Egypt is being convulsed by protests for and against the rule of President Mohammed Morsi on the one-year anniversary of his accession. Beneath the political turmoil and questions of legitimacy lie profound economic challenges that must be met by whoever governs Egypt.

The nation’s hopes for “bread, freedom and social justice” are being overwhelmed by the slow pace of economic change. Instead of undertaking reforms, Egypt has been relying on its wealthy neighbors for unconditional cash injections so that it can import food and fuel. Qatar’s recent infusion of $3 billion may provide temporary relief, but the unpredictability of such measures ― which include Saudi Arabia’s promise last week of a $500 million loan ― scares investors and postpones the inevitable fiscal consolidation that Egypt needs to stabilize its economy.

The need for reform is growing more urgent by the day. Unemployment is above 13 percent, from 9 percent in 2010. The most recent data show that one-quarter of the population is living in poverty, and the share is rising. Foreign reserves had plummeted from $36 billion before the revolution to about $13 billion in March of this year before funds from Qatar arrived. The black markets for dollars and fuel are thriving.

Scrapping a political and economic system and building a new one is never for the faint of heart, but the history of democratic transitions shows that speed is essential. Countries that democratize rapidly grow faster over the long run by about one percentage point above their pre-transition levels. In contrast, countries that take more than three years to adjust suffer extended weak growth. Years of uncertainty and sometimes unrest leave investors on the sidelines waiting for signs of political and economic stability.

Egypt is approaching the three-year mark that separates the rapid transitions from the rest. Its politicians need to produce an inclusive and predictable plan for a functioning democracy and undertake rapid economic adjustments. The costs of continued delay will be enormous, including years of rising unemployment. By acting quickly, countries such as Chile, Poland and South Korea experienced average per-capita growth of about 5 percent the decade after each of their democratic transitions began. But consider Mexico, Romania and Zambia, where transition was slow and growth averaged near zero for a decade.

The contrast between Poland and Romania is especially striking. Poland’s economic success was facilitated by peaceful elections and clear market-oriented reforms. By 1998, Poland attracted 40 percent of the foreign investment in Eastern and Central Europe. Romania’s political transition was hijacked by the communists and accompanied by frequent demonstrations; its economic transition, meanwhile, was delayed by popular demand for continued state support.

The Egyptian economy is now struggling under its own sluggish transition. Egypt and the International Monetary Fund have been talking inconclusively about an assistance package for more than a year, with no resolution in sight despite record IMF flows to the rest of the Middle East and North Africa. A good deal of this hesitation is, of course, political. The Egyptians are fearful of the strings attached to an IMF program; various IMF shareholders fret over such issues as Egypt’s increasingly restrictive treatment of foreign nongovernmental organizations.

But that is not the whole story. Egypt really does need a viable economic program for an IMF loan to work.

The right approach to Egypt’s economic problems would be to force it to bite the economic reform bullet now by ending wasteful expenditures, especially fuel subsidies. These cost almost half of government revenue at a time when Egypt’s budget deficit is more than 10 percent of gross domestic product and growing, and they encourage energy consumption, especially among wealthier Egyptians, while doing little to help the most vulnerable. Smart budget rebalancing would cut the subsidies, add more to the social safety net for the poor, and reduce the fiscal deficit.

Reform can be accomplished, even in the midst of a difficult political transition, provided social spending is redirected to those in need and the government clearly communicates its policy decisions. Once the poor are identified, cash transfers or targeted subsidies can flow to them as universal subsidies are removed.

History offers another lesson: that popular regimes or autocracies are most likely to succeed with economic reform. In Brazil, former President Fernando Henrique Cardoso had earned high marks for reining in hyperinflation, giving his subsidy-reform program credibility. In Poland, economic reforms following its transition were eased by popular support for democratic changes. Turkey, by contrast, first tackled electricity subsidies under a military regime in the 1980s. The term “shock policy” (only later to be dubbed “shock therapy”) was coined by Milton Friedman with reference to former dictator Augusto Pinochet’s economic reforms in Chile.

This suggests two possible strategies for economic reform in Egypt. First, Morsi could seek to renew political support by yielding on voice and accountability, thus gaining legitimacy for economic reform. Political reform would also ease tensions with Western donors, as well as lure back investors and tourists. With a serious economic plan in place, Morsi would signal that Egypt is open for business.

Or Morsi could pursue a second approach: taking advantage of Egypt’s history of autocracy to push through some of the necessary economic reforms under threat of economic crisis. Aid from the neighborhood could help finance the adjustment.

This strategy, however, is less likely to clear the way for the $4.8 billion IMF program that has been under discussion for more than a year. And an accord on that program is essential to unlocking funds from other international financial institutions, the European Union and the U.S., which could help to fill the remaining external financing hole of $10 billion or more.

Although Morsi’s government is nervous about imposing new costs on Egyptians, deferring reforms will only worsen its economic straits and make the necessary adjustments more painful. And the current strategy of relying on Persian Gulf countries for financing, without a clear economic program, will only make things worse. 

By Caroline Freund

Caroline Freund is a senior fellow at the Peterson Institute for International Economics and former chief economist for the Middle East and North Africa at the World Bank. ― Ed.

(Bloomberg)