssumption that all goods were fully traded. Clearly -270- such an assumption is unrealistic for any economy. There will always exist a class of non-traded goods, with prices above their exportable value but below the price of an imported equivalent, whose prices are established by the workings of domestic commodity markets. Certain commodities and services such as construction, transport, and utilities are almost universally non-traded. Hence, in order to make our estimates more realistic we must come to grips with the problem of including non-traded goods in measures of efficiency and incentives. The method chosen to incorporate non-traded inputs into the cost and incentives measures follows directly from the treatment of non-traded goods in the estimates of economic prices and accounting ratios discussed in Chapter 2. The input-output structure of the supplying industry is used to break down the marginal cost of production into tradable inputs and domestic factors. The value of these inputs in terms of the unit of account yields an estimate of the marginal economic cost of the non-tradable, which can be entered directly in the DRC calculation. Taking foreign exchange to be the (m+l)th primary factor, as was demonstrated in Chapter 2, the sum of all direct commodity and domestic factor inputs must equal the sum of the direct plus indirect (noted by a bar) inputs of foreign exchange and domestic factors at opportunity cost: a m m+1 m Z a P + E f P - f P + f +z f P (5) ii 8 s Si s s-1 Si a (m+l),J s-1 si s Economic Value Economic Value Total Economic Direct Plus Direct Plus of Intermediate + of Primary = Costs of = Indirect Use + Indirect Inputs Inputs Production of Foreign Use of Exchange Primary Inputs Rewriting (1) and substituting: 8 - - f -~ ? p ,(1') 3 i (m+1),j a]. 83 s Unit Direct Plus Direct Plus Economic = Economic - Indirect Use of - Indirect Use of Profit Price Foreign Exchange Primary Inputs and it is possible to derive: m £ f P DRC j = --sm sj s 1 f (m+l),j - 271 - Expression (3 ) gives the domestic resource cost ratio for the foreign exchange earned or saved by the activity. The numerator represents the opportunity cost of all domestic factors of production employed directly in the production of output j and indirectly in the production of inputs into activity j. The denominator gives the foreign exchange value of output minus the direct and indirect use of foreign exchange per unit of activity j. Expression (l') yields unit economic profits when inputs are non-traded and produced at constant marginal cost. There is another category of goods which may be labelled "less than fully traded". These are commodities which, although potentially tradable, are not in fact traded. Quotas on imports, for example, may result in domestic prices far in excess of the border price of competing inputs. Prices for such goods will vary with changes in the level of domestic supply and demand. In general, we have assumed that tradable goods are fully traded. This implies that changes in the supply of or demand for tradable commodities will be met through changes in the levels of imports and exports rather than from expansion of domestic production or deprivation of other consumers. Under this assumption, the correct valuation of these commodities is the border price and the DRC provides the appropriate measure of efficiency. The polar contrast to this asssumption is to consider all less than fully tradable goods as non-traded. If the activities supplying these commodites operate at constant marginal cost, the appropriate shadow price of an input is given by the marginal, economic cost in terms of- border prices, and the DRC can be computed in the manner described above. High marginal economic costs in the supplying industry would accordingly be reflected in the domestic resource cost ratio of the using industry. If the constant marginal cost assumption is not appropriate, when, for example, evaluating the marginal social value of an output, changes in the supply of and demand for commodities will result in domestic price changes, and thus in changes in the levels of producers' and consumersi surplus. The DRC criterion is not well adapted to the evaluation of investments in cases where domestic product prices are changing, although use of a full system of accounting ratios as discussed in Chapter 2 would permit us to incorporate these considerations at the cost of considerably increased complexity. Since our interest centers on questions of longer term comparative advantage and relative efficiency in industrial traded goods producing activities, we shall in general assume that tradable goods are fully traded. Capital Inputs In a discounted cash flow calculation there are no capital inputs per se. All inputs and outputs are recorded at the time at which they occur, and the problem of estimating the value of capital services in any given year does not arise. In a single period measure estimating the annual input of capital services poses some conceptual and empirical difficulties. The extent to which criterion (1) accurately substitutes for the net present value criterion is determined by the nature of the cash flows of inputs and outputs for the project to be evaluated. Unless the net stream of outputs less inputs changes sign from negative to positive only once during the lifetime of the project, and is of the same magnitude in all years in which it is positive, the two - 272 - measures will fail to yield consistent results. 1/ For example, if a project continuously increases its utilization of installed capacity over the lifetime of the investment, annual unit economic profit computed for an early period of operation of the project may be negative, although the discounted present value over the lifetime of the project may be positive. To compensate somewhat for this problem, estimates of the level of unit economic profits may be made on the basis of the actual level of output of the project in the year observed, on the basis of an estimated average level of output during the lifetime of the project, or on the basis of projected full capacity output. Use of the latter two estimates of output and input levels permits the evaluator to determine if random factors (strikes, equipment breakdowns, etc.) may have contributed to the apparent inefficiency of an investment observed in a given year. If capital investments yield a well behaved stream of output over the economic lives of all assets there is a straightforward method of determining the annual cash flow associated with the amortization of and return to the capital input. This-consists of finding the annual annuity (capital recovery factor) yielding a present value equal to the initial cost of the investment when discounted at a target rate of interest over the economic life of the asset. The rate of discount employed in economic cost-benefit analysis is given by the accounting rate of interest. Thus, for the single period measures discussed in this chapter the annual input of capital services into public sector projects may be consistently estimated by an annuity based on' the accounting rate of interest and the economic life of the capital good. The annuity, which is expressed in accounting prices, is directly entered as a cost item in the computation of expression (1). In specifying the resource cost ratio (expression (3')), it is important to decide whether capital inputs will be treated as a foreign or domestic resource cost. 2/ The "rental cost" of the capital input consists of both the rate of return established by the ARI and the annual rate of depreciation on the capital input. It is this rental cost which must be entered into the resource cost ratio as either a foreign or domestic cost. If the accounting rate of interest is established by the foreign borrowing rate faced by the economy -- i.e., if capital funds are in infinitely elastic 1/ Many of the difficulties involved in applying any single period measures of economic efficiency are caused by the need to convert capital inputs into current inputs. These issues are discussed below. 2/ Considerable confusion has developed in the literature on applications of the domestic resource cost criterion as to the treatment of capital goods. Suggested solutions have included treating depreciation on imported capital inputs as a foreign exchange cost while treating the financial return on capital as a domestic resource cost; presumably because investable funds were assumed to be in less than infinitely elastic supply. Such an approach fails to recognize that it is the capital fund tied up in the investment which is in limited supply and that the annuity cost of this fund requires allowances for interest and depreciation. For consistency, the rental cost of capital must be treated as a unit. We take a step towards resolving the issue by expressing the price of capital equipment, regardless of origin, in terms of a single unit of account. We are, therefore, free to treat the rental cost of capital as wholly foreign or domestic as appropriate. - 273 - supply at the accounting rate of interest -- the marginal source of investment funds may be treated as of foreign origin and the rental cost of capital should be treated as any other foreign exchange cost. IrL these circumstances, domestic resources will consist of labor and land only. But in an economy such as Egypt that the supply of capital funds is certainly perfectly elastic to all industries at a given interest: rate. Indeed, in a single period the total supply of investable funds may be fixed, and the marginal source of investment will then arise from savings switched from other domestic projects. Under these circumstances, it seems reasonable to conclude that capital inputs represent a domestic resource cost and to assign the rental cost of capital to the numerator of expression (3). Throughout the empirical work in this report we shall follow the latter course. The overall supply of funds for investment to the industries under study is not infinitely elastic at the foreign borrowing rate. This assumption, which is reasonable in the Egyptian context, has the added advantage of permitting value added at world prices to correspond to the traditional measure of value added and of allowing domestic factors to include, as normally understood, domestic capital and labor. Policy Issues and Two Concepts of Economic Costs Applications of efficiency criteria to existing investments require careful definition of the time horizon, level of output, and nature of costs relevant to the particular question being asked about industrial efficiency or policy. By and large, the literature on investment appraisal in developing countries has focused on evaluation of proposed investment projects and on identifying sectors in which economies have long-term comparative advantage. While these questions are relevant tco decisions regarding Egypt's industries, other policy questions regarding the actual operation of firms also arise. The first question to be asked in this study is whether investments in existing public and private sector industries are efficient (in the sense that they yield non-negative economic profits), in terms of their actual operation. In this case, firms are evaluated on the basis of their actual 1980-81 levels of output. All costs of investment and current costs of production are included, evaluated at their full opportunity costs to the economy. The resulting domestic resource cost ratios will indicate the efficiency of the investments if they were to operate over their lifetimes at the levels prevailing in 1980-81. This question is relevant to the evaluation of policies which have resulted in the investments examined. Firms which appear inefficient on the basis of their 1980-81 production levels may be judged efficient at some increased level of capacity utilization if average costs are sufficiently reduced by Low marginal costs of expanding output. Thus, in making decisions concerning the long run efficiency of firms which are constrained by supply side deficiencies, the relevant resource cost ratio is one in which the levels oE output and inputs are estimated on the basis of projected full capacity production. The long run resource cost ratio at full capacity provides a measure of the efficiency of firms if they were able to operate at full production iin the long run, with all cost including investment costs evaluated on the basis of their - 274 - opportunity costs to the economy. This measure is relevant for asking to what extent investments in an export activity are consistent with long run comparative advantage. Some policy questions relevant to the actual operation of firms require a different view of costs. For example, if the relevant policy question is whether existing firms show a sufficiently high level of economic profitability to justify their continued operation, the efficiency criteria must be modified to permit the evaluation of sunk costs. If there is little opportunity to transfer plant and equipment to some alternative use within the economy, the short run opportunity cost of the capital sunk in the investment may be low. Fixed capital costs considered as sunk may, therefore, be ignored in asking-whether the firm's benefits at the existing level of output justify the variable costs of production. For investments judged inefficient on the basis of their long run resource cost ratios, the variable opportunity costs of production may be sufficiently low to justify the continued operation of the firm. In estimating the short run resource cost ratio, an empirical problem arises in deciding which capital inputs should be assumed to have no alternative uses in the economy. Vehicles and certain types of machinery should have transfer values equal to their book (depreciated) value. Plant buildlings, if well located may have alternative uses, and working capital could be recovered. Capital inputs regarded as having no alternative uses will generally be those specialized items of plant and machinery which are specific to the production process. As a result, firms which employ capital inputs having ready alternative uses in the economy will tend to have a higher proportion of their capital costs included in the short run than investment projects with highly specific capital inputs. The Problem of Timing The shift from a multi-period measure of economic efficiency to a single period measure introduces an important limitation on the ability of the project evaluator to make decisions regarding the optimal timing of investments. In a multi-period measure of efficiency, the timing of expenditures and benefits exercises considerable influence on the evaluation of a specific project. For example, in evaluating which of two foreign or domestic investors should be permitted to exploit a given natural resource, one of the important factors affecting the net present values of the two projects may be the speed with which the alternative investors can begin producing significant levels of output. In the single period measure there is no adequate means of handling this issue except to take economic prices as average present discounted values and the levels of inputs per unit of output as weighted averages over the lifetimes of the two investments. If sufficient information is available to estimate these parameters, better use is made of the data in a full discounted present value calculation. Similarly, if economic prices or input-output coefficients are expected to change significantly over time, the single period measure should employ average economic prices or production coefficients, For these reasons - 275 - single period measures of efficiency are perhaps best used to evaluate existing investments where the time streams of firms' input and output flows have been roughtly similar. Analysis of proposed investments where timing may play a significant role should be carried out using the more comprehensive net present value criterion. Nonetheless, single period or average efficiency indicators can provide an invaluable background for future analysis of new investment projects. 