The Impact of Government Expenditure on the Private Sector in Egypt Since the Revolution:

Does it or does it not lead to crowding out

Eslam Hendawi

900211127

The American University in Cairo

ECON 3021: Intermediate Macroeconomic Theory

Fall 23

Dr Ahmed Sabry Abou-Zaid

Saturday, December 16th

compared to the preceding thirty years (Haikal et al., 2021). This was accompanied by a

structural change toward more reliance on foreign debt. The main conclusion is that

government and households borrowing from the domestic banks in Egypt led to over

one-to-one crowding out of private business credit (Haikal et al., 2021). The idea that

private sector credit is being displaced by government borrowing is a common topic in

discussions of policy for both developed and developing nations. In general, there are

three ways to discuss the overall impact of fiscal policy according to economic theory.

Keynesians contended that increased government expenditure stimulates economic

activity and pushes private investment closer in. The neoclassical school of thought, on

the other hand, maintained that more government spending inevitably crowds out private

expenditure. The crowding-out effect is attributed by the Neoclassical Theory of

Loanable Funds to the public deficit's upward effect on interest rates, which serves as a

mechanism to bring the capital markets into equilibrium (Haikal et al., 2021). This rise in

interest rates discourages private investment and contributes to the employment and

output short-run volatility that happens gradually. Furthermore, the rise in the public

deficit is linked to private investment by the Ricardian Equivalence Theorem. It contends

that an increase in the deficit will result in more taxes in the future to narrow the gap,

with no change on private expenditure (Haikal et al., 2021). However, an increasing body

of research indicates that the Ricardian Equivalence does not apply to developing

economies. In this paper, I intend to dissect multiple research papers on the manner and

decide which theory from the abovementioned theories occurs in Egypt.

When government borrowing rises and investment spending falls, it is known as

crowding-out. Crowding-out was first linked to rising interest rates as a result of

borrowing, but it has recently expanded to include a variety of pathways that may result

in little to no change in overall production, if any. However, the data that is now available

demonstrates how little there is of a relationship between equilibrium interest rates and

government borrowing. It is anticipated that this relationship will be considerably weaker

in developing nations where the central bank has frequently set interest rates

administratively and where the financial sector, particularly the banking system, has

historically been the target of significant government interventions. In the event that

market clearing does not dictate interest rates, the "quantity channel," or credit

availability, would be more important in understanding the effects of government

borrowing on private investment rather than the equilibrium interest rate .

Government Borrowing:

With the commencement of the revolution in January 2011, governmental spending rose

significantly while revenue growth slowed down. As a result, the overall budget deficit to

GDP has sharply increased, reaching 10.8% in 2011/2012 and 9.8% in 2010/11 (Shetta &

Kamaly, 2014). The government mostly relied on domestic funding sources, including the

CBE, the banking industry, and other non-bank organizations like the National

Investment Bank (NIV) and Social Insurance Funds, to cover this growing budget deficit.
Interest payments were elevated to 17.6% as a result of the government issuing more debt

papers to cover the growing deficit and the higher cost of borrowing as a result of Egypt's

credit rating being downgraded (Shetta & Kamaly, 2014). Excessive domestic

government borrowing led to an increase in public debt to 80.6% of GDP in 2012, from

76.2% of GDP a year earlier (Shetta & Kamaly, 2014). More than 80% of the

government's budget deficits were formerly covered by the domestic sector; however, in

2010–11, banking financing significantly increased to offset the decline in non-banking

financing (Shetta & Kamaly, 2014). 2011 saw a considerable acceleration in the growth

of domestic credit, rising at an annual pace of 22.65% as opposed to 7.8% in 2010. In

2012, this pattern was predominant due to the lack of notable foreign involvement in

regional debt markets. This encouraged domestic banks to add more securities issued by

the government to their portfolios. The banking sector's balance sheets demonstrate the

expanding size of the government: the banks' total claims on the government rose from

30% in June 2008 to 49% in June 2011, with the share of claims made in local currency

becoming even more important at 60% by the same month. The primary cause of this

increase is the 28% growth in T-bill and government securities investments between

December 2010 and 2011. Conversely, the percentage of bank claims from the private

sector decreased from 65% in June 2008 to 47% in June 2011 (Egypt, 2023).

Due to the downturn in economic activity and domestic banks' unwillingness to continue

lending to the private sector in an effort to keep their balance sheets as liquid as possible,

there has been a modest expansion in credit to the private sector (Arab Republic of Egypt

and the IMF, 2023). As a percentage of GDP, the banking sector's claims against the
public and private sectors have distinct trajectories, particularly since 2009. This

straightforward time series plot appears to show a very substantial negative correlation

between government borrowing and private credit.

Also, assessing the banks’ lending capacity, shows that the growth rate of banks’ lending

capacity has continuously surpassed that of total loans in Egypt. This is a case where the

banking sector could be populated by “Lazy banks” (Egypt, 2023).

Conclusion:

In summation, it is evident that the current state of public spending and its anticipated

trend in the near future are unsustainable, or at most will have significant long-term

social and economic implications. Furthermore, borrowing at a rate higher on the

domestic market than the foreign one strains the budget further and increases the risk of

crowding out, or squeezing out, the private sector's access to available money. According
to the World Bank, credit to the government offers the banking industry an alternate use

of funds, which accounts for the majority of the fall in credit to the private sector,

notwithstanding the present recessionary period's declining demand for credit (Egypt,

2023). Therefore, a fiscal adjustment will entail a return of credit to the private sector.

Given the significance of the private sector during Egypt's crucial period, much work

needs to be done to improve credit availability and spur economic growth. Therefore,

given the tightening budgetary constraints brought on by the rigid expenditure structure

and the stagnant revenues following the revolution, it is now more crucial than ever to

determine which portfolio of public expenditures in Egypt leads to economic growth and

to determine whether the debt-financed deficit crowds out the most necessary private

investment. It can clearly be concluded from the critical analysis in this paper that the

Neoclassical theory prevails, the theory that states that increased government borrowing

definitely leads to crowding out.

1) Shetta, S., & Kamaly, A. (2014). DOES THE BUDGET DEFICIT CROWD-OUT

PRIVATE CREDIT FROM THE BANKING SECTOR? THE CASE OF EGYPT*. 16(2).

https://meea.sites.luc.edu/volume16/pdfs/Shetta-Kamaly.pdf

2) Haikal, G., Abdelbary, I., & Samir, D. (2021). “Lazy Banks”: the case of Egypt.

Macroeconomics and Finance in Emerging Market Economies, 1–11.

https://doi.org/10.1080/17520843.2021.1998743

3) Haikal, G., Abdelbary, I., & Samir, D. (2021). “Lazy Banks”: the case of Egypt.

Macroeconomics and Finance in Emerging Market Economies, 1–11.

https://doi.org/10.1080/17520843.2021.1998743