Forward 91880 1 v1 Financial Development and Inclusive Growth Executive Summary Attaining Shared and Sustainable Prosperity in Egypt 2 Financial Development and Inclusive Growth Forward 3 Middle East and North Africa Finance and Private Sector Development Financial Development and Inclusive Growth Executive Summary Attaining Shared and Sustainable Prosperity in Egypt A Study Led By Sahar Nasr 4 Financial Development and Inclusive Growth Forward 5 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Forward Better functioning financial systems foster economic growth, poverty alleviation; moreover, a more equitable distribution of economic opportunities enhances overall economic development. It is critical that financial development leads to inclusive growth. This brings us to certain key questions: Who benefits from a better financial system? Does financial development induce an increase in per capita Gross Domestic Product (GDP) only because the very rich are getting even richer? Does finance expand economic opportunities for the bulk of society? Economic theory suggests that finance shapes the distribution of economic opportunities. The financial system affects the degree to which a person’s economic opportunities are defined. It influences who can launch a new business venture and who cannot, who can acquire education and who cannot, who can live in a neighborhood that fosters the cognitive and non-cognitive development of their children and who cannot, who can pursue one’s economic dreams and who cannot. A more competitive, better functioning financial system exerts a disproportionately positive impact on relatively low-income families. A large body of evidence finds that the functioning of the financial system influences the rate of long-run economic development, poverty alleviation, and the degree to which families and firms with sound investment projects have access to capital. When financial systems 6 Financial Development and Inclusive Growth Forward 7 effectively seek out the best investments, efficiently mobilize resources forward policy implications, given international best practice while to fund those investments, and carefully scrutinize the use of those taking into account lessons learnt from previous reforms in Egypt funds by firms and individuals, this tends to accelerate economic and what is needed to respond to the Egyptian people aspiration post development, alleviate poverty, and reduce income inequality. The revolution. greater the degree that financial systems collect society’s savings with one hand and funnel those resources, this tends to foster growth, promote poverty alleviation, increase inclusivity in the available economic opportunities and expands economic opportunities. Thus, the financial system affects the savings rate and the efficiency of Hartwig Schafer resource allocation, with enduring ramifications on economic activity. Country Director Therefore, getting the financial system to operate soundly is vital to Egypt, Yemen and Djibouti fostering sustained economic development. The World Bank Group According to the extent that the financial system performs these functions well, economies tend to grow correspondingly faster. For example, when banks screen borrowers effectively and identify firms with the most promising prospects, this is a first step in boosting productivity growth. When financial markets and institutions mobilize savings from disparate households to invest in these promising projects, this represents a second crucial step in fostering economic growth. When financial institutions monitor the use of investments after financing firms and scrutinize their managerial performance, this is an additional, essential ingredient in boosting the operational efficiency of corporations, reducing waste and fraud, and spurring economic inclusivity. There is a robust positive relationship between financial development and both poverty alleviation and reduction in income inequality. It is not just that finance accelerates economic growth, which trickles down to the poor; rather, finance exerts a disproportionately positive influence on lower income households. Building on the finance and poverty connection, there is a direct link between finance and human welfare. When policy reforms foster the development of the financial system, financial services improve, accelerating economic growth, which ultimately leads to ending extreme poverty and boosting shared prosperity. So where is Egypt when benchmarked with other emerging and developing economies? During the post-revolution transition, Egypt has been debating fundamental issues, such as maintaining market-oriented reforms, and promoting private sector-led growth. As uncertainty continues, reforms are debated, and crisis management is in full swing. A pressing challenge towards moving forward is the proceeding with the appropriate policy reforms, and this report puts 8 Financial Development and Inclusive Growth Acknowledgments 9 Acknowledgments The Egypt Financial Development and Inclusive Growth report was prepared by a team led by Sahar Nasr, Program Leader; and comprised of Asli Demirgüç-Kunt, Director, Development Economics and Chief Economist (Financial Development); Santiago Herrera, Lead Economist; Ahmed Kouchouk, Senior Economist; Karim Badr, Financial Economist (Macroeconomic Stability); Erik Feyen, Lead Financial Sector Economist (Financial Development); Ross Levine, Wilis H. Booth Chair in Banking and Finance, Haas School of Business (Financial Development); Catiana Garcia- Kilroy, Lead Securities Market Specialist (Non-Bank Financial Institutions); Anderson Caputo Silva, Lead Securities Market Specialist; Simon Walley, Housing Finance Program Coordinator (Egypt’s Mortgage Market); James Hanson, Visiting Professor of Economics, Center for Development Economics, Williams College, Williamstown Mass (Banks Economic Growth); Thorsten Beck, Professor of Economics, Tilburg University, and Founding Chair of European Banking Center (Banks Economic Growth); Jonathan Katz, former Secretary of the U. S. Securities and Exchange Commission (Capital Market Regulation and Economic Growth); Nabil Hashad, Former Chair, Arab Center for Financial and Banking Studies and Consulting (Islamic Finance); Monal Abdel Baki, Research Professor, Durban University of Technology; Rodney Lester, Insurance Sector Expert (Insurance and Pensions); Bahaa Ali El Dean, Attorney-at-Law, Arab Legal Consultants (Financial Sector Integrity); Henri Lorie, Financial Economist (Legal Framework); Hoda Youssef, Research Fellow, Woodrow Wilson School of International and Public Affairs of Princeton University (Macroeconomic Stability); Laila 10 Financial Development and Inclusive Growth Acknowledgments 11 Abdelkader, Financial Sector Specialist (Overview of the Financial Sector); Leasing Association. The authors are grateful to the guidance provided by Nahla El Okdah, Associate Operations Officer, IFC (Financial Leasing); the various stakeholders and private banks, especially Mr. Omar El Sayeh, and Mohamed Farid, Chairman and CEO, Dcode Economic and Financial Chairman Barclays Bank; Mr. Abdelsalam El Anwar, Chairman, HSBC; Consulting (Capital Market). Mr. Hisham Ezz Al Arab, Chairman and Managing Director, Commercial International Bank (CIB); Dr. Yasser Hassan, Managing Director, Al Watany Special gratitude is also due to Hartwig Schafer, Director, Egypt, Bank of Egypt (AWB); and Mr. Sherif Battisha, Deputy Chairman Post Office. Yemen and Djibouti; and Loic Chiquier, Director, Financial and Private The team would also like to thank Mr. El Sayed El Kosayer, Chief Executive Sector Development, and Capital Markets Global Practice, for their