9.2 Product Mix, The Choice of Technique, and Technical Efficiency: Sources of Variation in the DRC. A particularly striking feature of the DRC results presented in this Chapter is that in addition to major differences in resource cost ratios between industrial sectors, there is substantial variation within each sector in the DRC's of individual enterprises. In fact the differences in measured efficiency across firms within the same sectors are frequently as large as the differences between sectors. Thus, some understanding of sources of efficiency at the firm level may be aLS important to industrial policy analysis and investment planning as sectoral indicators of efficiency and comparative advantage. At the enterprise level three factors contribute to the level of economic efficiency as measured by the DRC: the output mix produced by the firm, the techniques of production chosen and the efficiency with which those techniques are employed. The issue of product choice is relevant to the interpretation of the DRC results in at least two respects. First, any classification of firms into sectors involves some arbitrary judgement as to the similarity of the products produced. In some of the sectors identified for the productivity and DRC studies the products produced by individual firms are sufficiently heterogenous that each enterprise represents a distinct sub-sector. In these cases the individual firm level results simply provide additional information on existing levels of efficiency and potential comparative advantage in product groups which were obscured by the broader sectoral aggregates. Second, however, even within a relatively defined industrial sector such as cotton textiles, substantial variation exists in the mix of outputs chosen by (or imposed upon) the individual firm. Because there is great variability in the relationship between market and accounting prices among individual commodities in Egypt, it is quite possible for two firms within the same industry having the same proportion of value added in total output to have very different ratios of international to domestic value added, due to variations in relative world and domestic input and output prices. Thus for example, cotton textile firms which use the bulk of their locally purchased long staple cotton input to produce rationed cloth for sale on the domestic market will have quite different ratios of value added at world prices to value added at domestic prices than those enterprises which produce mainly exportable yarn and cloth. In such cases, although the resource costs of producing a unit of value added at domestic prices may be similar across firms, DRC's will differ. From the point of view of trade and industrial policy it is important to understand the motivation of firms in -276- selecting their product mix and the incentives and constraints behind the decision of some firms to produce a more socially "correct" set of outputs than others. Industrial policies intended to further comparative advantage may have to be designed to influence product choice within firms as well as the broader sectoral allocation of investment. The relationship between the choice of technique, the efficiency with which the technique is used, and the DRC may be illustrated with the aid of Figure 9.1. The scatter of observed points in Figure 9.1 represents all possible combinations of factor inputs (say capital and labor) which are required to produce a unit of value added at international prices in a well defined industry. By joining the points that represent minimum input combinations a curve (FF') can be drawn such that no observation lies technically between the isoquant and the origin. The frontier, so defined, is referred to as an isoquant and represents the minimum possible combinations of factors of production required to produce a unit of value added at world prices, given the techniques available to the industry and the actual levels of efficiency with which the techniques are employed. Some firms, for example A, B, and C, will lie along the efficient isoquant. Although they employ different factor proportions they are all equally efficient in applying their chosen technique, since they lie along the isoquant of least input combinations. Other firms, however, such as D and E, will lie to the northeast of the frontier isoquant. These enterprises are technically inefficient in the sense that without changing their chosen technique they could reduce the inputs required to produce a unit of output to the levels represented by the efficient isoquant. Thus firm D could in principle reduce its inputs by the proporation OA/OD without any change in its level of output, simply by applying its chosen technique with the efficiency exhibited by firm A. Figure 9.1 L \ Sources of Variation in the DRC A O AtMeF 0 A'V - 277 - At any set of relative factor prices there will be one optimal combination of factor inputs which meets the objective of minimizing the social costs of production. If the economic prices of factors of production are represented by the slope of AA' the optimal capital labor ratio is given by (K/L)A and firm A employs the optimal technique of production at economic prices. Firms B and C although they are on the efficient unit isoquant do not employ the optimum technique and therefore have higher social costs of producing a unit of value added at world prices. Firm D, although it has the same capital labor ratio as firm A also has higher unit cost due to its technical inefficiency in production. The algebraic interpretation of line AA' is simply: -r*K + w*L r*(K/VAWP) + w*(L/VAWP) = = DRC, where r* and w* are the economic (shadow) prices of capital (K) and Labor (L) respectively and VAWP is value added at world prices. The sum of domestic resource costs per unit of value added at world prices, is by definition the DRC, and therefore AA' as well as any line segment parallel to it in Figure 1 indicates the level of the DRC of an activity located along it. This result makes it possiblie to interpret differences among DRC's in any set of firms as the sum of two so;urces of relative efficiency differences in the choice of technique and differesnces in the level of technical efficiency. In Figure 1 firm A has the lowest observed DRC. Indeed in this example it is the minimum DRC possible for the sector, although if actual prices differ from economic prices thesre is no reason in practice why any firm should choose the optimal technique of production at shadow prices. Firms B, C, and D all have higher DRC ratios, but the causes of their increased DRC's are quite different. Firms B and C are technically efficient but use an inappropriate technique of production at economic prices. Firm D uses the appropriate technique of production but at the lower level of technical efficiency than firm A. The social costs of inappropriate choice of technique can be offset by higher levels of technical efficiency and vice versa. Thus in Figure 1 firms B and D have equal D)RC ratios although firm D's relative inefficiency arises from inefficient use of an appropriate technique while firm B's equal relative level of inefficiency arises from efficient use of an inappropriate technique. The relatives contribution of these two factors, price efficiency at accounting prices, and technical efficiency cannot be determined independently of specifying the possibilities for factor substitution, either by estimation of a production function or by construction of an efficient unit isoquant. Once this is done, however, the difference between any observed DRC, say that of firm E in Figure 9.1 and the minimum observed DRC can be decomposed into the reduction in the DRC due to superior technical efficiency, the segment EB, and that due to superior choice of technique, the segment BS. - 278 - The relative magnitude of the two sources of inefficiency can have important implications for the design of industrial policies. Where most firms inma sector employ similar techniques of production, major variations in DRC's will arise from variations in technical efficiency. This in turn implies that policies directed at increasing the total factor productivity of individual enterprises, through for example improved management, can conceivably yield significant returns as a consequence of reduced economic costs of production. On the other hand, if all firms in the industry are relatively technically efficient, reductions in social costs of production can only arise from shifts to more socially appropriate techniques. The extent to which such alterations in the choice of techniques can be accomplished in the short run will depend on the flexibility of production processes currently in place. In most cases, however, movement toward economically more optimal techniques will require medium term policies designed to alter replacement decisions and the pattern of new investments. 9.3 Comparative Costs and Incentives in Egypt's Industrial Sector: An Overview This section presents an overview of the results of the DRC and effective protection calculations for both public sector and private sector firms. We attempt here to sketch some of the broad outlines of our results and their implications for industrial and trade policies in Egypt. In the following two sections more detailed information on incentives and performance is presented at the industry level for both the public and private sectors. Our estimates of effective rates of protection and domestic resource costs for the Egyptian industrial sector are summarized in Tables 9.1 through 9.5. The sample of firms and the range of industries is not small. The results are based on observations from seventy firms in the public sector and an additional twenty-four firms from the private sector covering twelve major industrial groups. The sample is biased, however, and marked by some notable omissions. Large scale, public sector firms are relatively overrepresented in the sample, as are newer, joint venture firms in the private sector. We have very few observations on smaller scale, older firms in the private sector, and our public sector sample is limited to firms operating under the authority of the Ministry of Industry. Thus two important industrial sectors, cement and pharmaceuticals are excluded from our sample of public sector enterprises. Nevertheless the breadth of our coverage is quite striking. The firms in our sample of public enterprises accounted for 79 percent of public sector output and 72 percent of public sector employment in 1979. The private sector sample, although less broadly based, contains representatives of most of the major new investment activities developed in the period following the "Opening". The precision of the estimated indicators of comparative advantage and relative incentives is subject to the usual uncertainties with regard to the accuracy of the microeconomic data on which they are based and to the possibility of error in the estimates of commodity accounting ratios. In Egypt, especially, the great complexity of the price system, with its legion of administered prices occasionally differing by producer or end user as well - 279 - as by commodity makes establishing the relationship between border prices and market prices particularly difficult. These warnings notwithstanding substantial care has gone into checking the consistency and verification of the microeconomic data provided by each firm, and we have devoted a great deal of attention to the estimation of commodity and factor accounting ratios. Hence we are confident that the results presented in summary form in this section and discussed in greater detail in the succeeding two sections are representative of relative levels of efficiency in the industrial sector and provide good indicators of the structure of incentives. The results with respect to relative efficiency are quite mixed both across individual industries and among firms within industries. In this section we concentrate on broad intersectoral comparison, but the reader should keep in mind that in many industrial groups the range of individual firm results is sufficiently large to result in overlapping of the distribution of DRC's across sectors. The results for the public sector are summarized in Table 9.1 and 9.2 and in Figures 9.2 and 9.3 which provide frequency distributions of DRC ratios for each of the four major industrial groups under the control of the Ministry of Industry, with both the low cost and high cost assumptions concerning the rental cost of capital. Broadly, the results indicate that sectors may be ranked in the following order of international competitiveness -- food, textiles, metals and chemicals. Both the food and textiles sectors show positive value added at international prices in all firms in our sample. Chemicals and metals on the other hand each have a substantial percentage of firms, roughly thirty percent, which have DRC ratios less than zero. These establishments in the chemicals and metals sectors actually use more foreign exchange to purchase the intermediate materials which they use in production than they generate in foreign exchange earnings from the output produced. Much of this incidence of negative value added at world prices can be traced to the energy intensity of production processes in the two sectors. Because energy inputs in Egypt, fuel oil, natural gas, and electricity, represent potential exports of petroleum foregone, setting domestic prices at levels well below international levels has resulted in a serious divergence between economic and market costs for this crucial input. Activities based on highly energy intensive processes may therefore appear profitable when evaluated at domestic market prices, but may be extremely wasteful of resources when examined in terms of border prices. In all four sectors a substantial percentage of firms have resource cost ratios exceeding unity. The factors of production used up in these activities have higher economic opportunity costs than the net output produced. They are therefore also inefficient, but unlike activities with negative value added at world prices, they do make some contribution to output valued at economic prices. Two estimates are used to "bracket" the value of capital: a "low" estimate obtained by pairing a 6 percent interest rate with the historic cost of capital and a "high" estimate obtained by pairing a 10 percent ARI with an estimate of the replacement cost of capital. The relative frequency of firms with DRC's exceeding one varies from a low of 21 percent (43 percent) in food manufacturing to a high of 46 percent (62 percent) in the chemicals sector at the low (high) rental cost of capital. - 280 - Table 9.1 Aggregate DRC and DRC Range - Egypt Public Sector Capital values at historical costs and 6% ARI and at replacement cost and 10% ARI Historical Cost ARI = 6% Aggregate Best Worst Textiles Cotton Textiles 0.629 0.395 2.003 Other Textiles 0.994 0.792 1.342 Foods Oils 0.566 0.385 2.281 Mfg. Food 0.314 0.105 1.960 Alcohol, Beverages, Tobacco 0.395 0.304 1.047 Chemicals Paper 1.714 0.458 -1.492 Basic Chemicals 1.938 0.622 -3.876 Miscellaneous -0.651 0.769 -0.576 Metals and Engineering Basic Metals -27.558 0.944 -0.255 Transport Equipment -6.431 0.519 -0.856 Electrical Machinery 0.591 0.257 5.492 China and Glass -3.931 15.592 -1.177 Replacement Cost ARI = 10% Textiles Cotton Textiles 0.889 0.572 2.626 Other Textiles 1.281 0.993 1.890 Food Oils 0.843 0.613 3.338 Other Food 0.516 0.158 2.961 Alchohol, Beverages, Tobacco 0.562 0.419 1.451 Chemicals Paper 2.803 0.697 -2.900 Basic Chemicals 3.457 1.283 -5.699 Miscellaneous -1.156 0.868 -0.825 Metal & Engineering Basic Metals -45.146 1.110 -0.380 Transport Equipment -8.467 0.749 -1.159 Electrical Machinery 0.800 0.336 7.294 China and Glass -5.431 10.707 -1.774 Table 9.2 Frequency Distribution of DRC Ratios by Industry: Public Sector - Egypt Cl) 'Ti ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ Hcoi 0 Cl4l) W ~ 4J4r Cu-p H 0 H 4 0H a C:: H H . CH " . 0. H " .4J 4W4 W S, O 4-JX .cx WW O i OJco:: o 41 Q XH "l C 4 4 $4 Hcii DRC Internal o- H C o On u . u oH HC C .) 0- 1 1 2 2 1 1 3 3 1 1 .2 2 (negative) (1) (1) (2) (2) (1) (1) (3) (3) (1) (1) (2) (2) 0, .25 3 3 0, .25 ~~~~~~~~~ ~(3) (3). ________________ _____ ____ ____() 3) ___ _. ______ _ _____ _ _____ _____ _____ ______ .25. .50 4 4 1 1 2 2 N 2 2 2 (2) ________ (1) (2) (1) ((1) 1 (2) (1)c o _ .50, .75 5 4 1 2 1 1 1 1 1 1 2 2 ___________ _________________ (5) (6) (1) (1) (1) (1) (1) . .