Egypt Financial Policy for Adjustment and Growth Volume 11 FinancialIntermediaries September20, 1993
CountryDepartment 11 (MN2) CountryOperations
Public Disclosure Authorized Middle Eastand North Africa Region FOR OFFICIAL USE ONLY
00 Public Disclosure Authorized
in D ... f oi Public Disclosure Authorized
- I . ) C
* I2 S1
'isclosed without World Rank authcgization Public Disclosure Authorized CURRENCY EOUIVALENTS
Currency Unit - Egyptian Pound (LE)
LE per US Dollar (average)
1991 3.009 1992 3.323 August 1993 3.348 (actual)
FISg& YEAR
July 1 - June 30
LIST OF ABBREVIATIONS
BCCI Bank of Credit and Commerce International BCCM Bank of Credit and Commerce Misr ChO Central Audit Organization CAPMAS Central Authority for Public Mobilization and Statistics (Central Government's Bureau of Statistics) CBE Central Bank of Egypt CLG Central and Local Government CMA Capital Market Authority CML Capital Markets Law CSI Contractual Savings Institution Da Defined Benefit DC Defined Contribu:ion DDSR Debt Debt Service Relief DFI Direct Foreign Investment ECAs Export Credit Agencies EGPC Egypt General Petroleum Corporation EIAA Egyptian Institute of Accountants and Auditors EISA Egyptian Insurance Supervisory Authority EPF Employees Provident Fund ERs Executive Regulations ERSAP Economic Reform and Structural Adjustment Program FRBNY Federal Reserve Bank of New York GAFI Investment Authority GASC General Authority Supply Companv GASI General Authority for Social Insurance GCFCG Gulf Crisis Financial Coordination Group HCs Holding Ccmr,any HDB Housing Development Bank IICs Islamic Investment Companies ISCs Income Subject to Contribution MIs Management Institutions MOE Ministry of Economy MOF Ministry of Finance MHPU Ministry of Housing and Public Utilities NBE National Bank of Egypt NIB National Investment Bank FOR OMCIAL USEONLY
NOIP National Organizationfor Insurance and Pensions 0N0 Open Market Operations PAo Public Economic and service Authorities PAC Pension AdministrationCommission PAPFs Private Alternative Pension Funds PAYG Pay-Au-You-Go PBDAC Principle Bank for Development and Agricultural Credit PCPFU Private ComplementaryPension Funds PER Public Enterprise. PRO Public Enterprise Office PFe Pension Funds PFMSo Pension Fund Management Institutions POS Point of Sale RC Risk Classification RCC Risk ClassificationCommission wrepo,w Reverse Transactions SAL Structural Adjustment Loan SAMP Structural Adijustment Monitoring Program SBA Stand-by Arrangement SCG Subject to Contribution SIMICs Social InsuranceManagement Institutions Commission SI5 Social Insurance System TB. Treasury Bills TPL Third-Party Liability VAT Value-Added Tax
GLOSSARY
Defined Benefit Pension Plan - Pensions are determined by an actuarial computation that incorporates salary and years of service.
Defined ContributionPension Plan - Pensions are solely determined by the accumulatedcontributions to an individual account and on the investmentperformance of tha fund.
Moral Hazard - Individual causing a deliberate loss in order to collect the proceeds of an insurancepolicy.
Morale Hazard - Attitude of indifferenceto loss created by the purchase of insurance.
Pay-as-you-goPension Plan - Benefits received by current retirGea are equal, on average to uontributionsby current active workers.
Saving - Rate of wealth accumulation.
Savings - Stock of financial assets.
This document has a restricted distribution and may be used by recipients only in the performance of their officialduties. Its contents may not otherwise be disclosedwithout World Bank authorization. PREACE AM ACKNLDGM S
This report presents the findings and conclusions of a World Bank mission that visited Egypt in late September and early October of 1991 to study financial policies and intermediationin the country. At the request of the Government of Egypt, the report presents an analysis of the main issues impairing efficient resource mobilizationand allocation The work program was designed to provide analytical support tv the policy reform program that the Egyptian Government has initiated in this important area. It was executed as a collaborativeeffort between the World Bank team and a group of counterpartsin the Egyptian Government. The recommendationsare directed at: (1) improving the policy environment; (ii) increasing the solvency and efficiency of financial intermediaries;(iii) increasing equity in the social insurance system; (iv) correcting labor market distortions;and (v) providing appropriate mechanisms to help develop a market economy.
Volume I presents the Executive Summary and the Policy Environment;Volume II covers the analysis of Financial Intermediaries. These volumes are intended primarily for Egyptian policymakers. Volume III contains the StatisticalAppendix and the Technical Annexes. Finally, it should be noted that this report does not cover the analysis of sector credit agencies (PrincipleBank for Development and AgriculturalCredit (PBDAC),Housing Bank, etc.), which will be undertaken in future sector-specificprojects.