guidance. Officer, Industrial Development and Workers Bank; Mr. Hassan Abdallah, Thanks are also due to Mr. Simon Bell, Sector Manager, Finance and Private Chief Executive Officer and Vice Chairman Arab African Bank; and Mr. Sector Development, Middle East and North Africa (MENA) Region. The Bruno Gamba, Chairman and Managing Director Bank of Alexandria. The authors are grateful to the peer reviewers Caroline Freund, Chief Economist; team would also like to acknowledge the countless other individuals from the Marilou Jane Uy, Senior Adviser; Sophie Sirtaine, Sector Manager; Michel banking, insurance and capital markets sectors who have contributed to the Noel, Service Line Manager; Yusuf Shahid, Chief Economist for the Growth preparation process. Dialogue, School of Business, George Washington University; and Didier Debals, Inspector General, Banque du France. The team would also like to thank Nada Shousha, Principal Country Officer, IFC; Xavier Reille, Manager, IFC; James Christopher Razook, Senior Operations Officer IFC; Amira El Saeed Agag, Operations Officer, IFC; Murat Sultanov, Operations Officer, IFC; and Ola Nour, Operations Officer, IFC. The report benefited significantly from the guidance and support of Patrick Conroy, Former Director and Senior Advisor. The authors would also like to acknowledge the contribution of Mauricio Pinzon Latorre, Research Assistant; Marwan Ezz Al Arab, Research Assistant; Lina Badawy, Research Assistant; Nehal Helmy, Research Assistant; Rana Hegazy, Research Assistant; Mostafa Abu El-Ela, Research Assitant; Amira Zaky, Program Assistant; and Nayyera Qutb, Team Assistant. The World Bank team greatly appreciates the close collaboration with the government of Egypt. Special gratitude and appreciation goes to H.E. Dr. Farouk El Okdah, Former Governor, Central Bank of Egypt (CBE). Thanks are also due to H.E. Mr. Hisham Ramez, Governor, Central Bank of Egypt (CBE); Mr. Gamal Negm, Deputy Governor CBE; Mr. Nidal Al-Kassem Assar, Deputy Governor CBE; Ms. May Aboul Naga, Regulations Department Head, CBE; Ms. Lobna Helal, Chairman and Managing Director, Egyptian Mortgage Refinance Company; and Dr. Sherif Samy, Chairman, Egyptian Financial Supervisory Authority (EFSA); Mr. Mohamed Omran, Chairman, Egyptian Exchange and Mr. Samy Khallaf, Debt Manager Ministry of Finance. Extensive consultation with stakeholders, private sector, banks, insurers, mortgage finance companies, and civil society took place throughout the preparation of the report. The team also wishes to thank Mr. Hisham Okasha, Deputy Chairman National Bank of Egypt; Mr. Mounir El Zahid, Chief Executive Officer, Banque Du Caire; Mr. Mohamed Naguib, Chairman and Managing Director, Societe Arabe Internationale De Banque; Mr. Mohamed Amiri, Head of Marketing and Credit Division, Societe Arabe Internationale De Banque; and Dr. Shahinaz Rashad, Chairman, Egyptian 12 Financial Development and Inclusive Growth Executive Summary 13 Executive Summary Prior to the revolution, Egypt had been Prior to the hit by the global financial crisis along with revolution, Egypt higher international food and fuel prices, which had been hit by induced capital outflows, a moderate slowdown the global crisis, in economic activity, stagnation in employment namely food, fuel growth, and high inflation due to rising food and financial prices. As the country was recovering from such crisis, which external shock and capital inflows started to flow induced a capital back, the 2011 revolution sent the economy into a outflow, a moderate tailspin. The Egyptian economy continues to be growth slowdown, adversely affected by the ongoing political unrest stagnation in and violence. Economic activity started to pick employment growth, up in the second half of FY14, as the government and high inflation accelerated its stimulus spending, but growth due to rising food is still feeble at 2.2 percent in 2014 (well below prices. As the country potential), similar to growth rates realized in the was recovering previous two years . The sluggish growth reflects from that shock and mainly contraction in the petroleum and tourism capital had started sectors. On the demand side, real investment flowing back, the continued to shrink in real terms due to high January 25, 2011 uncertainty and net exports remain a drag on revolution sent growth. However, the remainder of 2014 may the economy into a witness an improvement in economic activities, tailspin. thanks to the accommodative government 14 Financial Development and Inclusive Growth Executive Summary 15 policies pursued, including a notable stimulus Treasury bills that represent 41 percent of the backed partially by the Gulf aid packages. Gulf banking system assets, accounting for 40.0 States Saudi Arabia, United Arab Emirates percent of GDP, leaving little loanable funds and Kuwait, pledged around US$24 billion in available. Claims on the government to-total financial aid to Egypt since July 2013, of which domestic credit have increased to 60 percent, around US$17-18 (Cash and in kind) billion has while claims on the private sector credit dropped been received in 2014. to 37 percent in June 2013, as opposed to 54. The overall instability has adversely Starting 2014, with the exceptional affected investments and the private sector. financing from the Gulf trickling in, reserves Domestic investment fell to 13.1 percent of Gross increased to around US$17 billion at the end of Domestic Product (GDP) in 2014. Foreign direct September 2014 (equivalent to about 3 months of investments (FDI) have fallen to 1.1 percent of 2014 projected merchandise imports). In tandem, GDP in 2013. The sluggish growth and domestic the exchange rate appreciated during first half demand, high government borrowing needs, risk of 2014 before it started to slightly depreciate to averse practices by the banking sector, and the reach LE 7.15 per US dollar by end May 2014 drop in national investments and savings had and stabilized since then. However, a parallel a negative effect on the creation and growth market premium that had emerged by end- of micro and small enterprises (MSEs). These 2012 due to foreign exchange rationing—is still factors have contributed to an increase in persistent. The relative improvement in Egypt’s unemployment and poverty rates. Unemployment external conditions prompted rating agencies to increased from 8.9 percent in December 2010 to upgrade Egypt’s sovereign rating and outlook. 13.3 percent in June 2014. It is particularly high In November 2013, Standard and Poor’s raised among women at 25 percent and youth at 42 Egypt’s long- and short term foreign and local percent. The poverty rate also increased to 26.3 currency sovereign credit rating to ‘B /B’, with percent in 2013, up from 25 percent in 2011 and a ‘stable’ outlook. Fitch also upgraded Egypt’s 21.6 percent in 2009. outlook to ‘stable’ in January 2014. Egypt’s fiscal situation has been However, with the election of El-Sissi Egypt has been deteriorating sharply since 2010 due to weak as the president in June 2014, the economy is undergoing major real growth, adoption of populist measures, and expected to stabilize, and economic recovery is political and social the lack of corrective actions. The overall budget likely as the government moves forward with transformations, deficit reached 12.5 percent of GDP in 2014, down implementing the reform program, including following the from 13.7 percent a year earlier on the backdrop making the financial system more inclusive, January 2011 Starting 2014, with of exceptional Gulf receipts and the one-off a key contribution and reform to restoring revolution. Egypt the exceptional transfer of government