__ . . . (1) (1) (2) (2) .75, 1.0 2 2 1 1 2 2 1 2 1 1 1 (2) (2) (1) (1) (2) (1) (1) (1) (1) (1) (1) (1) 1.0, 1.25 2 2 1 1 2 3 1 1 1 1 (2) (2) (1) (1) (2) (1) (1) (1) (1) (1) M I__ _ .i25, i5 1 1 1 (2) (1) (1) (2) (1) (1) _ _ 1.4, 2.0 1 - 1 1 1 1 (3) (1) (1) 1 (2) (2) (1) 2.0+ 1 1 1 1 1 1 1 1 i 2 2 2 1 1 2 3 1 1 1 2 (1) (1) (1) (1) (1) (1) (1) (1) (1) (2) (2) (2) (1) (1) (4) (4) (1) (1) (2) (2 Note Left hand column ARI = 6% Right hand column ARI = 10% ( ) = Caoital Valued at REplacement Cost FREQUENCY DISTRIBUTION OF RESOURCE COST RATIOS EGYPT PUBLIC SECTOR 1o 7ET]L.ES 02 FOOD * CHEflILS o) 6 tERTS . ) C)- -C) C) C) S S 'r-'-- C3 CD C-)~ ~~~~~~~~~~~~~~~~~~~~~~C c~~~~~~~~~~~~~~~~~~~~J /~~~~~~~~~~~~~~~~~~~~~~~~~~c r~~~~~~~~~~~~~~~~~~~~r C) C -° S -.S l.5o .o + RCR RANGE FREOUENCY DISTRIBUTION OF RESOURCE COST RATIOS EGYPT PUBLIC SECTOR ol 7axriLES FOOD * CHEMICIALS D .. El tIEIfiLS C C) Q o 0t QCC: Io°w1|0...,,|o ac\ fl~~~~~~~~~~ E-J4 z~~~~~~~~F ROR RANGE - 284 - The proportion of firms which fall in the "acceptable" interval with DRC's ranging from zero to one varies from 89 percent in food manufacturing to 23 percent in chemicals at 6 percent ARI and the historic cost of capital. The equivalent comparison at 10 percent ARI using the replacement cost estimate of capital is from 57 percent to 8 percent for food and chemicals, respectively. The disparity in the proportion of firms judged acceptable under the two sets of capital cost assumptions points up two important aspects of the sensitivity of our results to the assumed rental cost of capital. First, given the age of capital stock in the public sector the divergence between book value and replacement cost is substantial and has a significant impact on the absolute level of the DRC. Second, however, the relative DRC levels among firms and industries remain largely unchanged. Thus, although our assumptions concerning capital costs have important implications for judgements concerning absolute efficiency they have relatively little effect on statements regarding relative efficiency levels. This is quite important because, from a dynamic viewpoint, we are as interested in relative efficiciency and changes in relative efficiency over time as we are in the absolute efficiency of any activity at a single point in time. Within each of the four sectors we consider several individual industries. The distribution of DRC results is quite large, even within these more narrowly defined groups but the broad sectoral patterns remain. In textiles the cotton textiles industry is substantially more efficient than other textile products. Indeed, there are few firms producing other textiles with DRC's in the acceptable range. This result is not surprising. Cotton textile manufacturing is an export oriented industry, largely based on indigenous raw material inputs. Non-cotton textiles on the other hand are primarily woven wool fabrics and carpets produced for import substitution using substantial quantities of imported intermediates. One disturbing aspect of the distribution of DRC's for the cotton textiles industry, however, is the relatively high incidence of DRC's in the unacceptable range in this mature industry. In light of the deteriorating productivity performance of the sector which was analyzed in Chapter 9, the existence of as many as 50 percent (at 10 percent ARI and replacement cost of capital) of firms in the industry with DRC's exceeding one is cause for concern regarding deteriorating international competitiveness in the sector. In particular the production of low count yarns and coarse cloths is a highly inefficient use of local long staple cotton inputs. In addition there is evidence of substantial overstaffing of enterprises in the cotton textiles industry and significant levels of technical inefficiency. It appears, therefore, that efforts to maintain the international competitiveness of the industry must focus on rationalization of the product mix, renewal and replacement of plant and equipment in many existing firms, reductions in surplus labor, and efforts to improve management practice. Our estimates indicate that there is scope for substantial improvement in the DRC for the industry with modest improvements in the technical efficiency with which enterprises are operated. Food products is another sector in which the ability to process locally supplied raw materials is a source of potential comparative advantage. The industry DRC results appear to bear out the truth of this - 285 - conventional wisdom in the Egyptian context. The edible oils industry registered impressive productivity gains at market prices during the 1970's. These improvements in total factor productivity are also reflected in the productivity of enterprises at international prices. The possibility of the expansion of the sector from an import substitute into an exporting activity hinges more intimately on agricultural policy, however, than it does on industrial policy. Expansion of refined edible oils is constrained by the availability of appropriate oil seed inputs. Thus its potential competitiveness as an exporter must be evaluated as an integrated agricultural and industrial activity. Food manufacturing is a heterogenous collection of food processing activities which generally appear to have acceptable levels of relative efficiency. An important traditional industry within the sector is sugar manufacturing which is another example of the importance of linkages between agriculture and industry in Egypt. The major input into sugar refining is, naturally, sugar cane. Sugar cane is a non traded good however, and its shadow price is set by the marginal social cost of production. Our estimates of the marginal social cost of cane production in Upper Egypt are sufficiently low to make the DRC for sugar refining extremely low as well. This DRC tells us that the integrated activity of growing and refining sugar is one sector in which Egypt appears to have substantial comparative advant:age. Expansion of sugar production, however, will come only at the expense of other crops. Our results in Chapter 4 indicated that given the existing refining technology expansion of sugar acreage was economically efficient, bul out results do not permit us to assess the potential gains from improvements in processing alone. Another important industry contained within miscellaneous food manufacturing is vegetable canning and preserving. This activity appears to be marginally efficient on the basis of its overall DRC, but there are great variations in the relative efficiency of individual product lines. Canning and preserving of fruits for example appears substantially more efficient than manufactuing of syrups and extracts. Evidence from other studies also implies that there are major variations in the economic efficiency of preserving various vegetables, based largely on variations in international relative prices of inputs and output and on the efficiency of Egyptian processing technology. Our data here are less detailed than we would like, and we are therefore hesitant to arrive at any jiudgements concerning the potential for efficient expansion of vegetable processing. Putting together the evidence on the deteriorating technical efficiency of firms in the sector with the relatively high DRC in 1980/81, leads us to speculate that new investments in food processing would have to exhibit substantially better levels of capacity utilization and technical efficiency than existing public sector enterprises. Since capacity utilization in the industry depends largely on the availability of agricultural supply, this is another example of the need for close coordination between agricultural and industrial policy. The chemical products sector evolved largely as an import substitute. Most activities in the sector are based on the processing of imported raw materials, with the notable exception of fertilizers, and the DRC results reflect the patterns which have come to be associated with import - 286 - intensive import substitution industries in many countries. In each of the three chemical industries in our sample a significant proportion of firms exhibited negative value added at world prices. These activities are highly undesirable from the viewpoint of economic efficiency, since the cost of intermediates at shadow prices exceeds the shadow value of output. There is also a substantial proportion of firms with DRC ratios exceeding two in each industry. The basic chemicals sector is particularly dramatic in its inefficiency. All of our observations either exceed two or are negative. These activities are in general import substitutes characterized by rapid international technical advances and substantial plant level economies of scale. Investments in Egypt appear to have been of less than minimum efficient scale and have operated at reduced levels of capacity utilization. The fertilizer industry presents an interesting contrast to basic chemicals. Both phosphate and nitrogenous fertilizers are produced in Egypt and both products have been exported at various times. On the basis of our 1980/81 DRC estimates it appears that the existing nitrogenous fertilizer units are competitive as import substitutes (although not as exports) while phosphate fertilizers are not efficient import substitutes. 1/ Since the phosphate fertilizer industry was an exporter at one point in it history, our finding that its DRC exceeds one by a substantial margin is indicative of a major decline in competitiveness. We have interpreted this decline in efficiency as the consequence of unfavourable international price movements in phosphate rock and energy inputs relative to the international price of output. There is also some evidence to indicate that the quality of the phosphate rock input is declining with consequent deleterious effects on the industry. The nitrogenous fertilizers subsector, on the other hand, has recorded a substantial improvement in its international competitiveness. This is largely due to a shift in techniques towards using natural gas as feedstock. The ability to use locally supplied natural gas in plants of minimum efficient scale has substantially improved the competitive position of the nitrogen-based fertilizer industry. Existing plants, however, do not show sufficiently low unit costs to overcome the CIF - FOB differential in the industry; thus, the activity in Egypt is only efficient when considered an an import substitute. There remains substantial scope for import substitution, however, and further investments should yield good economic returns. Paper and paper products was a sector which, as we noted in Chapter 8, was quite unevenly affected by the liberalization efforts of the opening. The DRC performance in the sector reflected in Table 9.2 mirrors the findings of the productivity analysis in the preceding chapter. Integrated pulp and paper mills do not appear to be efficient import substitution activities. Paper products manufacturers on the other hand, whether they utilize locally supplied or imported paper inputs, are relatively more efficient activities. In the integrated mills the lack of international competitiveness appears to 1/ The sample does not include Kima. - 287 - be due both to the need to import a substantial proportion of the pulp input and to the relatively small scale of Egyptian enterprises. It is possible that future investments in integrated paper manufacturing designed to utilize locally supplied pulp (rice straw and bagasse) may achieve more acceptable levels of efficiency, but at, present the industry does not appear to be a viable candidate for major expansion efforts. The metals sector consists of both iron and steel and aluminium production, and of fabrication of metal products, transportation equipment, machinery and electrical apparatus. The economic efficiency of these activities varies quite widely. In the basic metals complex a major source of inefficiency is the negative value added to world prices g8enerated by the aluminium industry. The industry, which is highly energy intensive, was introduced to utilize low cost hydro-electric power from the Aswan dam in the production of aluminium ingots from imported alumina. The rising social cost of electricity has had a particularly severe impact on the economic efficiency of aluminium production and the policy of providing power to the smelter at rates which are low by Egyptian standards has undoubtedly compounded the problem by providing little incentive for the firm to economize on energy inputs. At present its level of efficiency is sufficiently low to warrant an examination of the desirability of continuing to produce aluminium in Egypt. The iron and steel complex in contrast has made substantial improvements in its level of efficiency over the past twenty years. Although the DRC ratio for the integrated steel mill continues to exceed one, it has declined substantially as a result of the expansion and rationalization of production undertaken in the 1970's. Smaller producers of iron and steel products show mixed results with regard to their levels of efficiency, and some product lines appear to be competitive at international prices, but in general, future investments in basic metals production will probably achieve acceptable economic returns only as a result of reducing losses at accounting prices rather than as major sources of efficient import coimpetition or exports. In the transport equipment industry and in electrical machinery manufacturing there is great variance in the DRC ratios of individual firms. This variance reflects the fact that product lines within these sectors have very different levels of economic efficiency. Manufacture of automobiles for example appears to be quite inefficient while production of railway carriages has a good DRC. Similarly, production of industrial electrical apparatus and consumer durables appears to be relatively efficient, while manufacture of radios and televisions is apparently highly inefficient. The relative efficiency of private industrial investments is summarized in Table 9.3 and Figures 9.4 and 9.5. Our sample of private firms was purposively selected to represent a selection of largely new, Law 43 investments in three sectors, food products, textiles and metals/engineering/ building materials. These are the three major lines of manufacturing in which private sectror investment has concentrated since the liberalization of the trade regime and the promulgation of Law 43. - 288 - Table 9.3 Aggregate DRC and DRC Range - Private Sector Industries Egypt (Capital Value at Historical Cost) Aggregate Best Worst Textiles .920 .158 -.849 (1.152) (.181) (-.993) Food .581 .196 -.446 (.667) (.277) (-.547) Metals, Engineering & 1.622 .706 -.527 Building Materials (1.895) (.907) (-.595) Note: Figures in parenthesis are at ARI = 10% The private sector results show great similarity in terms of relative levels of efficiency of individual sectors to those from the public sector. Ranking sectors by declining relative levels of efficiency as measured by the aggregate DRC we find the same relative ordering as in the public sector; food products are judged most efficient, followed by textiles, and by the metals/engineereing and building materials sectors. In contrast to the public sector, however, there is greater within sector variability of resource cost ratios, and the relative frequency of firms with DRC's in the unacceptable range is higher in private industrial activities than in equivalent groupings in the public sector. For example the range of DRC ratios in food manufacturing in the private sector is from -.466 (-.544) to 2.928 (3.315) at 6(10) percent ARI and the historic cost of capital and the proportion of private sector firms in the unacceptable range is 57 percent. In contrast, in other food manufacturing in the public sector the range of DRC's is from .135 (.161) to 2.762 (3.188) and the proportion of firms in the unacceptable range is 21 percent. Inspection of Figures 9.3 and 9.5 reveals similar public-private differences for the other two sectors. This finding is not surprising. Firms in the private sector show greater heterogeneity with regard to the age of the enterprise, the type of product produced (and hence the degree of effective protection) and the level within plant efficiency than firms in the public sector. In particular a significantly higher proportion of private sector firms in our sample are new enterprises operating at low start-up levels of capacity utilization. Their relatively high DRC's reflect both the social cost of excess capacity and the initially high costs of learning in infant enterprises. The range of activities undertaken by our sample of firms in private sector food manufacturing is more narrow than that encountered in the public sector sample. We essentially numerated two types of activities: firms producing import substitute convenience foods and using mainly imported inputs FREQUENCY DISTRIBUTION OF RF.SOURCE COST RATIOS EGYPT PVA\/RTE SECTOR cn E.L LO -1~~~~~~~~~~~~~~~~~~~~~~~~~Oh( CD [LJ, 0] FE/ / IN~~~~~~~~~~~~~~N d.o 0 .2S .So -Is 1.0 1.25 t^S 2.o + RCR RHNGE. FREQUENCY DISTRIBUTION OF RESOURCE COST RATI'OS EGYPT PRIVATE SECTOR a TEXTELES zi FOODS o * MITS & ENflNE!R]NQ M CS Lnl In CD Q 1 C)~~~~~~~~N oX CsWo * & 1 b la &a0|o RCR RANGE - 291 - and firms processing domestically supplied agricultural products primarily for sale on the domestic market but with some exports. Interestingly despite the high import content of the convenience food industry and distributions of DRC ratios overlap sufficiently that neither activity appears to dominate in terms of relative efficiency. Indeed the two lowest DRC ratios in the private food manufacturing industry are found in firms using imported inputs to produce convenience foods. The relatively good economic efficiency of the convenience food sector is largely due to the natural protection afforded to output by the bulk and fragility of the final product. Transport cost to value margins are high and successful local branding and advertising provide an additional barrier to import competition. This suggests that although levels of efficiency in the sector are generally acceptable there may be limited scope for expansion beyond the import substitution phase, although one of the most successful private sector producers of convenience foods had succeeded in penetrating the Arab export market with its line of products. Performance in the basic food manufacturing sector is quite varied. Individual firms have DRC ratios ranging from negative vaLues to values in the acceptable range. The characteristics of efficient firms appear to be that they operate at high levels of capacity utilization, exercise close control over their supply of domestic agricultural inputs, and dii-ferentiate products by destination, with high cost and better appearance packaging employed in the export market. Additional scope for expansion into export: markets appears to exist in the industry, but to realize such expansions wil]L require in general improved reliability of agricultural supplies, upgraded packaging of the product, and more rigorous standards of quality control. Our sample of private sector textile firms consists of the one major producer of cotton yarn in the private sector and a selection of weaving, knitting and ready to wear producers. Levels of efficiency in