The financial sector plays a key role in development by mobilizing savings, by allocating investable resources, and by providing a mechanism for making payments. Inefficient financial markets are likely to damage the economic prospects of a country by increasing the cost of mobilizing savings, and thus diverting real resources away from investment and growth.
The Egyptian financial sector consists of the banking system and the nonbank financial intermediaries. The Central Bank of Egypt (CBE), the commercial banks, and a number of specialized banks constitute the main monetary institutions. The Central Bank of Egypt is the overseer of the banking sector. Nonbank financial intermediaries chiefly comprise savings institutions and insurance companies. The capital market is dominated by the Cairo and Alexandria stock exchanges, which are electronically linked and operate as a single exchange. Other participants are brokers and fund managers. The Capital Markets Authority (CMA) is the main supervisor of the financial services sector.
The banking sector
Throughout 1960–2000, the financial system was dominated by the banking sector. At end-2000, total domestic credit was roughly equal to one year’s GDP. By way of comparison, the free-float of equities available for trading on the stock exchange at current market prices, and the total value of listed bonds (mainly government bonds) was each less than 3 percent of GDP. Similarly, investments by the insurance and private fund sector, the bulk of which was in turn held in the form of bank deposits or listed shares, amounted to less than 5 percent of GDP.
The main source of funds for the banks during the period was deposits from the household sector. In 2000, such deposits accounted for more than 60 percent of total deposits. Domestic residents continued to hold much of their savings in the form of bank deposits, even though real inter-est rates on deposits were consistently negative from 1970 until 1991. The negative rates could reach punitive depths; for example, in 1979 and
again in 1985, real deposit interest rates dropped to almost 10 percent.
After 1991 they increased, but turned continuously positive only from 1995. Foreign exchange-denominated deposits in the banking system fluc-tuated a good deal from the time that the public was permitted to hold such deposits. Foreign exchange-denominated deposits (i.e. “dollariza-tion”) in 1991 reached 50 percent of total deposits. They dropped sharply after the economic reforms of 1991, falling to 28 percent by 1994 and to about 20 percent by 2000.
Between 1960 and 2000, the destination of lending changed signific-antly. In 1960, nearly 60 percent of domestic credit constituted net lending to the government; by 2000 the figure had dropped to about 25 percent. The remainder went chiefly to the domestic business sector, with significant proportions flowing to the household sector and the public enterprise sector; the former component was growing, the latter declining.
The structure and operating environment of the banking system also changed. Following the nationalization of the major economic units in the 1960s, the Egyptian banking system remained small and under the control of the public sector. In the 1970s the banking system was centralized in eight banks, of which four were commercial banks and the remaining four specialized banks. As part of the infitah policy, a banking law was enacted in 1975 (Law 120/1975) that identified three types of banks:
1 Commercial banks, which could accept deposits and provide finance for a wide variety of transactions.
2 Business and investment banks, which carried out medium- and long-term operations, such as the promotion of new businesses and the financing of fixed investments. They would also be allowed to accept deposits and to finance foreign trade operations.
3 Specialized banks, which would support specific types of economic activity; for example, the Principal Bank for the Development of Agri-culture and Credit (PBDAC), which was designed to channel credit to the agricultural sector.
The banking system expanded rapidly and in 1985 consisted of 83 banks, of which 74 were private. The latter included 23 branches of foreign banks and 24 local banks. However, despite this plethora of banks, the system continued to be dominated by the four public sector commercial banks which accounted for nearly 75 percent of deposits and about two-thirds of loans. Starting in 1990, several reforms were introduced that liberalized many aspects of the banking sector. During the 1990s, some consolidation of the banking system took place and a number of joint-venture banks were privatized. As a result, at end-2000 there were 63 banks registered with the Central Bank of Egypt. These included 28 commercial banks, 31 business and investment banks, and four specialized banks. The four
public sector commercial banks continued to dominate the banking scene, with about 70 percent of deposits and almost 50 percent of loans.
As part of the ERSAP adopted in 1991, Egypt introduced a number of reforms in the banking sector: The principal measures were the following.