deposit worth Egyptian economic growth and making it more inclusive. has embarked on a financing from the Pounds (LE) 30 billion from the Central Bank Egypt has been undergoing major political dramatic political Gulf trickling in, of Egypt (CBE) to the Treasury. However, fiscal and social transformations, following the transition with the reserves increased aggregates are likely to temporarily improve January 2011 revolution. Egypt has embarked on stepping down of to around US$17 in 2015, mainly due to structural reforms a dramatic political transition with the stepping former President billion at the end implemented in July 2014 (increasing and/ down of former President Hosny Mubarak, the Hosny Mubarak, the of September 2014 or enacting taxes and streamlining energy appointment of an interim caretaker government, appointment of an (equivalent to subsidies. th. and the dissolution of Parliament. The Egyptian interim caretaker about 3 months The high deficit and government borrowing people demands were summarized in “bread, government, and of 2014 projected needs has also led to the crowding out of private freedom and social justice”. The Supreme Council the dissolution of merchandise sector credit. Banks opted for purchasing of Armed Forces (SCAF) assumed executive and Parliament. imports). less risky, high-yield Government bonds and legislative powers until the Parliamentary and 16 Financial Development and Inclusive Growth Executive Summary 17 The Egyptian people Presidential elections were concluded, and a new the lack of corrective actions. The overall budget Egypt’s fiscal demands were constitution was put in place. The prolonged deficit reached 13.7 percent of GDP in 2013, up situation has been summarized in political transition and frequent changes in prime from 11 percent a year earlier. However, fiscal deteriorating “bread, freedom and ministers, and cabinet ministers contributed aggregates are likely to temporarily improve sharply since 2010 social justice”. to the delay and uncertainty about policies and in 2014, mainly due to the exceptional Gulf aid due to weak real directions, including those related to or affecting packages, and the one-off transfer of government growth, adoption of the financial sector. In June 2012, the Muslim deposit worth Egyptian Pounds (LE) 30 billion populist measures, Brotherhood candidate Dr. Mohamed Morsi won from the Central Bank of Egypt (CBE) to the and the lack of the presidential election. Treasury. Actual figures for the first nine corrective actions. After a year of very little progress made to months of 2014 indicate a lower overall deficit of The overall budget respond to the Egyptian people’s aspirations and 7 percent of the year’s projected GDP compared deficit reached 13.7 failure to introduce a more inclusive political to a deficit worth 10 percent a year earlier. percent of GDP process, including the leftists, liberals, and youth The high deficit and government borrowing in 2013, up from that had helped bring him to power, president needs has also led to the crowding out of private 11 percent a year Morsi was removed in the wake of massive sector credit. Banks opted for purchasing earlier. However, demonstrations protesting the dire economic less risky, high-yield Government bonds and fiscal aggregates are and political situation in Egypt. The protestors Treasury bills that represent 41 percent of the likely to improve in demanded early presidential elections after Morsi banking system assets, accounting for 40.0 2014, mainly due to The sluggish one year in office. The Egyptian military forces, percent of GDP, leaving little loanable funds the exceptional Gulf growth reflects headed by Marshal Abdel Fatah El Sissi, then available. Claims on the government to-total aid packages. poor performance the Minister of Defense and Military Production, domestic credit have increased to 60 percent, by manufacturing issued a 48 hours ultimatum to the president while claims on the private sector credit dropped and construction to respond to the demands of the protestors to 37 percent in June 2013, as opposed to 54. sectors, in addition On July 3, 2013, the Egyptian Military force Starting 2014, with the exceptional to contraction in convened with various political parties including financing from the Gulf trickling in, reserves the petroleum and Salifst party, representatives of Al-Azhar and increased to above US$17.5 billion at the end However, with the tourism sectors. the Coptic Church, and announced suspension of of April 2014 (equivalent to about 3 months of election of El-Sissi as the constitution, appointment of the head of the 2014 projected merchandise imports). In tandem, the president in June constitutional court, councilor Adly Mansour, the exchange rate appreciated during first half 2014, the economy is as an interim president, and conduction of early of 2014 before it started to slightly depreciate to expected to stabilize, presidential elections. A roadmap was announced reach LE 7.15 per US dollar by end May 2014. and recovery would and has been in progress. Two and a half years However, a parallel market premium that had be witnessed as the after the revolution of January 25, 2011, Egypt emerged by end-2012 due to foreign exchange government moves is undergoing major political, economic and rationing—is still persistent. The relative forward with the social transformation with the amendments to improvement in Egypt’s external conditions reform program, the 2012 Constitution approved in a referendum prompted rating agencies to upgrade Egypt’s including that the held on January 14–15, 2014, which saw a 38.6 sovereign rating and outlook. In November 2013, financial system percent turnout and a 98.1 percent approval rate. Standard and Poor’s raised Egypt’s long- and becomes more The presidential election took place in May 2014, short term foreign and local currency sovereign inclusive, a key with Marshal Sissi elected as a new president credit rating to ‘B /B’, with a ‘stable’ outlook. contribution to for Egypt. Parliamentary elections are expected Fitch also upgraded Egypt’s outlook to ‘stable’ in economic growth. after the Sumer of 2014. January 2014. Egypt’s fiscal situation has been However, with the election of El-Sissi as the deteriorating sharply since 2010 due to weak president in June 2014, the economy is expected real growth, adoption of populist measures, and to stabilize, and economic recovery is likely as 18 Financial Development and Inclusive Growth Executive Summary 19 the government moves forward with the reform existent mortgage finance market, as well as, The ambitious program, including making the financial system strengthening the regulatory and supervisory reform program of more inclusive, a key contribution and reform to frameworks governing the financial sector. the financial sector restoring economic growth and making it more Phase II (2009–2012) focused more on enhancing launched in 2004 inclusive. access to finance, and building a more inclusive witnessed smooth and competitive system. It aimed at improving implementation financial intermediation after achieving stability driven by the benign The Financial Sector Reform Program under the previous phase. The ambitious reform international The financial The financial sector, prior to 2004, was program of the financial sector launched in economic conditions sector, prior to 2004, dominated by state-ownership and an absence 2004 witnessed smooth implementation driven in addition to was dominated by of competition. The banking sector, the major by the benign international economic conditions commitment from the state-ownership financial intermediary, constituting