the sector vary, but there are some general trends which appear to emerge. The weaving firm is highly efficient at existing Levels of capacity utilization, and efficiency levels should improve further with expansion of capacity and increased use of by-products. This result appears to reinforce our argument developed in Section 10.4(a) below that Egypt retains comparative advantage in the production of higher count cotton yarns from long staple inputs. The good DRC of this enterprise also reflects ito a large extent its relatively newer vintage and the fredom of the Law 43 company from mandated employment. Our sample of weaving firms is not sufficiently large to provide a sound basis for assessing the efficiency of this relatively extensive private sector activity. In the knitting secitor it appears that economic performance divides along input lines. Firms empLoying cotton yarn as their primary input and selling their output in competition with the Public sector or on the export market appear to exhibit generally acceptable levels of efficiency. Firms which use imported synthetic yarns to produce clothing which competes mainly with highly protected imports on the other hand have generally unacceptable DRC ratios. Since these activities tend to be rather heavily protected against import competition the result is not altogether surprising. - 292 - In ready to wear clothing DRC results are similarly variable. Many of the firms sampled are new and in the early stages of learning, but projected DRC's at full capacity of export oriented firms fall within the acceptable range. Because many of the clothing firms in our sample are integrated backward into weaving or knitting, it is difficult to separate the making up activity from the production of cloth. For this reason firms employing cotton and cotton blended fabrics appear to be relatively more efficient than those producing clothing primarily of synthetic woven or knitted fabrics. In sum it appears that there is some scope for increased exports of cotton and cotton blended clothing from the private sector. Proposals for expanded import substitution in synthetic fabric lines should be examined with some care. Our small samples of private firms in metal products, and building materials make it difficult to offer any generalizations on the performance of these sectors. In engineering on the other hand we have a sufficiently broad range of observations to note with some confidence several features of the import substitution regime in engineering products as it applies to the private sector. Private enterprises in the engineering sector produce mainly consumer durables and electronic goods. These products enjoy high nominal protection against imports, but must compete with products produced by the public sector which are sold at controlled prices below the CIF-plus-tariff equivalent. There is no evidence, however that the controlled public sector prices exert downward pressure on the domestic price of private sector competitors, since the principal means for dealing with excess demand for public sector products have been quantity rationing schemes, resales of rationed products at market prices by entitled purchasers are apparently commonplace. Firms in the private engineering sector fall into two primary categories, local assembly operations which simply assemble components provided by a foreign supplier or partner into finished units, and manufacturing firms which produce a number of components, even of foreign branded units, domestically. Our results are uniformly bad for the assembly firms in our sample; the results for manufacturing firms are more mixed and appear to vary with the organization and management of the enterprise. In short private assembly operations producing consumer durable goods appear to conform to the classic pattern of low or negative value added at international prices and poor DRC's which accompany such heavily protected industries in many countries. Overall the nature of our data and the variability of the results do not support any sweeping generalizations regarding the relative efficiency of the public and private sectors. Within relatively well defined product groups the distributions of DRC ratios for individual firms overlap, although the public sector distribution appears to be somewhat more compact and may have somewhat better aggregate performance. The result is probably as much due to differences in the relative age of firms and to variations in products, however, as to any systematic differences in productive efficiency. Our - 293 - results indicate that selection of product lines, levels of capacity utilization, and managerial efficiency exercise a more fundamental influence on economic efficiency than ownership per se. Estimates of effective rates of protection for the industries in the public sector sample are presented in Table 9.5. We have defined three measures of effective protection. The first, called the overall effective rate of protection, is the traditional measure of the percentage by which value added at domestic prices exceed value added at world prices in the activity. Because of the system of price controls and impLicit subsidies on inputs which pervasively affects the Egyptian public sector we have also defined two other "experimental" effective protective rates. The first, called "effective protection due to tariffs", is estimated by inputing as the domestic price of output the tariff distorted price (or border price in the absence of the tariff) which would obtain if price controlS on output were lifted. Inputs on the other hand are valued at their tariff inclusive prices (or at the border price) rather than at domestic controlled prices. This measure therefore seeks to approximate the structure of protection which would obtain if price controls and administered prices were eliminated without modification of the existing structure of tariff protection. In our second experiment we constrain the firm to receive the domestic control price (or border price) for its output, but we charge it the border price less subsidy for its inputs. This scenario would obtain if the structure of tariff protection were eliminared, but the existing pattern of price controls and administered prices were retained. We have called this measure "effective protection due to subsidies". The two measures are not addiitive. Table 9.4 should be examined in conjunction with Table 9.5 which presents the ratio of the value of output at accounting (border) prices to the value of output at domestic prices and the total value of direct plus indirect tariffs and direct plus indirect subsidies as a percentage of the value of domestic output. The two tables convey essentially the same information regarding the structure of incentives in the public sector, Four sectors have negative value added at internai:ional prices, and therefore exhibit negative rates of effective protection. These negative rates, which occur in miscellaneous chemicals, basic metals, transport equipment, and china and glass, should not be interpreted as reflecting negative protection of domestic value added; rather they reflect very high positive protection of value added at domestic prices, since if border prices were to obtain the activities could not sustain themselves with existing techniques and levels of productivity. Other effective protective rates range from a low level of -94 percent in edible oils to a high of 89 percent in other textiles and paper. In common with studies of efficiency and protection in other countries the effective protective rates are lowest in those sectors in which relative levels of efficiency, as measured by the DRC, are highest; cotton textiles, edible oils, other food products, and electrical apparatus. What is more striking about our results, though, is that it is the price control system that has the most profound influence on the structure of protection of public sector firms. Effective protection due to taxes is - 294 - Table 9.4 Effective Protective Rates for Public Sector Industry - Egypt Industry Overall Due to Taxes Due to Subsidies Textile Cotton Textile -28.10 - 2.31 - 22.43 Other Textile 35.47 - 2.62 46.13 Food Eclible Oiis -93.97 - 6.31 - 81.66 Mf.g. Food -69.73 - 2.90 - 64.29 Alcohol, Beverage, Tobacco 4.61 - 22.27 32.46 Chemical Paper 88.90 - 14.06 115.80 Basic 45.35 - 7.60 79.95 Miscellaneous - 3.94 a/ - 1.70 - 8.98 Metals Basic Metals -2923.73 a/ -127.46 - 3552.14 Transport Equipment 354.91 a! -136.92 - 226.02 Electrical Machinery 9.30 - 3.47 19.55 Clhina and Glass -633.63 a/ - 25.71 - 656.04 Note a/ Negative Value Added at World Prices Table 9.5 World Value of Output and Direct and Indirect Taxes and Subsidies as Percentages of the Domestic Value of Output Domestic Value World Value Taxes Subsidies Textile Cotton Textiles 143.90 1.35 30.83 Other Textiles 91.18 2.86 18.76 Food Edible Oils 425.66 2.41 294.50 Mfg. Food 190.38 2.24 35.31 Alcohol,Beverage,Tobacco 71.96 32.01 11.92 Chemical Paper 89.82 12.34 17.81 Basic 138.83 1.76 57.37 Miscellaneous 98.59 0.61 4.27 Metals Iron and Steel 98.46 3.11 43.75 Transport Equipment 84.47 10.75 7.89 Electrical Machinery 96.55 4.54 6.19 China and Glass 112.72 8.89 86.46 - 295 - almost uniformly smaller than that due to subsidies. In four cases (alcohol, beverages and tobacco, basic chemicals, paper, and electrical machinery) the effective protective rates are of opposite sign; tariffs alone would result in negative effective protection on output. It is direct-plus-indirect implicit subsidies, which result in positive overall effective protection in these activities. In cotton textiles and edible oils in contrast the controls on output prices are sufficiently stringent to result in negative effective protection despite offsetting subsidies on inputs. In both of these sectors a shift to border prices distorted by tariffs would result in a substantial reduction in the bias against the sector. Both sectors have very high ratios of value of output at world prices to value of output at domestic prices and high but not equal values of direct plus indirect subsidies. The relative pattern of effective protection in the private sector as reflected in Table 9.6 is similar to that encountered in public sector industry. Food products exhibits negative effective protection. Textiles, metals and engineering, and building materials show positive rates of protection in ascending order of effective protective rates. The effective protective rates for the private sector are higher, reflecting the sector's ability to set prices at the levels implied by the structure of tariff protection. The influence of price controls on both inputs and outputs is substantially less than in the public sector. Effective rates of protection due to subsidies are correspondingly lower than those due to tariffs. Protection from domestic prices exceeding border prices on output is reinforced by direct plus indirect subsidies on inputs. In this sense private entrepreneurs receive levels of protection not accorded to their public sector competitors; this is probably an unintended benefit of the system of administered prices. Table 9.6 Average Effective Rates of Protection : Private Sector Overall Due to Taxes Due to Subsidies Textiles Spinning -42.2 -89.9 -41.7 Other 63.8 57.7 3.7 Food -38.9 -72.8 55.2 Metals/Engineering -253.8 a/ -200.2 -69.9 Building Materials 95.4 96.9 0.3 a/ Negative value added at world prices. - 296 - Table 9.7 Value of Output at International Prices, Total Tariffs and Total Subsidies as a Percentage of Output : Private Sector Value of Output Tariffs Subsidies Textiles Spinning 174.2 0.4 39.6 Other 79.4 4.8 15.1 Food 102.1 22.2 18.8 Metals/Engineering 61.9 15.3 7.9 Building Materials 72.3 15.0 1.0 The most striking difference in rates of effective protection occurs in textiles in which the public sector cotton textile producers face negative effective protection while private sector producers enjoy substantial positive protection. The divergence reflects both the effect of price controls on the output of public sector enterprises, particularly those producing rationed cloth and clothing, and the concentration of private activity in highly protected product groups within the sector. The single cotton spinning firm in our sample faces negative effective protection at levels similar to those encountered in the public sector. In the food sector there is tremendous variability in effective protection coefficients. Protection on those activities producing convenience foods varies from negative to extremely high depending on the levels of tariff protection and the incidence of subsidies on agricultural inputs. Direct plus indirect tariffs on inputs, primarily on packaging materials, are largely offset by the direct-plus indirect subsidies on agricultural inputs. In the metals/engineering and building materials sectors subsidies on inputs, primarily fuelds and electricity, fail to offset the levels of tariffs on inputs. Effective protection is nevertheless high, since firms are protected by substantial tariff barriers. The overall structure of protection in Egypt is characterized by sharp dualism between public and private enterprises. In the public sector the typical firm faces regulated prices on its output, coupled with substantial subsidies on its commodity inputs. The extent to which these two sets of implicit subsidies and taxes are offsetting determines the extent of effective protection. Many public enterprises in the competitive sectors would probably exchange the exisiting system of price controls and input subsidies for a system where they would pay the world price or even the tariff inclusive import price for their inputs but would have the opportunity to - 297 - charge the border price for their output. In the private sector in contrast it is the tariff structure which deliviers the bulk of effective protection. Price controls and subsidies play a less important role and incentives are cumulative in the sense that implicit subsidies on inputs raise effective protection above the levels which would prevail in their absence. Few if any firms, except in food processing would at present exchange the existing system of tariff protection for a regime in which output and inputs were sold at border prices. The upshot of this dualism of incentives is to hamistring efficient public sector firms relative to their counterparts in the private sector, and to offer excessive encouragement to many activities of dubious economic merit. Greater flexibility in the pricing rules applied to the public sector and a unification of incentives facing private and public producers would allow much greater financial returns to efficient activities and lead to improved resource allocation and investment decisions. We shall return to these issues of price reform and public sector flexibility in Chapter 10. In conclusion, it is worth observing that despite a very difficult policy environment and many political and social constraints, there are a great number of very efficient and competitive producers in both the private and the public sector. As we already argued in Chapter 8, this would appear to suggest that the potential for major productivity increases and thereby major improvements in efficiency and international competitiveness is there, if the average producer can come closer to best practice performance. It would seem that with the right kind of encouragement, sufficient investment, and more efficiency oriented economic policies, the industrial sector could meet the challenge of becoming, after oil and remittances decline in importance, the driving force of Egyptian development. 