The Bank team wishes to convey its appreciationto the Egyptian authoritieswho kindly provided valuable informationand support, especially to the Governor of the Central Bank of Egypt, H.E. Dr. Mahmoud Salah el din Hamed; the Minister of InternationalCooperation; H.E. Dr. Maurice Makramallah;the Minister of Cabinet Affairs and AdministsativeDevelopment; H.E. Dr. Atef Mohamed Ebeid; and the Economic Advisor to the Prime Minister, Dr. Youssef Boutros Ghali. The mission also met with officials from the Central Bank of Egypt, the Prime Minister's office and the Ministries of Finance, Interior, Economy, Planning, and Soclal Affairs and Insurance; CAPMAS; the Public Sector InformationUnit; and the National Investment Bank (NIB). The mission also met with public sector banks and insurance companies, as well as with private sector representatives: businessmen,bankers, insurers, economists, lawyers, accountants,auditors, tax experts, actuaries, trade associationsand professors from Cairo University and American University. In addition, the mission met with representatives of the donor community. In general, all parties were extremely interested in and supportive of the study.
The World Bank team contributingto the report consisted of Messrs.\Mmes.: Alberto R. Musalem (team leader, Chapter I and co-author to Chapters II, VII, VIII, X, XI and the NIB section of Chapter IX); Marcelo Giugale (issues on financial liberalization);Klaus Schmidt- Hebbel (domestic saving mobilization);Erik Nielsen (foreign resource mobilizatinn);Mark Gersovitz,Roger Gordon, and Joel Slemrod (the taxation of financial intermediation);Dimitri Vittas and Asli Demirguc- Kunt (the banking sector and the NIB section of Chapter IX); Luis Valdez (the insurance market); Gary Burtless (social insurance and a proposal for reform); Juan Ariztia (pension funds); and Robert Mertz and Robert Pardy (the securitiesmarket). Antony Thompson assisted in the compilation of the Gray Cover.Report. Valuable comments were provided by Professor Lawrence Kotlikoff of Boston University. The team was supplementedby: Fernando Batista (technicalsupport); Jo Bishoff (editor); Neda Pirnia (researchassistant); Jim Cantrell (computer systems); Lourdes Rasmussen,Marie Rebueno, Nancy Ribeiro and Hoda Rizkalla (word processing).
- it- EGYPT
FINANCIAL POLICY FOR ADJUSTMENT AND GROWTH
VOLUME I - POLICY ENVIRONMENT
TANI& OF CONTENTS
Paaa He. EXECUTIVE SUMMARY OVERVIERJ...... xxi Backr-grzn-d- The Economv...... xxill RfecentEconomlc PerformanMc...... xxil Financial LLberalizationand The Seaecioo of the ReforM Program...... xxiv Domestic RegsourceMobilization under Financial Reform and Stabilization ...... xxv. Foreign Resource Mobilization ...... xxviii Taxation of Financial Intermediation...... xxviii Possible Tax Reforms...... xxix The Pure Alternative of ExemDtina Capital Income...... xxix A Variant of the Pure Alternative System . . xxx The Ootion of a Classic Income Tax . . . . . xxx The BankinaSector...... xxx Increasing the Conte2tability of Bankina . . xxxi Removino Economic Reaulation...... xxxii Strengthenina Prudential Reoulation and suvervision...... xxxii Enhancing the Ooerating Efficiencg of Banks. xxxii TheIjnsuranceSector...... xxxill Short-Term ActionPlan...... xxxiv MedLum-and Long-Term Action Plan...... xxxlv The Social Insurance Syste ...... xxxv Prooged Technical Reforms ...... xxxv1i Private Pension Plans ...... xxxvll Status of PFs in Eayot ...... xxxviL General Rules to Pension Funds ...... xxxvili A Pro2wsal for Reformina the Soclal Insurance and Pension Systems...... xxxviii The Future Role of the National Investment Bank...... xli The Secur&ties Market ...... xli$ Government Reform Aaenda...... xlili TaxatLon...... xlii
BranfLng ...... xliv 5ocial Securitv...... xliv Private PensLon Schemes...... xlv CaRital-Market Reforms ...... xlv
CHAPTER 1 INT,RODUC.P2...... 1 Flnanclal IntermeaLjjatLon ...... 1 Financial Policy - overview ...... 2 - iv -
BacSkaround-!JheEconomY ...... S ExternalDebt .o...... 7 Imolementationof tha ERSP ...... 8 Recent Economic,Perfgrmane ...... 10 Scone of the Renort ...... 11
