By Lesley Wroughton Crucial negotiations between the International Monetary Fund and Egypt on a $4.8 billion loan program begin on Tuesday and a top IMF official said an agreement must address the nation's gaping budget deficit without constraining economic growth.
The goal, according to IMF director for the Middle East and North Africa Masood Ahmed, is to phase out wasteful subsidies, especially in the energy sector, and to use the resources for more spending on health, education and infrastructure development as the country emerges from decades of authoritarian rule.
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The IMF talks in Cairo will aim to reach an agreement before the end of the year. The deal is likely to unleash further financing from other international lenders like the African Development Bank,the World Bank. Finacning by regional donors such as Qatar and regional donors.
The Obama administration has also said it will offer Egypt $1 billion in debt relief as well as financing and loan guarantees for American companies and banks to invest in Egypt.
Egypt's economic problems are enormous. A budget deficit has mushroomed to 11 percent of gross domestic product, there is massive youth unemployment and currency reserves are low.
The government has spent the last several months developing an economic program and ensuring political and social support for it at the IMF's insistence. Ahmed said in an interview with Reuters the IMF mission will assess the specifics of the plan in coming weeks.
"The program has to address the challenges that Egypt now faces," said Ahmed.
"These challenges are quite formidable and they are both short-term challenges in terms of strengthening fiscal and external resilience, but also the challenge of laying the foundation for a revival of economic activity over the medium term that is going to provide jobs.
"Beyond the short term problem, the Egyptian economy has to be guided by a vision of inclusive and job creating growth, with more transparency and a level playing field. The future cannot be a return to the past."
Ahmed emphasized that it was important to prevent the budget deficit from widening further through a gradual reduction in energy subsidies, 60 percent of which benefit the wealthy that have more money to spend on energy products.
One proposal is to target the subsidies at Egypt's poorest households through direct cash transfers or vouchers. Cutting subsidies is a political hot button issue and Ahmed said it was important that the government be open and clear about its intentions.
The government, which took office in July, has vowed to push through reform of the subsidies, which consume as much as a quarter of the state budget, but still has to explain how or when it will happen.
"Our experience with subsidy reform in many countries is that such reforms are best done when they are well prepared and phased in rather than implemented overnight," Ahmed said. "I don't think it will be sensible to try to implement hasty changes in a way that aren't fully thought through or risk backlash.
The IMF has estimated that with necessary measures the government will be able to reduce the budget deficit to 10 pecent of GDP in the financial year ending June 2013. It also believes that further substantial cuts in the budget deficit will be needed in 2013-2014 to put the budget on a sustainable path.
Implementing the measures will reassure investors and boost confidence, Ahmed said.
"You have to take measures that are seen as being substantial and credible and have an impact on the outcome, even in the first year," Ahmed said. "At the same time I believe you also have to signal the direction of subsequent actions that will be taken.
"You also don't want to over-reach because if you cut back spending too quickly then you also have an impact on growth -- in a way you're cutting back stimulus - so its a fine balance."
Ahmed said the an IMF program will also help lower interest rates that local banks charge, which have been pushed up by increased demand by the government for financing and growing incertainty. Egyptian government has been borrowing around $2 billion a month from local banks, crowding out financing available for the private sector.
Analysts have suggested that one way of boosting economic activity and exports is for the government to educe the value of its currency. Some analysts have estimated the Egyptian pound to be overvalued somewhere in the vicinity of 40 percent.
The debate is a political hot potator and Egypt's president Mohamed Mursi has rejected any notion of a currency devaluation.
"I don't want to get into specific valuations, but the important point is that over the medium term Egypt needs to build resilience and become competitive," Ahmed said when asked whether Egypt will need to devalue its currency.
Popular protests in 2011 chased away both tourists and foreign investors, two of Egypt's main sources of foreign exchange, putting pressure on the currency and helping to widen an already gaping budget deficit.
A weaker pound would encourage exports and stop a drain on foreign reserves.
(Editing by Kim Coghill)