9.4 Economic Efficiency and Comparative Advantage in Egypt's Public Industrial Sector : The Detailed Results In this section we review in detail the evidence fLrom the surveys that were conducted jointly with the Ministry of Industry and Mineral Wealth concerning the trade prospects, economic efficiency and international competitiveness of public sector firms in ten sub-sectors of the Egyptian industrial economy, two in textiles, three in food products, two in chemical products and three metal products groups. We have calculated DRC's for each firm under four different assumptions concerning the rental cost of capital. We have selected accoun-ting rates of interest at six percent and ten percent, which bracket our estimates of the charnging ARI derived from the optimal growth model described in Part I of this Report. Capital is valued at both its historic cost, the book value for depreciation, and at an estimate of replacement cost derived from the age cf capital stock, assumed rates of inflation in capital goods prices, and rates of depreciation. The lowest rental cost is given by the pairing of a six percent ARI and historic cost of capital, and the highest by the pairing of a ten percent ARI and the replacement cost of capital. These values certainly bracket the "true" cost f the capital input in the DRC. - 298 - The primary purpose of this work is to test the sensitivity of the aggregate results to major assumptions regarding economic prices and to use individual firm and product based domestic resource cost and effective protection calculations to provide additional insights into the sources of efficiency differentials among firms and industries. The results were compared wherever possible to previous work on the Egyptian industrial sector with the purpose of setting the results in context and of following the historical development of a number of these industrial groups over the period since 1965. The Cotton Textile Industry Cotton textile manufacturing is the oldest industrial sector in the Egyptian economy and remains the single largest industrial group in terms of both output and employment. The postwar history of the industry is distinguished by three distinct phases of development. Prior to the proclamation of Arab Socialism in 1961 and the subsequent nationalization of private sector enterprises, the textile industry produced primarily for domestic import substitution, and was characterized by relatively small scale production units. In the period following nationalization firms were consolidated into twenty-two public sector companies, most consisting of several integrated spinning and weaving mills. Output increased rapidly in the period 1964-1973, both in response to rising domestic incomes and to a growing export market, primarily in Eastern Europe and the Soviet Union. The period following 1973 has been characterized by declining output in real terms in the public sector, and a major realignment of export markets for bilateral agreement areas to convertible currency markets. The public sector companies account for 85 percent of total cotton spinning capacity, about two thirds of weaving production and approximately fif-ty percent of knitting capacity. The private sector consists of two groups of firms, traditional small scale establishments engaged in weaving, knitting and clothing manufacturing which were not nationalized in the Socialist period, and a much smaller set of new medium to large scale investments, most of which are joint ventures under Law 43, in modern spinning, weaving, and knitting. New private sector investors have been particularly agressive in seeking out opportunities for import substitution in knitting and ready made clothing manufacturing, and a number of new enterprises have been established for the purpose of developing export markets in knitwear and readymade garments. Evaluation of the competitiveness and economic potential of the Egyptian textile industry is particularly difficult due to the diversity of inputs and outputs of individual firms. Moreover, the integration of spinning and weaving in most public sector plants makes independent evaluation of these activities problematic. The extensive set of controls on input and output prices, particularly on the input of raw cotton and on the production of rationed cloth makes the results particularly sensitive to the assumptions made regarding relative international and domestic prices for these commodities. - 299 - The available data allow us to present ERP's and DRC's for the integrated production of cotton yarn and cloth for 14 public sector firms in the cotton textile sector for the accounting year 1980/81. The public sector firms in our sample produced 85 percernt of total public sector output of cotton textiles in 1979, the last year for which complete sectoral production data are available. In addition to firm level DRC's and effective protective rates, data from the public sector permit us to compute DRC's for a number of product groups. These are based on information provided by the individual companies regarding the unit cost structure of individual products. Unfortunately the data are so arranged that weaving cannot be considered as a separate activity from spinning; the unit costs of woven cloth are for the integrated activity of spinning and weaving the final output. Two accounting ratios are of crucial importance in determining the aggregate level of efficiency of the sector. On the input side the results are particularly sensitive to the economic price assigned ito raw cotton inputs. A great deal has been written on the issue of the efficiency of using domestic long staple cotton as an input into the cotton textile sector. Generally it is argued that high grade cotton lint is "underspun" when it is used to produce coarse count yarns for "popular" (rationed) textiles to be sold on the domestic market. Since lower grade imported cotton could be employed in the production of most domestically consumed c:Loth, it would be feasible to import medium to short staple lengths and export the long staple lint released from domestic fabric production. The desirability of doing so, however, and the economic cost of "underspinning" domestic cotton depends a great deal on the assumptions made with regard to the demand for long staple cotton exports. As argued at length in Part II of this Report Egypt cannot be considered a price taker in the market for cotton exports, and hence that incremental exports of cotton lint result in a reduction in the international price of Egyptian long staple cotton. In these circumstances it is the marginal revenue earned from raw cotton exports which sets the relevant opportunity cost of cotton inputs into Egyptian mills, and not the world price. We have taken as our best estimate of marginal export revenue a value which is 80 percent of the border price of long staple cotton. This is also approximately equal to the differential between the CIF value of medium to short staple lengths and the FOB price of Egyptian cotton exports. Thus as our base case we take a scenario which favors the use of domestic cotton inputs in local mills as compared to the use of the unadjusted international prices. On the output side the main problem was to establish an accounting ratio (economic price) which reflected the border value of the "popular" (rationed) cloth output produced in substantial volume by the mills in the public sector. The average domestic price (weighted by volume) of the seven types of popular cloth produced by mills in the public sector is LE .176 per meter. This is well below the FOB unit value of similar exported cotton textiles of LE .435 per meter and results in an accounting ratio applied to the domestic controlled price of 2.47. There is undoubtedly some quality differential between the cloth released for export and that consigned to the - 300 - domestic market and therefore the true accounting ratio may lie below this estimate. An alternative which gives a very different picture of the relative efficiency of the textile sector is to treat popular textile output as a non-traded good. The rationale for this treatment arises if the rationed cloth price in Egypt lies below the CIF price of an imported equivalent and above the FOB price it could fetch on the international market, due for exaple to quality differences between rationed textiles and textiles which are generally traded. In this case an estimate of the marginal social benefit of an increase in textile production is given by the domestic price converted to border prices, which is a first approximation to the foreign exchange saved as a result of a unit increase in the output of rationed cloth as consumers shift their expenditure from other commodities. The conversion to border prices is done at the consumption conversion ratio of 1.13, and this value becomes an alternative estimate of the accounting ratio for rationed cloth output. The two accounting ratios probably bracket the true accounting ratio but it most likely lies closer to a value of 2 than to the consumption conversion ratio, since at least a portion of the sector's output of rationed cloth is of exportable quality. There is also the possibility that fabrics would have to be imported at the margin to fill domestic demand for some rationed cloth varieties which would lead to an economic price exceeding the fob export value. We have therefore taken as our base case accounting ratio for rationed cloth a value of 2.20. The results of our base case estimates and of tests of the sensitivity of the results to changes in the key accounting values are summarized in Table 9.8. The immediate impression gained from the table is that cotton textiles, despite their apparent stagnation in output and their poor productivity performance in the period after 1973, remain competitive at international prices. The base case DRC when capital is evaluated at replacement cost for the firms in our sample is .723 at an ARI of 6 percent and .889 at an ARI of 10 per cent. The sensitivity of the results to the assumed economic price of raw cotton inputs is substantial, however. Shifting from marginal export revenue to the export price of cotton results in an increase of 27 percent in the value of the DRC and results in an aggregate DRC value exceeding one at an ARI of 10 percent. The results show even greater sensitivity to the economic value of rationed cloth output. Reducing the accounting ratio for rationed cloth to 1.13, which implies an international price of LE .202 per meter raises the DRC by 70 percent and results in the sector appearing inefficient at both historic cost and replacement value estimates of the capital stock. Raising the accounting ratio fully to 2.47 results in a dramatic fall in the DRC to values in the range .55 to .79. Comparative data from two earlier periods are presented in Table 9.9. These DRC ratios are expressed as the ratio of the estimated DRC to the shadow exchange (taken as 35.2 PT/$ and 61 PT/$ in 1956 and 1969/70 respectively) rather than in their originally calculated form as a ration of LE/$ to facilitate comparison with our DRC estimates. One should be quite careful in interpreting these data, since the methods and assumptions employed in the previous studies and in our research may be quite different, particularly with respect to the valuation of capital and labor, and since the data sets are not strictly comparable. As rough indicators of magnitudes, however, they are remarkably consistent with our base cost estimates. At the - 301 - full export price of cotton inputs the sector is judged non-competitive in all three periods, while if replacement of long staple cotton inputs is simulated or if marginal export revenue is used rather than the export price of cotton inputs, the aggregate DRC for the text-ile sector is less than or equal to one. Table 9.8 Public Sector Cotton Textiles DRC ratios Aggregate Best Worst Accounting Rate of Interest 6% 10% 6% 102 6% 10% Base Case Historic Cost .629 .725 .395 .465 2.003 2.236 Replacement Cost .723 .889 .483 .572 2.298 2.626 Export Price of Cotton Historic Cost .798 .919 .413 .483 3.987 4.452 Replacement Cost .954 1.126 .483 .572 4.574 5.228 Rationed Cloth as Non Traded Good Historic Cost 1.072 1.232 .414 .483 -35.330 -39.281 Replacement Cost 1.284 1.512 .483 .572 -40.486 -46.229 Rationed Cloth at High Value Historic Cost .554 .642 .359 .419 1.526 1.706 Replacement Cost .665 .789 .447 .539 1.750 2.003 Table 9.9 Aggregate DRC Estimate for the Cotton Textile Sector in Egypt 1956 1965/70 1980/81 Full Export Price of Cotton 1.330 1.408 1.127 Replacement of Cotton by Imports or Exports Valued at Marginal Revenues 1.009 .892 .889 Sources: 1956 and 1965-70 estimates from B. Hanson and K. Nashashibi Foreign Trade Regimes and Economic Development: Egypt. New York: Columbia University Press from the National Bureau of Economic Research, 1975 - 302 - The DRC shows remarkably little trend toward increasing competitiveness over a period of more than twenty five years. This result is broadly consistent with the evidence provided on the productivity performance of the industry in Chapter 8 and with the results of the previous studies of productivity trends in Egyptian textiles. Previous research has indicated that operational conditions in the public sector textile industry have been characterized by underutilization of capacity, deterioration and obsolence of equipment, substantial excess employment of labor and insufficient autonomy extended to firms in adjusting their product mix and investment programs. Internationally, total factor productivity in cotton textile production has been increasing at a rate of approximately 2 percent per year, although major textile exporters such as Korea have experienced rates of productivity gain of more than double the international average. Set in this context it is remarkable that the Egyptian textile industry has succeeded in maintaining its international competitiveness in the 1970's and its inability to increase productivity is probably reflected in the rather static export performance of the sector between 1973 and 1980. The competitiveness of the Egyptian textile industry is determined in part by its product mix as well as by its productivity performance. In Table 9.10 we present estimates of the DRC for the four major product groups produced by most of the integrated public sector mills, cotton yarn, rationed "'popular" textiles, non-rationed textiles, and clothing. The financial data underlying these DRC estimates were provided by the individual enterprises to the Ministry of Industry for the purpose of establishing unit cost-price relationships at market prices. These cost price relationships are used by the Ministry to set production subsidies on commodities with costs exceeding their control prices and to revise product prices for the textile sector as a who'Le. Common capital costs of the enterprise and overheads are divided among product groups, according to the principles of the public sector unified accounting system, in proportion to the value of output at domestic prices, and spinning and weaving are treated as an integrated activity in the production of cloth. Aside from applying the relevant accounting ratios to the financial flows data, our only modification of the data provided in the unit cost estimates is to impute an annual rental of capital based on the ARI. Table 9.10 DRC Ratios for Individual Product Lines in Public Sector Cotton Textiles Percentage Less Best Worst Average Than One Yarn .445 1.245 .788 75.0 Integrated Yarn and Popular Cloth 2.418 -2.227 - 1/ 0.0 Integrated Yarn and Non Rationed Cloth .800 -.094 - 37.5 Clothing .414 -.201 - 66.6 Note: 1/ It is not possible to average negative and positive DRC values. - 303 - Differences in the resource costs of the four activities are quite striking. Yarn production is consistently identified as the most efficient activity in integrated mills. The average (unweighted) DRC for spinning in our sample is .788, and seventy five percent of the firms in the sample have DRC's below one for yarn production. Interestingly those enterprises in our sample which are engaged primarily in yarn production are among the observations exhibiting the highest DRC's for the activity. We interpret these results to indicate that in spimning the greatest comparative advantage rests with the spinning of higher yarn counts, given the riature of the sector's long staple cotton inputs. 