over in addition to commitment from the Egyptian Egyptian authorities, and an absence of 95 percent of the financial system’s assets, authorities, and the relative political stability and the relative competition. suffered from heavy government intervention, witnessed during those years as opposed to Phase political stability. weak creditor rights, and a compliance-based II of the reform program, which was interrupted regulatory and supervisory framework. This significantly at its early stages with the January resulted in relatively low and unproductive 25th, 2011 revolution. credit, negligible innovation and a large stock Overall, the reform program produced of non-performing loans (NPLs). A relatively positive results. For the first time in recent small insurance, mutual fund and contractual history, the banking sector became majority- savings sector, underdeveloped bond, and almost owned by the private sector and open The banking sector, non-existent mortgage markets, thin trading in to competition. The banking sector was the major financial equities, weak corporate governance, and poor consolidated, and the number of banks was intermediary, financial infrastructure, characterized the non- reduced from 57 to 39 banks. State-owned constituting over bank sector in Egypt. The limited size of these banks were subject to financial, operational, and 95 percent of the non-bank intermediaries contributed to the institutional restructuring leaving a stronger financial system’s absence of long-term savings and the overall and more competitive sector. The Central Bank On the non-bank assets, suffered from limited access to finance. Ancillary financial of Egypt (CBE) also worked on strengthening front,reforms heavy government firms, such as stock brokerages, specialized the corporate governance of the banking system entailed the intervention, weak non-depository lenders (including leasing and designing a Basel II framework customized restructuring of the creditor rights, companies and microfinance lenders) and rating to the Egyptian banking system. On the non- insurance sector, and a compliance- agencies were present, but remained relatively bank front, reforms entailed the restructuring of including reducing based regulatory underdeveloped. The financial institutional the insurance sector, including reducing public public ownership; and supervisory infrastructure and the legal and regulatory ownership; overhauling the legal and regulatory overhauling the framework. framework were woefully deficient. framework; establishing a new mortgage finance legal and regulatory The Egyptian authorities launched in system; and deepening and strengthening the framework, 2004, a two-phase financial sector reform capital markets At the same time, the financial establishing a new program aiming at enhancing the stability institutional infrastructure was improved mortgage finance and soundness of the system, which would be significantly, evident in the creation of the first system; deepening increasingly private sector-led, able to contribute private credit bureau and the establishment of a and strengthening more effectively to Egypt’s growth performance. safe, secure payments system, among others. the capital markets. Phase I (2004–2008) focused mainly on All this improved the financial sector’s reforming the banking sector, restructuring the resiliency to the global crisis and the lengthy insurance and pension systems; strengthening transformation of the political regime since the the capital markets, developing the almost non- revolution, and helped it weather the crisis. 20 Financial Development and Inclusive Growth Executive Summary 21 The reforms did not lead to improvements in Developments and Challenges in the financial intermediation, and was accused of Banking Sector catering to large, well-established firms. Small An additional macro-financial issue of The CBE closely and medium enterprise (SMEs) did not fully concern is the potential “crowding-out” of credit monitored and reap the benefits of these reforms, the country to the private sector by government borrowing. supervised all banks had no legislative body for almost three years, The crowding-out, accompanied with weak to ensure that any which negatively affected legal reforms and the appetite for borrowing given the overall uncertain financial weaknesses passage of laws that were crucial for improving economic environment and the security situation, are addressed in financial intermediation and enhancing access to led to a decline in the credit to the private sector a timely manner, the marginalized groups and underserved areas. to 37 percent in June 2013, from 50.7 percent in and undertook To a large extent, this issue was compounded January 2011. regularstress testing. by macroeconomic instability—increased The CBE closely monitored and supervised government deficit and huge borrowing from all banks to ensure that any financial weaknesses the banking system since 2008 as a result of are addressed in a timely manner, and undertook the global crisis, and the lengthy uncertainties regular stress testing. The loan quality and of the transition to a new political regime after profitability indicators was expected to be affected January 2011. by the slowdown in economic growth, capital Financial Although sectoral analysis shows that outflows, and a rise in interest rates associated intermediation has there is no liquidity crisis in the banking sector, with the political uncertainty. An increase in been low, as evident MSEs have limited access to finance. Financial NPLs in the banking system is a likely result in the loans-to- intermediation has been low, as evident in the of the contraction in economic activities and the deposit ratio that loans-to-deposit ratio that declined from 50 turmoil following the revolution. A key sector declined from 50 percent in 2011 to reach 46 percent in January that has been significantly affected is tourism, percent in 2011 to 2014. Moreover, there is lack of term funding, while construction, mining, and manufacturing reach 46 percent which especially hampers sectors that are the have also suffered. Yet actual indicators prove in January 2014. main creators of jobs, such as manufacturing. the exact opposite as a clear decline in NPLs Moreover, there is This is compounded by the increase in the ratio from approximately 10% in 2012 to 9.1 in lack of term funding, banking sector’s risk aversion, as evidenced in the 2013 due to write offs conducted by bans under which especially decline of private sector credit-to-GDP from 36.1 their normal course of action. Consequently, the hampers sectors percent in June 2009 to 27.5 percent in January recent bank performance indicators that show that are the main 2014. MSEs suffer disproportionately from low little change in the loan portfolio quality or creators of jobs, such financial intermediation, and are offered limited profitability indicators, almost three years after as manufacturing. financial products. A recent Investment Climate the shock. Rapid Assessment Survey (2012) reveals that However, this light, it is crucial to ensure only 11 percent of micro enterprises and 17.4 that an adequate macro-prudential regulatory percent of small enterprises have bank loans, framework is in place. In particular, bank as opposed to 38.2 percent of large enterprises regulators may need to account for bank ownership (Figure 3), of these surveyed firms, more than structure in developing an early warning system 70 percent raise concerns regarding the surge that would alert them about potential problems in the cost of finance post revolution. As a in the banking industry. Most