Interest rates on the Egyptian pound were liberalized. Foreign exchange controls were significantly reduced and the different exchange rates were unified at the level of the most devalued rate. Credit ceilings were abolished in October 1992 for the private sector and in July 1993 for the public sector. The unremunerated reserve balances held at the CBE were brought down to 15 percent of a bank’s total Egyptian pound deposits.1 The required reserve ratio on foreign exchange deposits was brought down to 10 percent; moreover, these reserves were remunerated.
The liquidity ratio was reduced to 20 percent for local-currency and 25 percent for foreign-currency balances. Capital adequacy ratios for banks were brought into line with the Basel Accord.
Further reforms continued in subsequent years – in 1997 the Central Bank required all banks to publish financial reports on the basis of Inter-national Accounting Standards (IAS), and in 1998 legislation was enacted permitting the privatization of the public sector banks. The joint-venture banks started to be privatized. The public sector banks were required to reduce their ownership in joint-venture banks to a maximum of 20 percent; by June 2000, state ownership in 15 (out of 23) of such banks had dropped below 20 percent of capital.
Credit facilities granted by commercial banks to public sector com-panies and to the private sector were limited to 65 percent of the total of deposit balances and equity (paid-up capital and reserves). Claims of com-mercial banks on the household and trade sectors put together were not permitted to increase by more than 12 percent a year. Commercial banks were not allowed to finance the import of consumer durables. However, for several years the effectiveness of these ratios and credit ceilings was limited because the penalties for their violation were relatively minor.
How did the various groups of banks perform after liberalization? Table 7.1 shows some key measures of performance for three groups of banks:
the public sector commercial banks, private banks, and specialized banks.
The greater each ratio in the table, the more profitable is the bank, other factors being equal. In general, private banks performed better than the other bank groups, with the profit margin and the return on equity being particularly high. The high profit margin, defined as the ratio of net income to total operating income, indicated that private banks were more efficient at controlling expenses. This contributed to the higher return on equity, measured as the ratio of net income to equity. The private banks also showed a higher return on assets (measured as net income per unit of assets).
The interest margin (the ratio of net interest income to earning assets), is a summary measure of net interest returns on income-producing assets.
El-Shazly (1999, 2001) explained the relatively lower interest margin in private banks as being at least partly due to a smaller loan portfolio rela-tive to the deposit base. The low interest margin of the public sector banks reflected nonaccrual of interest on a large volume of non-performing loans to state-owned enterprises. The specialized banks were able to post higher interest margins because they were able to borrow lower-cost funds from state-owned financial enterprises (i.e. their interest expenses were artificially lowered).
The role and working of the Egyptian financial sector during 1960–2000 raises a number of important issues.
How effectively did financial sector policy contribute to the development of the economy?
The answer must be: “Only moderately well.” This resulted from four factors. First, the relative size of the sector remained limited. Between 1960 and 2000, the financial sector developed in complexity and in the absolute values of its various components. However, by some important measures the growth of the sector fell short of the requirements of the economy. For most of the 1990s, money supply broadly defined (i.e. M2) grew more slowly than GDP, so that M2:GDP was falling and the ratio at end-2000 was lower than a decade earlier.
Second, for most of the three decades 1960–90, the Egyptian financial system was subject to repressive policies. Financial suppression, sometimes termed “illiberal finance,” is characterized by administrative control on most interest rates and over the allocation of credit to particular sectors, the taxation of the banking sector through unremunerated reserve requirements that are well in excess of that required on prudential grounds, repressive controls on new entry into banking, direct ownership of banks by the state, and tight controls on external capital movements.
Table 7.1 Measures of bank performance, 1991–2000 (period average, in percent) Public sector Specialized Private commercial banks banks banks
Return on equity 5.6 2.8 18.5
Return on assets 0.2 0.2 1.3
Profit margin 2.4 2.4 14.4
Interest margin 0.7 3.7 1.1
(Provisionsequity)/assets 11.1 13.7 17.4
Deposit growth 11.9 11.1 12.8
Source: El-Shazly (2001) [updated].