'Integrated mills are reporting only the unit cost structure of spinning yarn not for consumption in their own weaving operations. This yarn tends to be medium to high count exportable yarn rather than the coarser counts employed in domestic textile production. The firms engaged primarily in spinning produce a wider range of yarn counts, and the consequences of underspinning of the long fibre input are reflected in the higher DRC ratio for their total yarn output. The hypothesis that domestic cotton inputs are not well utilized in spinning coarse count yarns for the production of low gradle textiles is further supported by the DRC results for popular textile production. Due to the high incidence of negative DRC's it is impossible to compute a meaningful average DRC for this activity, but there is no observation in the sample in which the DRC for popular textile production is less than one. Sixty percent of the firms reporting production costs for rationed textiles had negative value added at international prices in the activity. This means that the opportunity cost of their commodity inputs, primarily long staple cotton exceeds the shadow value of output. '[n these cases the Egyptian economy would be better off to export cotton at its marginal export revenue and import cloth CIF than to continue its poroduction in present mills usirLg existing techniques. For the mills with positive value added at intenational prices it is relevant to ask whether the activity is socially desiraLble if capital costs are treated as sunk and therefore assigned to zero opportunity cost. Even in this case there is no firm which would have a short run DRC below one. Detailed examination of the unit cost estimates of firms in the sample indicates that unit labor costs in rationed textile production exceed those in spinning and non-rationed textile production by a factor of from 2 to 4 times. This suggests that the cost to the enterprise of surplus labor are being largely attributed to rationed cloth production. If' this is the case the DRC estimates are probably biased upwards and it is possible that some existing mills would have short run DRC's below unity, but the overall force of the conclusion that utilization of domestic cotton inputs in the production of rationed textile cloth is economically highly inefficient remains undiminished. The picture is more mixed when one examines the efficiency of non-rationed textile production. Aga:in the presence of firms with negative DRC's precludes the computation of a meaningful average DRC for the activity, but the range of individual results is large, extending from a minimum of .80 to a maximum of -.094. Approximately thirty eight percent of the firms in the sample producing non-rationed cloth have DRC ratios below one. Thus although the results are not as good as for spinning, the efficiency of integrated -304 - spinning and non-rationed textile production is sufficiently good to warrant investigation into the sources of superior performance by those enterprises which have low DRC's and to suggest that well planned and implemented investment projects in textile production for higher quality import substitution or export may continue to exhibit satisfactory economic returns. The evidence on the manufacturing of clothing in the public sector survey is spotty. Only three of the firms in the sample reported production costs for clothing manufacturing, and there was substantial variation in product type and in the measured DRC. Two of the three firms had DRC's below unity, including one highly efficient producer of knitted cotton clothing, while the third firm reported negative value added at international prices. Given the scarcity of information on clothing production in the public sector it is difficult to generalize concerning its relative efficiency, but it appears that there is substantial scope for efficient import substitution and perhaps entry into export markets in a least some ready-made garment lines. As the results for individual product groups suggest, the aggregates presented in Table 9.8 mask substantial variation in the efficiency of individual enterprises in the textile sector. Table 9.11 summarized the firm leveL variation in petformance by presenting the frequency of DRC's below one under several alternative sets of assumptions regarding accounting ratios. The interfirm variation in resource costs and relative efficiency is substantial. Base case estimates of the DRC range from a minimum of .40 - .60 to a maximum of 2.0 - 2.6, depending on the assumed valuation of the capital stock and the Accounting Rate of Interest. Even under the most pessimistic assumptions regarding the economic values of cotton inputs and rationed cloth output, a substantial proportion of individual firms remain efficient at accounting prices. The result has an important implication for the interpretation of the aggregate DRC for the sector of an indicator of comparative advantage. Where a subset of firms remain efficient, even if the aggregate resource cost ratio for the industry exceeds one, it is possible that there is scope for additional investments in the sector. Proposed investments should presumably replicate the characteristics of efficient firms, rather than those of the average firm for the sector, and if such replication is possible, new investments will be competitive and will tend to improve the overall competitive position of the industry. If, on the other hand, the distribution of observations around the mean DRC is quite compact and few if any firms are competitive, it is unlikely that new investments in the sector will show a high probability of efficient operation. In Section 9.2 we discussed three possible sources of interfirm variations in DRC's, product mix, the choice of technology, and the efficiency with which technology is applied to production. Given the very differnt DRC estimates associated with the production of yarn alone, of integrated spinning and weaving, both for rationed and non-rationed cloth, and of clothing manufacturing, a logical beginning would be to ask if product mix appears to influence systematically measured efficiency. For example, an enterprise with an exceptionally high production quota of rationed cloth might be expected to have very low measured efficiency relative to other firms with similar -- 305 - techniques of production and technical efficiency, simply because of the adverse international price relationship between long staple cotton inputs and coarse cotton cloth output. Our data do not reveal any systematic relationship between product mix and relative efficiency in cotton textiles. Although there is some variation in the proportions of output (by value) represented by yarn, rationed cloth, non-rationed cloth, and clothing producecl by individual firms, these variations do not appear to be systematically related to any detectable way to relative levels of efficiency of the enterprise. For example the firm Table 9.11 Frequency of DRC's for Cotton Textiles (percent of sector) 0 Qn x(s,t), mn~~~~~ s=1,.*.,S;n In our estimation procedure we impose constant returns to scale and the regularity conditions of monotonicity and convexity on the production function. EGYPT ISSUES OF TRADE STRATEGY AND INVESTMENT PLANNING Appendix B The Macroeconomic Data Appendix B The Macroeconomic Data List of Tables Table No. Page No. B.] Population, Rates of Birth, Death and Natural Increase .... 407 B.2 Employment by Economic Sector . . ........................... 407 B.3 Gross Domestic Product at Current Prices . . . 408 B.4 Gross Domestic Product at Constant 1975 Prices ... 409 B.5 Resource Balance at Current Prices . . . 410 B.6 Gross Fixed Investment at Current Prices . . . 411 B.7 Balance of Payments - Current Account .................... . 412 B.8 Balance of Payments - Capital Account ... 413 B.9 Summary of Fiscal Operations . . . 414 B.10 Government Revenue ... 415 B.l1 Government Current Expenditure . . . 416 B.12 Public Sector Savings at Current Prices . . . 416 B.13 Direct Subsidies Paid from the Special Fund for Subsidies and the Treasury Fund .. . 417 B.14 Trading Operations of the General Authority for Supply of Commodities . . . ......... 418 B.15 Prices of Supply Commodities . . . 419 B.16 Public Sector Investment Expenditure . . . 420 B.17 Transfers of Profits to Central Government from Public Enterprises ........................................ 421 B.18 Public Authority Currency Deficits by Sector ... 422 B.19 Monetary Survey (Revised Presentation) ... 423 B.20 Production of Major Agricultural Crops ... 424 B.21 Output of Selected Industrial Products . . . 425 B.22 Production and Distribution of Crude Petroleum ... 426 B.23 Natural Gas Reserves and Production . . . 426 B.24 Petroleum Products and Gas Balances ... 427 B.25 Petroleum Export Prices . . . 428 B.26 Wholesale Price Index . . . 429 B.27 Consumer Price Index for Urban Population . . . 430 B.28 GDP Deflators ............................................. 431 B.29 Import and Export Price Indices . . . 432 Standard Table 1 ; Egyptian National Accounts Summary . ... 433 Standard Table 2 : Egyptian National Accounts Summary . 434 Standard Table 3 : Egyptian Balance of Payments . 435 - 407 - Table B. 1: Population, Rates of Birth, Death and Natural Increase 1/ 1974 1975 1976 1977 1978 1979 1980 Estimated 1981 Population (thousands) 36092 36990 37891 38794 39743 40983 42289 43465 Birth Rates (per thousand) 35.7 36.0 36.4 37.3 37.2 40.9 40.9 40.2 Death Rates (per thousand) 12.7 12.1 11.7 11.8 10.5 11.0 10.9 10.2 Rate of Natural Increase (%) 2.3 2.4 2.5 2.6 2.7 3.0 3.0 3.0 Growth Rate (Z) 2.4 2.5 2.4 2.4 2.4 3.1 3.2 2.8 Source: Central Agency for Public Mobilization and Statistics 1/ Includes estimates of migrant population. Table B. 2: Employment by Economic Sector (In Thousands of Persons) 1974 1975 1976 1977 1978 1979 1980/81 Commodity Sectors 5758 5931 5848 5911 6082 6262 6457 Agriculture 4212 4218 4068 4104 4135 4165 4200 Industry, Petroleum & Mining 1150 1175 1200 1247 1297 1351 1450 Electricity 38 41 47 48 52 53 63 Public Utilities 43 50 53 55 60 64 64 Construction 315 447 480 457 538 629 680 Distributive Sectors 1280 1371 1429 1495 1543 1578 1677 Transportation, Comm. & Storage 397 404 415 444 449 452 460 Trade & Finance 883 967 1014 1051 1094 1126 1217 Service Sectors 1992 2131 2228 2481 2634 2797 3046 Housing 139 143 144 145 147 155 166 Other Services 1/ 1853 1988 2084 2336 2487 2642 2880 Total 9030 9433 9505 9887 10259 10637 11180 Source: Ministry of Planning and IBRD estimates. 1/ For 1978-1980/81, IBRD estimates assume annual growth rates of 6.5, 6.2 and 6.0 percent respectively. - 408 - Table B. 3; Gross Domestic Product at Current Prices (In Millions of Egyptian Pounds) 1974 1975 1976 1977 1978 1979 1980/81 Commodity Sectors 2332 2828 3359 4089 4869 6867 9594 Agriculture 1280 1468 1744 2038 2286 2530 3427 Industry & Mining 746 880 993 1120 1319 1650 2144 Petroleum 112 149 247 468 626 1908 3105 Electricity & Public Utilities - 65 88 96 106 121 132 157 Construction 129 243 279 357 517 647 761 Distribution Sectors 807 1032 1355 1679 2233 3059 3809 Trans., Comm., & Storage 180 220 260 322 395 586 768 Suez Canal -3 40 141 169 294 406 .543 Trade, Finance & Insurance 630 772 954 1188 1544 2067 2498 Service Sectors 1058 1196 1451 1766 1919 2175 2775 Housing 203 209 222 244 262 287 321 Other Services 855 987 1229 1522 1657 1888 2454 (Tourism) 1/ (72) (99) (127) (134) (167) (190) (247) GDP at Factor Cost 4197 5056 6165 7534 9021 12101 16178 Net Indirect Taxes 142 162 562 810 774 604 768 GDP at Market Prices 4339 5218 6727 8344 9795 12705 16946 Source: Ministry of Planning and IBRD estimates. 1/ The 1980/81 figure was derived by assuming the same growth rate as for other services. - 409 - Table B. 4 Gross Domestic Product at Constant 1975 Prices (In Millions of Egyptian Pounds) 1974 1975 1976 1977 1978 1979 1980/81 Commodity Sectors 2584 2828 2995 3180 3490 3719 4155 Agriculture 1384 1468 1491 1447 1528 1592 1695 Industry & Mining 825 880 948 1012 1068 1152 1307 Petroleum 106 149 226 350 427 471 611 Electricity & Public Utilities 66 88 97 108 125 127 135 Construction 203 243 233 263 342 377 407 Distribution Sectors 876 1032 1224 1384 1604 1986 2343 Trans., Comm., & Storage 187 220 245 289 333 487 562 Suez Canal -3 40 142 171 201 235 281 Trade, Finance & Insurance 692 772 837 924 1070 1264 1500 Service Sectors 1167 1196 1261 1520 1474 1498 1723 Housing 203 209 225 243 259 278 318 Other Services 964 987 1214 1277 1215 1220 1405 (Tourism) (83) (99) (114) (107) (121) (126) (145) 1/ GDP at Factor Cost 4627 5056 5478 6084 6568 7203 8221 Net Indirect Taxes 2/ 157 162 500 654 564 360 390 GDP at Market Prices 4784 5218 5978 6738 7132 7563 8611 Source: Ministry of Planning. 1/ The same growth rate as for other services was applied. 2/ Derived by applying the GDP deflator to the current price data. - 41( - Table B.5 Resource Balance at Current Prices (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 GDP at market prices 4339 5218 6727 8344 9795 12705 16946 Resource gap (import-export) 1726 1101 789 894 1496 1899 2254 - Imports of goods and nfs 1616 2154 2287 2770 3626 5804 7992 - Exports of goods and nfs 890 1053 1498 1876 2130 3905 5738 Total resources (GDP + resource gap) 5065 6319 7516 9238 11291 14604 19200 Final consumption 4090 4578 5606 6804 8190 10431 14089 - Public 899 1298 1670 1628 2012 2172 3263 - Private 3191 3280 3936 5176 6178 8259 10826 Gross investment 975 1741 1910 2434 3101 4173 5111 Gross fixed investment 685 1282 1471 1873 2685 3763 4702 - Public 582 863 980 1505 2230 2847 3306 - Private 103 419 491 368 455 916 1396 Changes in stocks 290 459 439 561 416 410 409 - Public 174 275 263 337 250 270 264 - Private 116 184 176 224 166 140 145 Source: Ministry of Planning and Central Bank of Egypt _411 Table B. 6 : Gross Fixed Investment at Current Prices (In Millions of Egyptian Pounds) 1974 1975 1976 1977 1978 1979 1980/81 Commodity Sectors 390 633 847 1136 1587 2275 2869 Agriculture 54 94 98 146 191 258 374. Industry & Mining 192 287 379 561 765 1010 1215 Petroleum 1/ 74 122 186 206 201 448 594 Electricity & Public Utilities 59 99 104 175 298 399 557 Construction 11 31 80 48 132 160 129 Distribution Sectors 198 399 399 473 729 974 1060 Trans., Comm., & Storage 2/ 190 384 373 443 692 904 964 Suez Canal (0) (58) (71) (102) (305) (270) (n/a) Trade and Finance 8 15 26 30 37 70 96 Service Sectors 97 250 225 264 368 514 773 Housing 53 177 128 126 156 221 450 Other Services 44 73 97 138 212 293 323 Gross Fixed Investment 685 1282 1471 1873 2685 3763 4702 Less: Expenditures for the Purchase of Land 5 17 21 35 47 58 52 Investment Expenditure 680 1265 1450 1838 2638 3705 4650 Public Sector 598 852 966 1477 2191 2803 3270 Private Sector 102 413 484 361 447 902 1380 Memo; Foreign Investment 34 88 182 204 218 497 n/a Oil Companies 32 81 155 155 136 371 n/a Law 43 Companies 2 7 27 49 82 126 n/a Source: Ministry of Planning. 1/ Exploration and production by foreign and domestic companies. 2/ Includes Suez. _ 412 - Table B.7: Balance of Payments - Current Account (In millions of U.S. dollars) 1974 1975 1976 1977 1978 1979 1980/81 Trade balance -1800 -2733 -2490 -2764 -3440 -3312 -4037 Merchandise exports, f.o.b. 1818 1875 2169 2346 2558 4024 6002 Petroleum 251 473 828 1012 1262 2860 4442 Egypt (187) (289) (644) (720) (802) (1880) (3013) Foreign companies (64) (184) (184) (292) (460) (980) (1429) Cotton 663 371 312 457 286 348 380 Other agriculture 194 155 231 260 223 198 260 Textiles 366 478 301 300 272 267 370 Other manufactures 344 398 497 317 515 351 550 Merchandise imports, c.i.f. -3618 -4608 -4659 -5110 -5998 -7336 -10039 Wheat and flour -798 -642 -547 -600 -841 -772 -1086 Other agriculture -247 -444 -748 -500 -696 -905 -1470 Intermediate goods -1513 -1939 -1404 -1466 -1673 -1968 -2483 Petroleum (-444) (-320) (-263) (-135) (-149) (-243) (-333) Other int. goods -(-1069) (-1619) (-1141) (-1331) (-1524) (-1725) (-2150) Capital goods -588 -1090 -1445 -1894 -2022 -2846 -3900 Domestic comp. (-506) (-865) (-1051) (-1500) (-1700) (-2315) (-3150) Foreign comp. (-82) (-225) (-394) (-394) (-322) (-531) (-750) Manuf. cons. goods -472 -493 -515 -650 -766 -845 -1100 Net non-factor services 92 95 627 773 927 597 813 Receipts 433 628 1150 1542 1541 1561 2203 Tourism 265 332 464 728 702 601 712 Suez Canal 0 85 311 428 514 589 780 Other n.f.s. receipts 168 2i1 375 386 325 371 711 Payments -341 -533 -523 -769 -614 -964 -1390 Balance on goods and n.f.s. -1708 -2638 -1863 -1991 -2513 -2715 -3224 Net factor services 70 122 413 472 1098 1143 850 Receipts 276 452 827 1010 1905 2519 3104 Workers' remittances 189 366 755 897 1761 2214 2625 Other n.s. receipts 87 86 72 113 144 305 479 Payments -206 -330 -414 -538 -807 -1376 -2254 Interests-official -51 -89 -77 -292 -314 -150 -604) Interests-private -18 -26 -34 -48 -72 -86 Profits transf. abroad -50 -140 -140 -219 -392 -948 -1330 Other f.s. payments -87 -75 -163 -21 -29 -192 -320 Current account balance -1638 -2516 -1450 -1519 -1415 -1572 -2374 Source: Ministry of Finance and IMF - 413 - Table B.8: Balance of Payments - Capital Account (In millions of U.S. dollars) 1974 1975 1976 1977 1978 1979 1980/81 Current account balance -1638 -2516 -1450 -1519 -1415 -1572 -2374 Autonomous non-monetary capital 198 584 1178 1270 1582 2269 2406 Transfers 42 90 87 63 54 88 60 Direct investment 87 225 444 477 387 710 1170 Official loans (net) -21 210 490 803 1028 1034 874 Drawings (140) (361) (598) (931) (1202) (1208) (1376) Repayments (-161) (-151) (-108) (-128) (-174) (-174) (-502) Private loans (net) 90 59 157 -73 113 437 302 Suppliers' credit 70 62 88 -84 83 428 302 Drawings (295) (365) (501) (467) (684) (998) Repayments (-225) (-303) (-413) (-551) (-601) (-570) Other (net) 20 -3 69 11 30 9 - Balance of autonomous transactions -1440 -1931 -272 -249 167 697 32 Balance of payments financing 1261 1506 780 1601 809 72 279 Grants 1261 986 705 382 291 72 279 Loans - 520 75 1219 518 - - 3alance of non-monetary transactions -179 -425 508 1350 976 769 311 Unallocated -874 -698 -1184 -435 -504 -462 -441 Monetary capital 1053 1123 676 -915 -472 -307 130 Commercial banks 584 89 226 -1005 -494 -101 160 Central bank (net) 469 1034 450 90 22 -206 -30 Official loans and deposits 412 1280 252 203 -9 -9 Bilateral payments -28 -241 -10 -121 -35 -59 Reserves 47 24 81 -88 14 -98 IMF (net) 38 -29 127 96 52 -40 Source: Central Bank of Egypt, IMF and IBRD staff estimates - 4L4 - Table B. 9: Summary of Fiscal Operatiors (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 lndirect taxes 552 784 996 1530 1563 1834 2355 Foreign trade taxes 231 400 538 979 920 905 1329 Other indirect taxes 321 384 458 551 643 929 1026 Direct taxes 197 256 345 460 613 685 1622 Personal income taxes 33 31 48 55 52 55 73 Business profit taxes 143 195 278 387 538 656 1506 Others 21 30 19 18 23 29 43 Non-tax government revenue 97 120 101 113 119 235 331 Total government reyenues 846 1160 1442 2103 2295 2809 4308 Public economic sector surplus 338 364 574 652 1012 875 2718 Transferred profits 188 154 243 384 539 501 1751 Self-financing investment 150 210 331 268 473 374 967 1/ Social insurance surplus 245 253 295 353 381 491 632 Public changes in stocks 174 275 263 337 250 270 264 Total public revenue 1603 2052 2574 3445 3938 4445 7922 Central and local government current expenditure 2/ -899 -1298 -1670 -1628 -2012 -2172 -3263 Public authorities deficits -87 -93 -119 -139 -185 -234 -259 Consumer subsidies -410 -622 -434 -650 -900 3/ -1370 3/ -2161 4/ Interest on public debt -61 -74 -107 -130 -173 -234 -490 public investment expenditures 5/ -771 -1175 -1320 -1946 -2725 -2817 -4030 Total public expenditure -2228 -3262 -3650 -4493 -5995 -6827 -10204 Overall public resource gap -625 -1210 -1076 -1048 -2057 -2382 -2282 External financing 6/ 119 210 488 513 767 628 638 Domestic financing 506 1000 588 535 1290 1754 1644 - Banking system 7/ 314 731 437 471 827 1256 442 4/ - Postal saving 18 17 19 16 25 21 22 - Domestic bonds 2 - - 16 26 51 19 - Savings certificates 43 50 54 76 135 157 229 - Other domestic financing 8/ 129 202 78 -44 277 269 932 Source: Ministry of Finance 1/ includes some bank borrowings by public sector companies. 