important is result, they often resort to alternative sources of to adopt a financial inclusion strategy, which finance, relying on personal savings (79 percent) would promote access to finance, especially to or inheritance (15 percent) to raise capital, while previously marginalized segments of the society. only four percent access the formal market. . Central Bank of Egypt understands the positive effect of financial inclusion and its importance 22 Financial Development and Inclusive Growth Executive Summary 23 More generally, the on financial and economic stability, and banking investment in the private sector nor greater lack of certainty sector soundness. Efforts are exerted to access to finance occurred. regarding future understand the major concerns and problems that Major challenges confronting Egypt in Major challenges government hinder financial inclusion. Accordingly financial further developing its equity market include confronting Egypt in policy, combined inclusion takes a high priority on the CBE’s top the absence of a sufficient supply of tradable further developing with ambiguity management’s agenda in order to take all the securities as well as the marginal role played its equity market about government necessary actions to increase financial inclusion by institutional investors. Although mutual include the absence commitment, can levels specially related to SMEs finance. funds in Egypt have grown considerably in the of a sufficient supply adversely affect the past decade, from 22 funds with LE 3.9 billion of tradable securities situation. under management in 2001 to 91 funds with as well as the Development of the Non-bank Financial Sector LE 66 billion under management in February marginal role played 2014, these funds are not significant investors by institutional Non-bank financial sector reforms have in equities. Over 90 percent of all mutual fund investors. been slow to be implemented due to a variety of assets are invested in short-term debt or finance reasons. The move to a full-risk based supervisory instruments. Growth has been concentrated approach at Egyptian Financial Supervisory in money market mutual funds (MMMF), as Authority (EFSA) has been disrupted. The opposed to equity that did not grow in terms of management that followed has been overwhelmed assets under management relative to MMMF. by the volume of complaints and accusations related to the insider trading, minority In that regard, it is critical to expand the shareholders’ rights, and lax enforcement of supply of shares listed on the EGX. This could regulations. This has contributed at that time be accomplished through the government listing to the delays in non-bank financial institutions a portion of its asset holdings, increasing the (NBFI) reforms. However, in August 2013 a new number of shares of government entities already Chairman has been appointed, the third since listed and increasing the free float threshold for EFSA inception, together with a newly appointed existing and prospective listed companies. In board an aggressive regulatory reform program order to increase the role played by institutional has been adopted, culminating in significant investors; the respective oversight authorities changes to numerous laws, executive regulations should review their asset allocation guidelines and decrees, at an unprecedented pace. to enable entities such as insurance companies and pension funds to invest a portion of their Equity Market. On the non-bank front, assets in equities; and finally, perform a and in specific for the capital markets, the comprehensive analysis of the adverse impact on authorities established two funds (i) Investor market liquidity and efficiency that has resulted Protection Fund, which insures investors against from certain regulatory requirements that are any illegal activity by brokerage companies such intended to mitigate market volatility. A few as fraud, trading without investors consent; of these requirements include, limitations on however, it does not cover any losses arising from intra-day and margin trading, a prohibition on normal trading activities; and (ii) the Settlement short selling, a statutory prohibition on brokers Significant Guarantee Fund that ensures the timely engaging in proprietary trading, and price limits achievements settlement for any transaction conducted through and trading halts. It is worth noting that it was were achieved in the Egyptian Exchange (EGX) in case any party announced that effective end of July 2014, such government debt defaulted on the transaction. This ensured less precautionary measures will be removed. markets while the defaults for any stock market transaction and timely settlement of all transactions however, The few months leading the mid 2014 non-government neither greater financial system credit to witnessed EFSA’s issuance of new listing rules, segment remained and overhauled executive regulation of the relatively nascent. 24 Financial Development and Inclusive Growth Executive Summary 25 Capital Markets law, introduction of exchange small companies; fourth, create a rationalized traded funds (ETFs) in addition to a new real CSD mechanism for both government and non- estate investment funds regime. government fixed income securities. Fixed Income Market. Despite progress Insurance and Pensions. Although Although the made in the government debt markets, the non- the Egyptian insurance sector was opened to Egyptian insurance government segment remained relatively nascent. foreign competition in 1998, it did not include sector was opened to By December 2010, the government yield curve the necessary supervisory capacity building; foreign competition had been lengthened to 7-years, rollover risk development of the necessary supporting in 1998, it did not had been significantly reduced and secondary infrastructure; and the installation of include the necessary market trading in the government bond market management in the state owned insurers capable supervisory was gradually developing. This was additionally of operating in a competitive market place. The capacity building; supported by plans to upgrade and harmonize main emphasis in the first generation reforms development of the the existing segmentation of the clearing and adopted in 2004. Hence, carried out between 2004 necessary supporting settlement platforms between T-bills at the and 2008, was mainly to restructure the state infrastructure; and CBE and T-bonds at Misr for Central Clearing, owned insurance sector and build supervisory the installation of Depository and Registry (MCDR). capacity. This period witnessed the mandatory management in the Although certain Although certain regulatory hurdles could split of life and non life insurance, additionally in state owned insurers regulatory hurdles be improved, limited market development has early 2014 EFSA allowed insurance companies capable of operating could be improved, been caused by two structural bottlenecks: the to contract asset managers to manage their in a competitive limited market dominance of banks as the main funding source funds. This move aimed at allowing insurance market place. development has at relatively low rates because of excess liquidity, companies to benefit from professional money been caused by and the need to consolidate government bond management capabilities. Additionally, EFSA two structural markets as a price reference in the long end of authorized marketing of insurance policies bottlenecks: the the yield curve. To address these challenges, a via post office branches along the same line as dominance of prioritized set of key recommendations, include: bankassurance. New rules