2/ Include 50Z of Treasury and Investment Fund expenditures. 3/ Subsidies adjusted for LE 331 million received by GASC to cover price adjustments (LE 191 million in 1978 and LE 140 million in 1979). 4/ Includes LE 595 million expenditure incurred in 1980/81, but shown as arrears by the MOF in 1981/82. 3/ includes 50% of 'treasury and Investment Fund expenditures and public changes in stocks. 6/ Defined as drawings minus amortization; interest on foreign debt is included in SInterest on public debt. 7/ As given in the monetary accounts. 8/ Derived as a residual item and includes net capital transfer. - 415 - Table B.10 Government Revenue (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 Total government tax revenue 749 1040 1341 1990 2176 2574 3977 Direct taxes 197 256 345 460 613 740 1622 Personal income taxes (33) (31) (48) (55) (52) (55) (73) Business profit taxes (143) (195) (278) (387) (538) (656) (1506) Property taxes (21) (30) (19) (18) (23) (29) (43) Indirect taxes 552 784 996 1530 1563 1834 2355 Taxes on goods and sevices (195) (229) (283) (340) (360) (567) (755) Include: Excise and consumer duties - 82 97 144 155 268 483 Price differential - 147 186 196 205 299 271 Foreign trade taxes (231) (400) (538) (979) (920) (905) (1329) Include: Custom duties 231 400 466 588 727 905 1329 Exchange profits - - 72 391 193 - - Other taxes (59) (63) (86) (97) (141) (200) (271) Include: Stamps - 61 82 89 126 155 168 Others - 2 4 8 15 45 103 Local government revenue (67) (92) (89) (114) (142) (162) (252) Non-tax revenue 97 120 101 113 119 235 331 Fees - 26 38 47 54 81 110 Miscellaneous - 94 63 66 65 154 221 Total government revenue 846 1160 1442 2103 2295 2809 4308 Source: Ministry of Finance - 416 - Table B. 11: Government Current Expenditure (In millions of Egyptian pounds) 1974 1975 1976 1977 L978 1979 1980/81 Genieral public services 1/ 179 236 307 429 467 572 1281 Defense 2/ 340 587 756 599 709 772 1034 Education 163 193 240 244 297 365 359 Health 81 92 80 80 96 114 140 Community and social services 4 5 29 30 54 86 106 Economic services 48 57 72 69 90 105 134 Agriculture 19 21 61 62 84 48 61 Irrigation 20 26 50 53 TransporL-communication 9 10 11 7 6 3 20 Local government expenditure 61 91 109 117 135 162 209 Current Expenditure from treasury and investment fund 3/ 23 37 77 60 164 - - Government current expenditure 899 1298 1670 1628 2012 2172 3263 Source: Ministry of Finance i/ Includes Investment Fund current operating expenditure and Treasury Fund oulay for pensions and contingencies. I2 Includes emergency fund deficit. 3! 50A of treasury and investment fund expenditure. Beginning 1979 expenditure fr-om the Emergency Fund has been allocated to functional categories. fable B. 12: Public Sector Savings at Current Prices (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 lotal public sector savings 146 -35 244 898 668 433 1753 Net government savings -560 -880 -763 -288 -736 -968 -1448 Total gross government revenue (749) (1040) (1341) (1990) (2176) (2574) (3977) Total government consumption (-899) (-1298) (-1670) (-1628) (-2312) (-2172) (-3263) Consumer subsidies (-410) (-622) (-434) (-650) (-900) (-1370) (-2161) 1/ Public sector financial savings 287 317 449 496 773 640 2305 Transferred profits (188) (154) (243) (384) (539) (501) (1751) Investment self-financing (150) (210) (331) (268) (473) (374) (967) 2/ Other public sector revenues (97) (120) (101) (113) (119) (235) (331) Public authority deficits (-87) (-93) (-119) (-139) (-185) (-234) (-254) interest on public debt (-61) (-74) (-107) (-130) (-173) (-234) (-490) Public sector stock accumulation 174 275 263 337 250 270 264 Social security surplus 245 253 295 353 381 491 632 1/ Includes LE 595 million expenditure incurred in 1980/81, but shown as arrears by the MOF in 1981/82. i/ It includes some bank borrowings by the public sector companies which should normally be excluded from self-financing. 3/ dank staff estimates, DRM model. - 417 - Table B.13; Direct Subsidies Paid from the Special Fund for Subsidies and the Treasury Fund 1/ (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 General authority for supply commodities 329.1 490.9 321.5 313.4 639.7 5/ 1023.1 5/ 1703.0 6/ Cairo and Alexanidria public transport authorities 4.1 5.9 10.2 11.5 17.6 28.4 26.9 Agricultural credit corporation 8.5 5.0 8.7 0.1 0.1 0.1 5.3 Agricultural stabilization fund 2/ - 81.5 34.2 34.7 38.3 102.4 119.1 Textile corporation 12.0 23.7 39.9 16.3 44.3 46.0 98.0 Petroleum corporation 3/ 0.6 10.7 10.2 12.0 15.9 32.5 51.9 Cooperative building authority 0.1 0.3 0.2 0.4 1.2 2.9 6.9 Government credit banks - - 9.9 29.3 17.3 31.2 Press paper subsidies - 3.0 2.5 6.6 4.1 5.0 6.7 Industrial output subsidies - - - - 72.6 49.5 58.3 Price adjustment fund 4/ - - - 228.0 - - - of which: GASC - - - 124.0 - - - Other 55.1 1.1 6.1 16.7 37.0 62.8 59.1 Total 410.0 622.1 433.5 649.6 900.1 1370.0 2166.4 Source: Ministry of Finance 1/ The Special Fund for Subsidies was established in 1975, prior to which direct subsidies were included in various sections of the budget. 2/ For fertilizers and pesticides; includes Treasury Fund payments. 3/ For bottled gas and kerosene. 4/ The Price Adjustment Fund was established in 1977 to finance the cost of phasing in the domestic price impact of commodites imported at the parallel rather than the official exchange rate. 5/ Include 330 million LE paid to GASC in 1979 to cover price adjustments in 1978 and 1979. 190 million LE were allocated to 1979 and 140 million LE to 1978. 6/ Includes LE 595 million expenditure incurred by GASC which was monetized in 1981/82. - 418 -- Table B. 14 : Trading Operations of the General Authority for Supply of Commodities (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 Subsidies (Losses) 393.2 423.7 281.4 343.2 452.4 998.3 1665.6 Wheat & Flour 216.4 260.9 171.6 149.1 222.8 647.0 858.4 Maize 16.5 31.1 23.1 40.6 53.8 40.7 88.2 Edible Fats & Oils (Rationed) 55.3 72.2 43.2 54.6 137.4 176.4 154.1 Sugar (Rationed) 68.9 20.8 6.1 0.0 0.0 6.5 220.4 Tea 0.0 0.0 0.0 18.3 12.8 56.2 24.9 Coffee 0.0 0.0 0.0 5.6 0.0 0.4 0.0 Other 36.1 38.7 37.4 75.0 251.6 71.1 319.6 Profits 63.1 15.0 31.2 12.6 29.3 0.0 0.8 Cottonseed 2.0 2.1 2.0 2.0 0.0 0.0 0.0 Edible Oil (Non-rationed) 8.0 0.0 0.0 0.0 0.0 0.0 0.0 Tea 14.0 11.5 13.2 0.0 0.0 0.0 0.0 Sugar (Non-rationed) 36.0 0.0 0.0 8.6 26.1 0.0 0.0 Other 3.1 1.4 16.0 2.0 3.2 0.0 0.0 Coffee 0.0 0.0 0.0 0.0 0.0 0.0 0.8 Total Net Losses (-) 1/ -330.1 -408.7 -250.2 -330.6 -423.1 -998.3 -1664.8 Source: General Authority for Supply Comtmodities. 1/ Not inclusive of administrative costs or settlement of arrears. - 419 - Table B.15: Prices of Supply Commodities (In Egyptian pounds per metric ton) Jan.-June 1974 1975 1976 1977 1978 1979 1980 1980/81 1/ Average import prices 2/ Wheat 99.3 77.5 61.3 46.1 52.0 124.6 146.6 141.1 Wheat flour 111.1 80.6 93.2 70.6 74.0 174.9 223.4 241.8 Maize 70.8 58.8 53.4 42.3 27.0 113.5 115.3 144.6 Vegetable oil 347.8 346.5 222.3 280.0 262.0 561.0 448.6 492.2 Lentils 227.2 214.5 188.6 158.3 119.0 272.3 388.9 415.7 Sesame 235.0 250.0 232.7 227.9 319.0 638.8 634.3 725.8 Tea 406.0 550.0 600.0 1000.0 910.0 1200.0 1450.0 1414.0 Coffee 537.1 488.7 1045.3 2689.0 1450.0 2527.0 2666.8 2081.3 Edible,fats 260.0 247.5 229.6 252.8 311.0 628.0 633.9 498.9 Frozen beef 416.2 300.0 305.0 517.8 436.0 1173.0 1127.8 1314.8 Sugar 286.0 208.1 147.6 96.6 86.0 186.0 394.0 516.0 Domestic buying prices 3/ Wheat 43.3 46.7 46.7 46.7 63.3 70.0 83.3 83.3 Rice (paddy) 31.2 40.0 50.0 50.0 65.0 65.0 65.0 75.0 Sesame 158.3 183.3 208.3 208.3 208.3 218.8 541.7 583.0 Horsebeans 58.0 83.9 83.9 96.7 96.7 219.2 161.3 225.0 4/ Sugar 5/ 45.5 63.6 72.7 72.7 81.8 - - 209.0 6/ Domestic selling prices 3/ Wheat 30.9 28.2 29.2 29.2 24.7 24.7 22.3 41.3 Wheat flour 55.0 55.0 67.8 67.8 67.8 67.8 - 7/ - Maize 33.0 33.0 33.0 33.0 60.0 60.0 60.0 60.0 Rice (bleached) 51.0 51.0 51.0 51.0 46.0 46.0 50.0 50.0 Sesame 110.0 110.0 276.0 276.0 450.0 450.0 450.0 450.0 Vegetable oil (rationed) 49.7 49.7 49.7 49.7 49.7 100.0 100.0 100.0 Sugar (rationed) 70.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Lentils 98.0 98.0 98.0 98.0 98.0 98.0 110.0 110.0 Horsebeans 51.6 51.b 51.6 51.6 92.9 92.9 100.0 100.0 Vegetable oil (additional) 100.0 100.0 100.0 100.0 100.0 300.0 300.0 300.0 Tea (Ceylon) 2178.0 2178.0 2178.0 2178.0 2600.0 2600.0 2600.0 2600.0 Coffee (Brazilian) 760.0 760.0 760.0 2633.0 1840.0 ---------- cost price -------- Sugar (additional) 250.0 245.0 245.0 245.0 245.0 245.0 300.0 300.0 Edible fats 150.0 200.0 220.0 220.0 250.0 250.0 250.0 250.0 Source: General Authority for Supply Commodities 1/ Piscal year beginning July 1 and ending June 30. 2J Average prices for imports contracted for during period. 3/ Prices as of end of period. 4/ Since May 1981. S/ Cane price divided by the average sugar extraction ratio (0.11) to improve comparability with selling price, the latter, however, includes also processing and distribution costs. 6/ Since July 1980. 7/ Since June 30, 1980, the following wheat flour prices have been charged (in Egyptian pounds per metric ton): for European bakeries (70.7), shami (69.5), macaroni factories (82.1), sweets factors (120.8), tourist: places (220.0). - 420 - Table B.16: Public Sector Investment Expenditure (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 General public services 15.2 24.1 75.1 98.4 101.1 147.5 369.7 General administration 1.8 4.2 23.1 32.3 48.4 53.0 82.4 Public order and safety 8.6 2.9 6.0 16.1 17.2 20.1 21.0 Local administration 4.8 17.0 46.0 50.0 35.5 74.4 266.3 Education 23.0 39.8 41.1 38.7 82.1 82.6 104.4 Health 7.3 14.8 3.0 10.3 23.7 22.8 20.0 Housing 45.2 68.9 220.9 144.7 201.1 303.2 363.7 Community and social services 2.4 4.7 1.6 1.8 6.0 5.7 5.8 Economic services 461.9 749.6 465.7 589.2 981.4 1081.9 1256.5 Agriculture 54.5 93.1 70.7 74.7 117.6 175.6 200.4 Mining, petroleum, and manufacturing 248.8 360.5 148.8 73.5 100.6 100.0 146.3 Electricity 33.1 47.9 57.7 102.5 210.7 204.8 384.9 Transportation and communication 108.8 212.9 188.0 321.2 537.6 573.2 500.6 Trade and supply 11.7 22.7 0.4 6.6 14.6 27.6 22.0 Tourism 5.0 12.5 0.1 10.7 0.3 0.7 2.3 Other public investment 18.6 11,2 567.5 665.8 916.0 903.3 1645.5 Nonfinancial public enterprises 1/ - - 522.8 647.3 886.9 903.3 1570.5 Unallocated 2/ 18.6 11.2 44.7 18.5 29.1 - 75.0 Total public sector investment 573.6 913.1 1374.9 1548.9 2311.4 2547.0 3765.6 Adjustment for known investment arrears - -50.0 -395.0 - - - - Public sector investment expenditure 573.6 863..l 979.9 1548.9 2311.4 2547.0 3765.6 Source: Ministry of Finance 1/ Since the abolition of the public economic organizations at the end of 1975, no functional classification of public sector company investment has been available. 2/ Includes Treasury Fund advance payments and Investment Fund equity participation in joint ventures; excludes private sector share of joint venture investments. - 421 - Table B. 17: Transfers of Profits to Central Government from Public Eterprises (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 2/ 1980/81 Public authorities 1/ 188.5 154.5 192.6 288.8 373.1 431.6 1639.5 Agriculture and irrigation 2.4 1.9 0.5 1.2 3.6 0.3 1.5 Industry and petroleum 25.4 36.5 85.9 177.1 192.2 253.0 1376.0 Textile industry (11.8) (9.1) (-) (-) (-) (-) (-) Petroleum industry (3.3) (17.5) (84.4) (177.1) (192.2) (253.0) (1376.0) Other (10.3) (9.9) (1.5) () () () (-) Electricity 8.3 - 2.8 - - - - Transportation and comm. - 23.0 61.9 75.2 133.8 163.9 216.0 Suez Canal (-) (14.2) (45.7) (57.6) (107.2) (148.0) (187.2) Other (-) (8.8) (16.2) (17.6) (26.6) (15.8) (28.8) Finance and economy 140.4 84.3 39.9 25.5 31.5 13.2 33.2 Ootton general organization (114.5) (54.0) (-) (-) (-) (-) (-) Central Bank (25.9) (23.1) (30.6) (20.5) (28.0) (10.8) (30.9) Other - (7.2) (9.3) (5.0) (3.5) (2.0) (2.3) Supply anid international trade 5.6 5.8 - 0.5 0.7 - - Housing and construction 0.4 - - - 1.3 1.1 1.0 Other 6.0 3.0 1.6 9.3 10.0 0.1 11.8 Public sector companies - - 50.3 95.6 165.8 69.4 111.9 Cotton export profits - - - 1.7 12.6 - 38.0 Other - - - 93.9 153.2 69.4 73.9 Total 188.5 154.5 242.9 384.4 538.9 501.0 1751.4 Source: Ministry of Finance I/ Includes transfers from the public economic organizations in 1975 prior to their subsequent abolition. 2/ There is a problem with the profit transfer figures for 1979. Bank staff estimates indicate a value of LE 1001 million for 1979. The reason behind the discrepancy between the MOF figure and IBRD estimate is the change in transactions accounting procedures between the central goverment and public enterprises from accruals to cash basis so that the difference shows up in January-June 1980 accounts. - 422 - Table R.18: Public Authority Currency Deficits by Sector (In millions of Egyptian pounds) 1974 1975 1976 1977 1978 1979 1980/81 Agriculture and irrigation 12.6 12.6 16.4 15.5 18.0 22.9 20.8 Industry and petroleum 1.0 1.1 1.3 1.5 1.6 1.7 1.5 Transportation and communication 5.9 6.0 7.0 15.4 34.3 43.6 60.6 Finance and economy 0.3 0.5 0.3 0.7 0.8 0.4 0.6 Housing and construction 7.4 10.0 10.1 8.8 13.9 20.2 19.3 Health 1.5 1.6 2.7 5.2 5.7 6.8 8.2 Education, research, and youth 31.4 39.0 56.6 63.0 76.7 92.6 134.4 Culture and information 9.5 11.2 16.3 27.5 32.8 41.3 22.9 'lourism - - - 1.8 1.3 2.0 2.9 Defense, security, and justice 2.9 3.2 - - - - - Public economic organizations 1/ 14.6 8.2 - - - - - Unallocated 2/ - - 7.9 - - 3.5 3.6 Total 87.1 93.4 118.6 139.4 185.1 235.0 274.8 Source: Ministry ot Finance 1/ The public economic organizations were abolished at the end of 1975. 2/ Payment by Treasury Fund of public authority arrears. - 423 - Table B.19: Monetary Survey (Revised Presentation) (In millions of Egyptian pounds) End of perioct 1974 1975 1976 1977 1978 1979 1980 1981 Foreign assets (net) -184 -973 -921 -670 -2196 -2017 -1489 -1310 Foreign assets 609 745 1021 1678 2320 2684 3669 4020 Foreign liabilities -750 -1685 -1862 -2206 -4249 -4481 -5032 -5259 IMF position (net) -43 -33 -80 -142 -267 -220 -126 -71 Claims on public services sector 1904 2882 3239 3680 6647 8625 10388 11472 Central and local government (1707) (2436) (2896) (3382) (5955) (7631) (8826) (9306) Public aujthorities (197) (446) (343) (297) (692) (994) (1562) (2166) Claims on households and enterprises 789 1092 1326 1742 2026 2653 4055 6802 Public sector companies (434) (645) (885) (1095) (1208) (1384) (1734) (2224) Private sectLor 1! (355) (447) (441) (647) (818) (1269) (2321, (4578) Unclassified assets 111 150 247 328 410 413 314 689 Assets = liabilities 2620 3151 3891 5105 6889 9675 13268 18653 Money and quasi-money (currency + deposits - toreign currency deposits) 2001 2429 2798 3507 4356 5548 7603 9799 Currency 948 1156 1388 1750 2183 2657 3407 4301 Deposits 1053 1273 1667 2353 3028 4187 5610 7977 - Private sector demand 1/ (305) (405) (540) (782) (948) (997) (1108) (1148) - Private sector order 1/ (262) (321) (483) (653) (983) (1678) (2782) (4740) - Public sector companies (486) (547) (644) (918) (1097) (1512) (1720) (2089) Private foreign currenicy deposits 2/ - - 257 3/ 596 4/ 855 1296 1414 2479 Public services sector deposits 218 249 287 413 697 1514 2459 2414 Central and local government (118) (117) (140) (155) (265) (339) (710) (899) Public authorities (100) (132) (147) (258) (432) (1175) (1749) (1515) Counterpart funds 142 171 156 142 125 105 66 35 Capital account 172 192 232 275 485 641 1147 1622 Unclassified liabilities 150 197 266 350 448 704 651 1119 Interbank claims (net) -64 -86 -111 -176 -78 -134 -72 -264 Source: Central Bank of Egypt, IMF, and IBRD staff estimates 1/ Includes cooperatives and specialized banks. 2/ Includes earmarked deposits. 3/ Assumed as 25% of total commercial bank deposits. 4/ Ratio of private to total foreign currency deposits assumed to be same as December 1978. - 424 - Table B. 20: Production of Major Agricultural Crops (Production in thousands of metric tons.: area planted in thousands of feddans; yield in metric tons per feddan) 1/ Agricultural Year EBooed October 31 1973/74 1974/75 1975/76 1976/77 1977/78 1978/79 1979/80 1980/81 Winter crops Wheat Production 1,884 2,033 1,960 1,697 1,933 1,856 1,796 1,938 Area plated 1,370 1,394 1,396 1,207 1,381 1,391 1,326 1,400 Yield 1.30 1.46 1.40 1.41 1.40 1.33 1.35 1.39 norsebeans 2/ Productioni 234 234 254 270 231 236 213 208 Area plantea 244 246 260 292 239 250 245 238 Yield 0.9b 0.95 0.98 0.92 0.97 0.95 0.87 0.87 Onionis 3/ Production 359 229 240 263 223 157 188 154 Area planted 39 26 31 37 29 23 22 19 Yield 9.20 8.bO 7.74 7.11 7.69 6.77 8.49 8.33 Berseem (clover) Area planted 2,797 2,812 2,757 2,315 2,783 2,783 2,7'1 2,778 Sununer and autumn crops Cotton Production (lint) 441 382 386 399 438 484 529 539.? Area planted 1,453 1,346 1,248 1,423 1,189 1,195 1,245 1,178 Yield 0.304 0.284 0.309 0.294 0.369 0.405 0.425 0.458 Rice (paddy) Production 2,242 2,423 2,300 2,272 2,351 2,511 2,384 2,234 Area plantea 1,053 1,053 1,078 1,040 1,031 1,040 972 95' Yield 2.13 2.30 2.13 2.19 2.28 2.41 2.45 2.34 Maize (including Nili) Production 2,640 2,781 3,047 2,724 3,117 2,938 3,231 3,309 Area planted 1,755 1,830 1,891 1,765 1,898 1,885 1,906 1,924 Yield 1.51 1.52 1.61 1.54 1.64 1.56 1.70 1.72 Millet (sorghum) Production 824 775 759 648 681 635 642 653 Area planted 499 489 475 409 434 407 410 413 Yield 1.65 1.58 1.60 1.59 1.57 1.56 1.57 1.58 Sugarcane Production 7,018 7,902 8,446 8,379 8,296 8,791 8,618 ... Area planted 208 218 242 249 248 249 252 .. Yiela 33.7 38.20 34.9 33.6 33.45 35.35 34.14 Groundnuts Production 25.2 27.7 28 30 26 27 26 26 Area planited 29 32 32 36 31 31 28 28 Yield 0.87 0.87 0.88 0.83 0.83 0.87 0.90 0.90 Fruits ana vegetables Citrus truits Production 963 1,013 889 797 990 1,216 1,067 1,033 Area planted 155 162 178 183 188 190 198 198 Oates Production 39b 415 417 461 377 406 446 391 Area planted 34 ... 