for insurance brokers banks as the main (i) increasing the efficiency and liquidity of the have also been adopted by EFSA. funding source at money markets; (ii) resuming the pre-revolution The private supplementary pension relatively low rates program to consolidate the government bond’s sector continues to experience unprofessional because of excess yield curve, which will involve efforts in the management and a number of plans that are liquidity, and the primary market and the secondary market heavily underfunded. Actions taken to date need to consolidate (eliminate de facto primary dealer (PD) monopoly, have been largely of a diagnostic nature, government bond introduce an electronic trading platform, create although a draft law has been produced to enable markets as a price a securities lending facility and impose and the supervisory entity to effectively do its job reference in the enforce quoting obligations on PDs); and (iii) and to require the appointment of professional long end of the yield establishing corporate bond market development fund managers. To address these challenges, a curve. as a priority. prioritized set of key recommendations include: In this regard, a steering committee setting up of a central database to collect Motor comprising relevant government agencies in close Third Party Liability (MPTL) exposure and consultation with market stakeholders should be claims, passage of the Private Pension Law to established. The focus of this committee should strengthen EFSA’s ability to supervise private include, upgrading primary market rules along pension funds, ensure properness of the fund with developing a hybrid market model aimed management, upgrade EFSA’s enforcement at non-bank institutions, moving from a merit capacity to risk rate insurers and private to disclosure based primary market regime, and pension funds to take appropriate enforcement explore available options to facilitate access by action. 26 Financial Development and Inclusive Growth Executive Summary 27 Mortgage Market. Creating a vibrant cumbersome property registration process mortgage lending market was one of the delaying of the execution of a secured lending authorities’ key priorities over the past decade. system based on property. The installment loan The government introduced a number of reforms, system provided by real estate developers also including setting the legal and regulatory poses many problems for lenders as well as for framework, the establishment of a mortgage the mortgage market acting as an incentive to liquidity facility, the setting up of a fund to delay the subdivision of their plots into individual Despite the support low and middle-income housing, and titles thereby making mortgages impossible to financial leasing streamlining property registration through secure until the whole development is complete. industry’s relative a nationwide mapping and titling program. Moreover, funding mortgages is constrained by cumulative growth These building blocks have helped in gradually EMRC’s inability to create a bridge between the and the favorable developing the mortgage sector in Egypt. Despite capital markets and the housing market. The developments in the increase in the number of mortgage finance cost of funds for mortgage finance companies and the market since To help improve companies, they still account for a small share banks is a serious flaw that exists in the Egyptian the issuance of access to formal of lending due to inadequate availability of long- deposit market with deposits being largely price Law 95 of 1995, home ownership term funds and delays in registering property inelastic, making it difficult for EMRC or indeed leasing remains by low and middle titles in the new urban communities. other capital market funding mechanisms to relatively small and income households, compete with much less expensive deposit based underutilized in To help improve access to formal home the government has funding. Egypt. ownership by low and middle income households, in the past provided the government has in the past provided Strategic interventions to support an a range of subsidies, a range of subsidies, through a plethora of efficient, robust and better equipped mortgage through a plethora special programs. Many of these public housing market entail the authorities to review of special programs. schemes continue to involve large government developers financing and regulation of developer subsidies. The Affordable Housing Program was installment loans with the aim of creating a safer launched in 2010, which aimed at expanding and more sustainable system; develop regulatory the residential mortgage market and increasing measures to better monitor maturity mismatch access to mortgage loans for low and middle- risks to curb the strong reliance on the deposit In order for the income households in order to improve housing base for long term lending, and reduce systemic leasing industry to affordability. This program that aimed at risks in the market. A key reform is to improve reach its potential improving the targeting and efficiency of property registration, and a move towards and develop further, subsidies by linking subsidies to affordable ‘general boundary’ principles, which would yield a number of short- mortgage loans. efficiency improvements and a much more rapid term measures need In February 2014 the Central Bank of roll-out of the systematic registration program. to be considered. There are a number of reasons Egypt announced a mortgage loan initiative for Most importantly is to expand and progress the underlying the low and middle income earners by allocating 10 Affordable Housing Program that would yield Egyptian mortgage billion Egyptian pounds to banks over a period major social benefits, as well as economic benefits market’s relative of 20 years at low price to be relent to low income through job creation. underdevelopment. earners at 7% and to middle income earners at 8%. Financial Leasing. Despite the financial The cumbersome The initiative should play an important role in leasing industry’s relative cumulative growth property registration boosting the construction and real estate sectors and the favorable developments in the market process remains as well as availing housing units at affordable since the issuance of Law 95 of 1995, leasing the fundamental prices .CBE has announced this initiative under remains relatively small and underutilized in obstacle. its corporate social responsibility role. Egypt. There are several constraints facing The mortgage market remains relatively the leasing industry that have inhibited its underdevelopment, mainly due to the growth and ability to achieve its full potential. 28 Financial Development and Inclusive Growth Executive Summary 29 In order for the The most important inhibiting factors include: assets, for an equivalent to US$7.9 billion, leasing industry to (i) the scarcity of long-term funding; (ii) the accounting for less than one percent (0.7 percent) reach its potential difficulty of repossessing assets associated of total global Islamic finance assets, which is and develop further, with the inadequate enforcement of ownership very small. Banks are the main source of Islamic a number of short- rights and the delays in the collection of overdue finance in Egypt. term measures need payments; (iii) legal obstacles that create unfair In order for Islamic finance to further Enhanced access to to be considered. disadvantages to leasing and create unnecessary grow in Egypt, special laws for the introduction finance necessitates barriers to the expansion of the sector; (iv) the and practice of Islamic banking (Islamic that banks be able need for a sounder institutional environment Banking) must be put in place. Such laws would and willing to “move to operate within, particularly through the facilitate the operation of Islamic Banking side up the ladder” in establishment and development of more by side with conventional banks. There needs to terms of individual effective registry procedures; and (v) the lack be an adequate supply of qualified staff for the risk-taking, and risk- of understanding of the sector and the limited continuing expansion of the Islamic banking based supervision information and data available on it. industry and for proper risk management. must accompany In order for the leasing industry to reach Improving risk management is very important as this development its potential and develop further, a number of Islamic products are becoming more complex and of financial short-term measures need to be considered. sophisticated with financial innovation. Given intermediation. First, the definition of leasing inLaw 95 of the specific nature of risk, Islamic banks need 1995 must be modified to contain a clearer, a specific risk management approach. Reserve more precise definition that differentiates this requirements in this case should be relatively In order for Islamic transaction from others including property higher to cater to the potential significant default finance to further hire or rent to prevent abuses of tax benefits risk as well as to prevent depositors’ losses in case grow in Egypt, and double taxation. It would also be of great of poor performance and rapid capital outflows. special laws for the benefit to amend the law to allow for leasing introduction and for non-commercial purposes. Furthermore, it is vitally important for the industry that the Financial Sector Integrity and practice of Islamic Economic Growth banking must be put private credit bureau moves forward with the establishment of its moveable assets registry. In Banking Supervision. A thorough reform in place. the long-term, there is a need to secure long term of the regulatory and supervisory framework funding needed to grow exponentially. The bond was an integral part of the reform program, as a and asset-backed securities markets need to be result of which the banking sector has emerged further developed in order to extend the average as more efficient and transparent, financially maturity of leasing contracts and better serve sounder, and better equipped to manage the potential and existing clients. Furthermore, a risks inherent to its activities. Enhanced stronger judicial system, which is able to enforce access to finance necessitates that banks be foreclosures and ensure the efficient and effective able and willing to “move up the ladder” in repossession of assets in case of default, is also terms of individual risk-taking, and risk-based key to developing a more supportive regulatory supervision is accompanying this development environment for leasing. of financial intermediation. With regard to the issue of diversification in bank lending, limits Islamic Finance. Egypt has, marginally, to bank exposures to a single client and its due to the minor size of Islamic banks and its related parties, and to the parties related to operations compared to he whole sector, been the bank itself already encourage competition involved in the recent expansion of Islamic and diversification in bank lending. There is finance.. Egypt is ranked the fourteenth in terms also a need to establish a stronger linkage of countries with Shar’ia compliant financial 30 Financial Development and Inclusive Growth Executive Summary 31 between management of these exposures and of collateral; and third, the banks must be . . . Banks must progress with access to finance. For instance, provided an appropriate incentive structure that be provided an approval of new branches could, in part, depend encourages them to move into higher reward/risk appropriate on the bank’s performance regarding large lending opportunities. This can only be achieved incentive structure exposures. CBE is already giving the priority through greater competition, based on market- that encourages them to the approvals on opening branches in remote oriented corporate governance. to move into higher In regards to areas outside greater Cairo and Alxandria, reward/risk lending facilitating SME accordingly to CBE existing regulations on opportunities. opening branches. Furthermore, the system of Financial Institutional Infrastructure This can only be financing, there is strong evidence that loan classification, collateral, and provisioning Financial Market Infrastructure. achieved through the development must be reviewed from the perspective of access With regard to well designed and enforceable greater competition, of SME financing to finance given that it affects banks’ credit secured transaction rules, there are many based on market- has been hampered decisions. Specifically, greater flexibility in the weaknesses in the legal framework and its oriented corporate by the existence of collateral regime is needed to facilitate access to enforcement, such as the lack of real estate governance. a large informal finance. This would apply to SMEs, in particular. title registration. these weaknesses are sector where In regards to facilitating SME financing, there entrenched and long standing, and call for companies operate is strong evidence that the development of SME greater flexibility and novel approaches, without proper financing has been hampered by the existence of such as a “register-able” property mortgage documentation for a large informal sector where companies operate finance based on an “interim” real estate title tax evasion purposes without proper documentation for tax evasion registration, which could form the base for and thus are not purposes and thus are not bankable. Moreover, mortgage collateral and its registry. Another bankable. Banks are from a corporate mindset and need to significant gap with secured transactions, shift to the SMEs financer requirements relating which need to be addressed, is the lack of a to credit origination, follow up, and monitoring legal and regulatory framework for the use of a such sector. and registration of a broad range of movable Although, CBE requires banks to property collateral. Furthermore, the existing create SMEs unit in each bank, and SME’s bankruptcy procedures continue to focus portfolio has increased since the exemption exclusively on liquidation, and need amending. reserve requirements on SMEs portfolio. Egypt has made significant advances in Understanding the Three overarching factors must be examined: the availability of reliable credit information, a shortcomings of the first, the broad regulatory infrastructure must key requirement for soundness and facilitating status quo including be conducive to SME lending. This calls for greater access to finance, but more can be done. pre January 2011 minimum accounting standards manageable The obligation to obtain an I-Score report before reforms in Egypt is for SMEs, credit bureaus specializing in SME a bank can extend credit should be applied in key to approaching assessment, efficient legal enforcement of creditor other financial institutions as well. Furthermore, reform. and borrower rights in the case of transactions one priority should be to ensure that the fees of with SMEs, and specialized SME credit rating the credit bureau do not discourage microfinance agencies; second, prudential regulations cannot, institutions from becoming members of I-Score even unintentionally, be biased against the and using its credit information, and some form smaller enterprises. This