35 ... 33 ... 34 34 Other fruits Production 612 640 705 644 717 751 768 850 Area planted 118 123 135 138 144 150 163 17(0 Potatoes Production 709 720 893 1,010 772 1,019 1,214 1,210 Area planted 95 98 128 152 128 142 167 16il Yield 7.50 7.30 7.0 6.6 6.0 7.2 7.26 7.56 Other vegetables Production j,297 5,800 b,029 5,791 6,357 6,755 6,747 5,829 Area planted 725 797 801 778 822 873 878 368 Source; Ministry oi Agriculture 1/ Production lay not always equal tile product of area planted and yield because of rounding. i/ Excludes crops consumed green (as vegetables and forage). i/ Winter (export) crop only. - 425 - Table B. 21: Output of Selected Industrial Products (In thousands of metric tons unless otherwise stated) 1974 1975 1976 1977 1978 1979 1980/81 Spinning and weaving Cotton yarn 179 181 193 210 212 218 239 Cotton textiles (million square meters) 759 772 873 905 918 950 980 Foodstuffs Sugar 577 526 576 614 629 632 619 Cheese 135 153 147 149 161 160 183 Preserved fruits and vegetables 18 24 48 41 40 51 60 Cottonseeo oil 170 161 160 166 169 168 202 Oilseed cakes 540 720 417 430 431 433 540 Soft orinks (million bottles 660 784 960 984 1,389 1,424 2,222 beer (million liters) 29 29 30 39 42 36 46 Cigarettes (billions) 23 21 28 25 27 30 33 Chemicals Sulfuric acid 30 36 28 27 30 31 21 Superphosphates 465 520 493 513 502 483 474 Ammonium nitrate 320 400 500 1/ 622 1/ 698 1/ 851 1/ 3,345 1/ Tires (thousands) 814 923 859 903 857 933 1,106 Engineering products Cars (units) 8,169 11,576 9,799 12,817 14,562 15,670 18,734 Trucks and tractors (units) 2,342 2,825 3,807 4,445 4,101 5,087 4,899 buses (units) 360 305 307 475 465 552 622 Refrigerators (thousands) 55 109 112 129 138 190 259 Televisions (thousands) 68 77 88 138 166 228 406 Metallurgical products Reinforcing bars 232 219 202 230 249 302 281 Steel sections 81 106 151 128 157 177 179 Steel sheets 125 211 156 235 229 264 380 Cast iron 55 66 63 78 109 112 24 Aluminum ... ... 54 90 101 102 134 Mining products Phosphate 499 428 392 468 483 527 521 Source: Ministry of Industry 1/ At 31.0 per cent nitrogen equivalent 2/ At 15.5 per cent nitrogen equivalent - 426 - Table B.22: Production and Distribution of Crude Petroleum (In millions of metric tons) 1974 1975 1976 1977 1978 1979 1980/81 By location: 7.5 11.7 16.6 20.9 24.4 26.3 31.0 El Morgan, July and Ramadan 4.3 7.8 10.0 14.3 17.4 18.6 22.6 Other Red Sea & Eastern Desert 1.6 1.9 1.5 1.4 1.2 1.1 1.5 Western Desert 1.6 1.7 1.6 1.5 1.4 1.5 1.0 Sinai - 0.3 3.5 3.7 4.4 5.1 5.9 By Share- Cost recovery exports N.A. N.A. 2.2 3.1 4.3 5.1 6.2 to cover actual costs N.A. N.A. 1.1 1.6 2.7 2.5 1.8 returned to EGPC N.A. N.A. 1.1 1.5 1.6 2.6 4.4 Profit oil N.A. N.A. 13.0 16.5 18.9 20.2 23.8 Egyptian share N.A. N.A. 11.3 14.8 16.2 17.0 20.2 Partners' share N.A. N.A. 1.7 1.7 2.7 3.2 3.6 GPC production 1/ N.A. N.A. 1.4 1.3 1.2 1.1 1.11 Total Egyptian share 5.0 8.8 13.8 17.1 18.8 20.7 25.6 (plus purchases of crude oil) 3.9 3.6 2.3 0.5 0.2 0.2 - used for refining 6.9 8.6 10.5 11.1 11.9 12.3 14.3 change in stocks 0.7 1.4 - 0.5 0.2 0.2 0.8 exports 1.3 2.4 5.6 6.0 7.9 8.4 10.5 Partners' share 2.4 2.9 2.8 3.8 5.6 5.6 5.4 exports 1.0 1.7 2.1 3.3 5.4 5.4 5.4 sales to Egypt 1.4 1.2 0.7 0.5 0.2 0.2 - Source: Egyptian General Petroleum Corporation 1/ EGPC subsidiary Table B.23 Natural Gas Reserves and Production (In thousand metlric tons) 1/ Recoverable Reserves Production (Million Area metric tons) 1/ 1978 1979 1980/81 Abu Madi 50.8 142.0 166.0 625.0 Abu Gharadig 13.6 441.0 476.0 790.0 Abu Qir 26.2 - 221.0 395.0 Abu Qir North 2/ 15.8 - - - Amal - - - Gulf of Suez 27.2 -- - Total 133.6 5'83.0 863.0 1810.0 Source: Egyptian General Petroleum Corporation 1/ One metric ton of natural gas is approximately equal to 46,200 cubic feet, or 1.2 metric tons of fuel oil equivalent. 2/ Under appraisal. - 427 - Table B. 24: Petroleum Products and Gas Balances 1/ (In thousands of metric tons) 1974 1975 1976 1977 1978 1979 1980/81 Gasoline and naphtha Production 1225 1335 1492 1529 1711 1771 1989 Consumption N.A. N.A. 735 916 930 1085 1277 Net exports N.A. N.A. 757 613 781 686 712 Kerosene Production 1245 1203 1311 1384 1464 1454 1489 Consumption N.A. N.A. 1328 1365 1464 1454 1489 Net exports N.A. N.A. -17 19 - - _ Jet fuel Production 90 91 125 123 178 181 154 Consumption N.A. N.A. 60 89 246 256 420 Net exports N.A. N.A. 65 34 -68 -75 -266 Gas oil and diesel fuel Production 1350 1607 1697 1961 2182 2312 2621 Consumption N.A. N.A. 1493 1684 1909 2151 2817 Net exports 1/ N.A. N.A. 204 277 273 161 -196 Fuel oil Production 2800 4165 5060 5254 5466 5527 6767 Consumption N.A. N.A. 4066 4345 4482 4825 5533 Net exports N.A. N.A. 994 909 984 702 1234 Asphalt Production 65 118 131 142 192 202 292 Consumption 65 118 131 142 192 202 292 Net exports - - - - - - Natural gas Production N.A. N.A. 104 353 583 863 1810 Consumption - - 104 353 583 863 1810 Net exports - - - - - Butane gas Production 60 49 60 66 74 141 224 Consumption N.A. N.A. 211 254 277 357 392 Net exports N.A. N.A. -151 -188 -203 -216 -168 Total Production 6835 8515 9980 10812 11850 12451 15346 Consumption 5983 6813 8128 9148 10083 11193 14030 Net exports 852 1702 1852 1664 1767 1258 1316 Source: Egyptian General Petroleum Corporation 1/ Consumption derived as a residual and hence includes stock adjustments. - 428 - Table B. 25: Petroleum Export Prices (In U.S. dollars per barrel) Ras Weighted Effective Date/ Morgan Belayim Gharib Average Period Averages Blend 1/ Blend 1/ Blend 1/ Price 2/ 1978 From October 1 12.81 11.57 10.73 11.89 1979 From January 1 13.45 12.23 11.40 12.54 From March 1 16.50 15.05 14.06 15.41 From April 1 17.15 15.32 14.33 15.83 From June 1 20.50 17.60 16.90 18.57 From July 1 32.50 26.50 21.50 27.83 From October 1 32.50 27.50 21.50 28.25 From December 1 34.00 28.50 22.50 29.44 1980 From January 1 34.18 29.15 23.68 30.30 From March 1 34.13 29.24 24.00 30.37 From July 1 34.03 29.22 24.00 30.60 From December 1 36.00 31.00 26.00 32.51 1981 From January 1 40.50 37.00 32.00 37.79 From April 1 37.50 35.50 31.50 35.75 From May 1 36.00 33.00 30.00 33.90 From June 1 33.00 30.00 27.00 30.90 From July 1 33.00 30.00 27.00 30.84 From November 1 34.00 31.00 29.00 32.28 1982 From January 1 34.00 31.00 28.00 32.12 From February 1 33.00 29.00 26.70 30.64 1979 24.56 20.90 17.70 21.68 1980 34.26 29.36 24.09 30.85 1979/80 33.45 28.18 22.75 29.29 1980/81 36.18 32.22 27.54 33.29 July-December 1980 34.36 29.52 24.33 30.92 July-December 1981 33.33 30.33 27.67 31.32 Source: Egyptian General Petroleum Corporation. 1/ The characteristics of the three crudes are as follows: Morgan Blend 32 API, 1.4 percent sulphur; Belayim Blend 29 API, 2.1 percent sulphur; Ras Gharib Blend 24-25 API, 3 percent sulphur. 2/ Weighted according to share of total exports. For 1979 these are .38, .42, and .19; for January-June 1980, .43, .38, and .19; for 1980/81, .48, .35, and .18; and from July 1981, .43, .42, and .16. - 429 - Table B. 26: Wholesale Price Index (1965/66 - 100) 0Otober End of Period 1974 1975 1976 1977 1978 1979 1980 1981 Agricultural crops (27.6) 1/ 172.3 178.7 205.0 240.6 253.9 292.7 357.3 374.4 Foodstuffs and beverages (19.9) 168.9 190.0 213.2 236.1 247.4 299.7 329.5 370.6 Tobacco and tobacco products (7.1) 122.6 122.7 122.7 122.9 123.0 134.3 138.4 138.4 Yarn, textiles, etc. (20.5) 122.3 122.4 125.3 128.1 175.0 184.1 231.3 240.4 Petroleum and fuels (7.4) 138.3 148.7 157.8 159.5 170.8 192.1 233.9 243.3 Paper (1.2) 258.4 258.7 257.2 241.0 248.1 317.0 390.0 423.8 Wood (1.2) 255.9 255.9 358.6 370.7 238.1 365.7 482.2 479.5 Construction materials (2.6) 151.7 179.2 188.6 212.1 261.4 390.2 417.4 474.4 Medicines (1.6) 107.9 110.2 110.2 158.3 158.3 158.3 182.4 183.8 Chemical products (2.8) 118.5 125.3 130.8 130.8 134.7 162.1 185.7 224.0 Meat and metal products (1.0) 165.8 178.1 190.7 213.8 237.5 251.0 293.6 333.3 Transportation equipment (1.0) 173.9 173.9 173.9 195.8 232.9 264.8 287.7 287.8 All items (100.0) 161.8 161.8 178.5 196.9 213.0 249.4 293.9 315.4 Source: Central Agency for Public Mobilization and Statistics 1/ The numbers in parentheses are commodity weights. The weights indicated do not sum to 100.0 as the index for all items also includes (with weights in parentheses) poultry and fish (3.4) inedible animal products (0.8), tanned skins (0.3), household appliances (1.2), and machinery and equipment (0.4) - 430 - Table B. 27: Consumer Price Index for Urban Population (1966,'67 = 100) End of Period 1974 1975 1976 1977 1978 1979 1980 1981 Food and beverages (52.5) 1/ 161.3 181.9 209.2 231.3 254.7 277.3 348.8 394.3 Cereals (11.2) 120.9 121.5 125.8 135.8 139.3 134.4 181.3 194.5 Pulses (6.6) 186.1 20:2.1 218.1 256.9 273.9 305.4 488.1 474.2 Meat, fish and eggs (13.1) 190.3 234.2 287.8 316.2 331.8 383.7 455.5 536.5 Dairy products (5.9) 173.3 216.6 240.9 279.6 315.4 336.9 468.7 493.0 Vegetables (3.8) 210.4 218.5 276.8 241.3 331.7 336.8 326.7 538.0 Fruits (2.9) 154.2 187.6 230.2 263.6 362.2 392.4 401.9 488.8 Housing (15.7) 106.5 103.6 109.1 109.5 110.2 111.2 116.1 114.1 Furniture and other durables (1.3) 109.0 128.4 136.3 156.3 181.1 187.7 187.8 201.9 Clothing (8.4) 129.9 140.1 147.4 188.1 239.1 247.5 298.6 313.3 Transportation and communication (4.4) 123.1 122.6 136.0 144.7 145.1 185.6 193.9 207.9 Services (9.9) 127.3 140).5 144.0 180.8 203.8 244.2 272.8 280.8 Personal expenses (7.8) 120.4 125.0 128.1 133.9 160.7 187.9 210.7 213.7 All items (100.0) 141.0 155.2 171.2 191.1 212.6 233.5 281.0 307.9 Source: Central Agency for Public Mobilization alnd Statistics. 1/ The numbers in parentheses are indicative commodity weights based on the commodity weights employed in five regional subindices and population weights for these regions. The regional weights are based on a family budget survey of 1964/65 and the sample population census of 1966. _431- Table B. 28: GDP Deflators (1975=100) 1974 1975 1976 1977 1978 1979 1980/81 Commodity Sectors Agriculture 92.5 100.0 117.0 140.8 149.6 158.9 202.2 Industry & Mining 90.4 100.0 104.7 110.7 123.5 143.2 164.0 Petroleum 105.7 100.0 109.3 133.7 146.6 405.1 508.2 Electricity & P.U. 98.5 100.0 99.0 98.1 96.8 103.9 116.3 Construction 63.5 100.0 119.7 135.7 151.2 171.6 187.0 Distribution Sectors Transp., Comm., Storage 96.3 100.0 106.1 111.4 118.6 120.3 136.6 Suez Canal 100.0 100.0 99.3 98.8 146.3 172.8 193.2 Trade, Fin., Insurance 91.0 100.0 114.0 128.6 144.3 163.5 166.5 Service Sectors Housing 100.0 100.0 98.7 100.4 101.2 103.2 100.9 Other Services 88.7 100.0 101.2 119.2 136.4 154.8 174.7 (Tourism) (86.7) (100.0) (111.4) (125.2) (138.0) (150.8) (170.3) 1, GDP at Factor Cost 90.7 100.0 112.5 123.8 137.3 168.0 196.8 Source: Ministry of Planning and IBRD Estimates 1/ IBRD estimates. _ 432 - Table B. 29: Import & Export Price Indices t1975=100) 1974 1975 1976 1977 1978 1979 1980/81 Import Price Indices Wheat & Flour 130.7 100.0 95.6 96.7 109.8 131.8 158.2 Other Agricultural Comm. 101.3 100.0 107.7 119.1 128.1 143.6 160.8 Petroleum 91.2 100.0 107.1 117.9 126.6 234.1 324.7 Other Intermediate Goods 87.7 100.0 106.2 114.7 123.4 138.2 154.8 Capital Goods 87.7 100.0 106.2 114.7 123.4 138.2 154.8 Manufactured Con. Goods 87.7 100.0 106.2 114.7 123.4 138.2 154.8 Total Goods 90.5 100.0 106.4 118.0 127.6 147.4 167.6 Non-Factor Services -87.7 100.0 106.2 114.7 123.4 138.2 154.8 Weighted Average (Goods & NFS) 90.2 100,0 106.4 117.9 127.2 146.5 166.3 Export Price Indices Cotton 134.9 100.0 126.5 127.5 120.5 120.5 138.5 Other Agricultural Comm. 146.2 100,,0 101.2 107.3 122.0 129.3 148.6 Textiles 119.5 100Q.0 106.1 113.3 122.0 136.6 157.0 Petroleum 91.2 100.0 107.1 117.9 126.6 234.1 324.7 Other Manufactured Goods 86.4 100.0 106.1 113.3 122.0 136.5 152.9 Total Goods 123.3 100.0 96.7 101.5 102.7 147.5 194.1 Non-Factor Services 87.6 100.0 106.2 114.7 123.4 138.2 154.8 Weighted Average (Goods+NFS) 114.4 100.0 101.4 109.1 111.6 146.1 184.2 Source: Central Bank of Egypt and IBRD estimates. - 433 - Standard Table 1 Egypt National Accounts Summary (In millions of Egyptian Pounds at current prices) 1976 1977 1978 1979 FY1980/81 1. Gross domestic product at market prices 6727 8344 9795 12705 16946 2. Resource gap (M-X) 789 894 1496 1899 2254 3. Imports (g + n.f.s.) 2287 2770 3626 5804 7992 4. Exports (g + n.f.s.) 1498 1876 2130 3905 5738 5. Total expenditures 7516 9177 11167 14308 19200 6. Consumption 5606 6743 8066 10135 14089 7. General government 1670 1628 2012 2172 3263 8. Private 3936 5115 6054 7963 10826 9. Investment 1910 2434 3101 4173 5111 10. Fixed investment 1471 1873 2685 3763 4702 11. Changes in stocks 439 561 416 410 409 12. Domestic saving 1121 1601 1729 2570 2857 13. Net factor income 347 458 964 804 611 14. Current transfers 39 30 29 62 42 15. National saving 1507 2089 2722 3436 3510 Average exchange rates 16. US dollar per Egyptian pound 2.21 2.07 1.85 1.43 1.43 (weighted average of all current account items) 17. US dollar per Egyptian pound (exports) 2.21 2.07 1.92 1.43 1.43 18. US dollar per Egyptian pound (imports) 2.26 2.12 1.82 1.43 1.43 19. US dollar per Egyptian pound (factor receipts) 1.62 1.50 1.46 1.43 1.43 20. US dollar per Egyptian pound (factor payments) 2.55 2.49 2.38 1.43 1.43 The national accounts data in current Egyptian pounds are based upon data provided by the Ministry of Planning and the Central Bank. The exchange rates shown in lines 16, 17, 18, 19 and 20 are weighted averages of the multiple official rates for the periods 1976-1978. The exchange rate was unified in 1979. Egyptian pound import and export figures for 1976-1978 are based on exchange rates specific to imports and exports. 4 {34 - Standard Table 2 Egt National Accounts Summary (In millions of USS at constant 1978 prices) 1976 1977 1978 1979 FY1980/81 1. Gross domestic product (at m.p.) 151595 16926 18121 19203 21877 2. Terms of trade effect 610 533 0.00 816 1593 3. Gross domestic income 15805 17459 18121 20019 23470 4. Resource gap (5-6) 2169 2079 2767 2396 2508 5. Imports (g + n.f.s.) 62817 6438 6708 7324 8891 6. Capacity to imports 4118 4359 3941 4928 6383 7. ffxports (g + n.f.s.5 3508 3826 3941 4112 4790 8. TQtal expenditures 17974 19538 20888 22415 25978 9. Consumption 13400 14385 15152 16014 19067 10. General government 399,2 3442 3723 3334 4416 11. Private 9408 10943 11429 12680 14651 12. Investment 4574 5146 5737 6407 6917 13. Fixed investment 3516 3960 4967 5777 6363 14. Changes in stocks 1058 1186 770 630 554 15. Domestic saving 2679 3256 2969 3491 3866 16. Net factor income 829 968 1783 1234 827 17. Current transfers 93 63 54 95 57 18. National saving 3601 4287 4806 4820 4750 Egyptian pound deflators (1978 100) 19. Gross domestic product 0.819 0.912 1.0C0 1.224 1.433 20. Imports (g + n.f.s.) 0.673 0.796 1.000 1.466 1.663 21. Exports (g + n.f.s.) 0.790 0.907 1.000 1.757 2.216 22. Total expenditures 0.774 0.875 1.000 1.205 1.367 23. Government consumption 0.774 0.875 1.000 1.205 1.367 24. Private consumption 0.774 0.875 1.000 1.205 1.367 25. Fixed investment 0.774 0.875 1.000 1.205 1.367 26. Change in stocks 0.774 0.875 1.000 1.205 1.367 27. Weighted average exchange rate index 1.195 1.119 1.000 0.773 0.773 Data are from Ministry of Planning and Central Bank sources. Current price Egyptian pound data in Table 1 were converted to constant 1978 dollars using the! Egyptian pound deflators shown in lines 19-26 and the 1978 weighted average exchange rate. In the absence of individual deflators for consumption a-nd investment, the 'Total expenditures' deflator is used. - 435 - Standard Table 3 Egypt Balance of Payments (In millions of US$ at current prices) 1976 1977 1978 1979 FY1980/81 1. Exports (g + n.f.s.) 3319 3888 4099 5585 8205 2. Merchandise (f.o.b.) 2169 2346 2558 4024 6002 3. Non-factor services 1150 1542 1541 1561 2203 4. Imports (g + n.f.s.) 5182 5879 6612 8300 11429 5. Merchandise (f.o.b.) 4235 4645 5453 6669 9126 6. Non-factor services 947 1234 1159 1631 2303 7. Resource balance -1863 -1991 -2513 -2715 -3224 8. Net factor income 413 472 1098 1143 850 9. Factor receipts 827 1010 1905 2519 3104 10. Factor payments 414 538 807 1376 2254 11. (M & LT interest paid) 77 292 314 150 604 12. Net current transfers 87 63 54 88 60 13. Current balance -1363 -1456 -1361 -1484 -2314 M & LT capital inflow 14. Direct investment 444 477 387 710 1170 15. Official grant aid 705 382 291 72 279 16. Net M & LT loans 653 1938 1629 1462 1176 17. Disbursements 1174 2617 2404 2206 2150 18. Repayments 521 679 775 744 974 19. Other M & LT (net) 69 11 30 9 - 20. Net credit from IMF 127 96 52 -40 -132 21. Net short-term capital 468 -925 -538 -169 -142 22. Errors and omissions -1184 -435 -504 -462 -370 23. Change in reserves (minus indicate increase) 81 -88 14 -98 333 Data are from Central Bank sources. 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