calls for the banks to of fee subsidy could be considered. Two priorities be allowed to take on exposures to SMEs based would be the creation of a central registry for on a much broader choice of possible collaterals. both immovable and movable collateral along As already mentioned, this would require a with the creation of a SME rating agency, with new legal framework for movable collateral, possible government support to mitigate the supported by a centralized registry for all types deterrent effect of rating fees. 32 Financial Development and Inclusive Growth Executive Summary 33 The prevailing Entry and exit rules that promote greater experience offers several models and policy choices legal framework competition should incentivize the banks to for consideration by Egyptian policy makers. constrains the cost broaden their lending activities. In this regard, Collateral legislation is poorly enforced. The Central Bank of and terms of finance. the conditions for approval of new branches Property rights registration and titling issues Egypt should develop Some laws are poorly gives greater weight to the prospects for make it difficult for firms, especially SMEs, incentives that written, especially increasing access to finance in the location being to use land assets as collateral. Even when encourage banks to those regarding considered, by making the local density of SMEs collateral is registered, there is no information seek an international secured transactions, an important variable in the decision, and giving on its value. This inadequate legal and judicial credit rating, for bankruptcy, and priority of branches approval to remote location system has resulted in uncertainty and high cost, instance by making settlement of disputes outside the greater Cairo and Alexandria. Going making banks reluctant to lend or instead opt it a condition for The prevailing forward, ending the moratorium on new banks to over collateralize their lending. Shortcomings banks to undertake legal framework and promoting the market-oriented behavior in rules for secured transactions have hindered certain types of constrains the cost of state-owned banks, are priorities, as is the access to finance. Egyptian law recognizes three borrowing. and terms of finance. introduction of a full-fledged banking resolution major forms of security, mortgage, pledge, and Some laws are poorly regime. A uniform, limited, and funded deposit business charge, all of which are governed by written, especially insurance scheme would not work due to negative rules that have shown various shortcomings in those regarding religious connotation. actual practice. secured transactions, Legal Framework. Understanding Governance and Transparency. With bankruptcy, and the shortcomings of the status quo including respect to reliable financial reporting and settlement of pre January 2011 reforms in Egypt is key auditing, there is a need to include in the banks’ disputes. to approaching reform. The prevailing legal quarterly reporting requirements information framework constrains the cost and terms of on the structure and concentration of the banks’ finance. Some laws are poorly written, especially shareholders, and on the loan concentrations those regarding secured transactions, bankruptcy, reflecting the largest borrowers, given the and settlement of disputes. Moreover, the court relevance of this information to the incentives for system, though well reputed for its impartiality enhancing access to finance. Furthermore, with and independence, suffers from several drawbacks the increased significance of brokerage, mortgage Policy actions for that keep it from helping expedite debt collection finance, and financial leasing subsidiaries further reform and resolve other financial disputes. The and affiliates, banks are required to quarterly should begin introduction of Specialized Economic Courts in reporting of their consolidated operations as well. with improving 2008 did not result in having specialized courts macroeconomic There is a requirement to have separate for financial institutions or specialized judges stability—a risk management and audit committees. Greater with adequate knowledge of financial market necessary but not conformity between CBE and EGX governance risks. There is difficulty in discussing specific sufficient action for disclosure requirements should encourage reform concepts in the absence of well-articulated financial deepening, banks to list. In addition, the Central Bank of and comprehensive policy objectives to be made by increased credit to Greater conformity Egypt should develop incentives that encourage the new government. Yet it is important for policy the private sector, between CBE and banks to seek an international credit rating, for makers to appreciate that fundamental changes and increased access EGX governance instance by making it a condition for banks to are needed. This is far from straightforward and to finance. and disclosure undertake certain types of borrowing. is not risk free. These changes relate to reforming requirements, the law on secured transactions, bankruptcy through further strengthening of CBE law and the functioning of the court system. Macroeconomic and Financial Stability Such changes should aim at reforming the laws, The main challenge for policymakers in requirements, should regulations and procedures governing each Egypt is to design a framework that ensures the encourage banks to matter and not an element thereof. International continued independence of the CBE. This implies list. 34 Financial Development and Inclusive Growth the importance of better coordination between fiscal and monetary policy to anchor expectations. This independence is needed to ensure the ability to influence inflation expectations and maintain them within the inflation target range. Policy actions for further reform should begin with improving macroeconomic stability—a necessary but not sufficient action for financial deepening, increased credit to the private sector, and increased access to finance. Other possible actions include further reductions in the risks of a systemic financial crisis and increased market discipline, by continuing to improve financial supervision and the early warning of financial indicators, and by establishing a legal framework for intervention if need be. There is a momentum This will lead to, greater intermediation for reform and an of funds to the private sector, more inclusion, appetite for change; and more financial services to the public at it is crucial to tap lower cost. Other possible actions would increase on this opportunity competition in the financial sector and improve at such a critical access to credit—these include providing a transition time. legal basis through a new law for micro-credit financial institutions and extending the coverage of I-Score to small borrowers. This will also entail having a more transparent policy for entry of “fit and proper” banks, easing restrictions on bank branching, increasing the use of the networks of the Post Office, and encouraging greater use of the existing licenses for mobile banking. In conclusion, the Egyptian revolution has resulted in many positive outcomes, one of which is the desire and power to change and reform institutions. There is a momentum for reform and an appetite for change; it is crucial to tap on this opportunity at such a critical transition time. Enhancing the policy dialogue and consultations with all stakeholders, including civil society, government officials, Parliamentarians, political forces, academia, private sector, donors, and development partners will ensure the continuity of reforms.