CHAPTER II ISSUES ON FINANCIAL LIBERALIZATION ...... 15 Introducti2n ...... 15 The Balance of Paymentes inflation and Devaluation ...... 15 Monetarv Policy -- Intu°ad Interxvntion . 18 Monetary and Excha:ige Rate Policies ...... 19 Monetary Instruments ...... 9. .9 . 9 . . 19 Open Market Operations ...... 20 Reversed Tr-nsactions t"reoos"9 . . . . . 21 Bank Specific Credit Ceillnag . . . . . 21 ReServe ReouireMents ...... 21 Discount Wndow ...... 22 Shiftina Public Sector Deosit ...... 23 The Informatlon System for Monitorlng Policy . . 23 Portfollo Shifts and Risk Management ...... 24 Possible Fcical Implicatir,piof Financial Libera;ization...... 29 The Real Public Sector and FLnancial LLberalization ...... 31 Financial Liberalization and The Beauencing cf the ReformProcess . . . . . * . . . . * . .. 35
cH"TER III DOMESTIC RESOURCE MOBILIZATION UNDER FINANCIAL EFORM MMD STABILIZATION ...... 39
Introduction...... 9 * * * . * . . * . . 39 Historical Pattern of Savino and Investment . . . 40 Domestic and National Saving Rates in Egypt and Other Developing Countries ...... 40 Investment-SavingBalances...... 42 Government Deficits: Financina and Sustainabilitv ...... 43 Government Deficits and Financing ...... 46 Deficit Financing, Einancial RepreLsson and Inflation Tax ...... 49 StabilizatLon, Flnancial Liberalization, and Sustainable Deficits ...... 52 Private Consumption Behavior...... 57 Impact of Financial Reform and StabilizatLon on Private and Public Savino...... 59 Conclusions and Policy Implications ...... 61 References...... *. . 65
CHAPTER IV FOREIGN RESOURCEMOBILIZATIOt ...... 69 Introduction ...... 69 The Loss of Creditworthines...... 70 Early Measures to Address the Debt Overhana . . . 75 - V -
The Four Public sector Banks' Buy-back Operations...... 75 The Debt ConversionProgram...... 77 ZFLnl and~re2hensive oDerations to Eliminate the Debt Ovghana ...... 79 Forsiga Reserve Manaement...... s80 o InvestmentObjectives and Strategy ...... 81 CurrencyRisk ...... 81 UsuidUX . * * * * * . * * . * ...... 81 Interestfate R . . ...* . .. . . 81 Investment Horizon and PRtfolioRLtu=rn . . 82 Credit Risk ...... 82 Settlement, Accounting and Internal Controls . . 82 Kev Parameters fog a Return to Creditworthiness. 82 concluseions.i**. . . - . 0 . -. 0 0 0 . * 88
OUCHAPTERVITAXATION OF FINANCIAL INTERMEDIION ...... 91 Tax Treatment of Direct,Investment in a corporatian ...... 92 Purchase of New Equity ...... 92 Purchase of Corporate Bonds...... 100 Finance Through New Share Issues or Retentions . 103 Investment,Throuh Commercial and Industrial Eartnershin...... 104 Investmentby_ CoroorationsLn Cor -oration. . . 106 Taxation of Investments Through Finangial Intermediaries&...... * . . . . 107 Investment Through Banks ...... 107 Investing Through InsuranceCompanies . . . . . 110 Investing Through Pension Funds ...... 111 ConsumptLon Tax Treatment of Pension Accounts. . 112 Mutual Funds (Law 146 Companies) ...... 113 Investments In Eogt Funneled Through ForeLan Fira...... 113 Efficienov Imolications of the Existing Tax
Distotion ...... * 115 Possible Tax Reforms to Lessen or Eliminate These Distrions ...... 117 The Pure Alternative of Exempting Interest Income...... 118 A Variant of the Pure Alternative System . . . . 119 The Option of a Classic Income Tax . o . . . . . 121 Tax Treatment of Financial Intermediaries . 123 Leasina Eauiment ...... 123 Government Tax Reform Program...... 124 - vi -
VOLUME I: Fiuures and Tables
Figure 11.1a Annual Changes in Bankina S jg Agsets as a Percent of Bruad Monsv Held b' Private Sector ...... *.. . 16 Fiquro X1.2i Real Interest and Exchano,a Rates Semi-annual.in Percent Per Annum . . . . . 20 Figure 11 3s US Dollar Real Exchanae Rate .Index !...... 26
Piture 11.4t Interest and Inflation Rate Differentials ...... 27 Figure 11.5: Real Interest Rate ...... 28
FLouSr 111.1s Gross Domeatic Saying and Grose National Savino Ratios in Eaypt (1959/60- 1990/91) and 83 Develoning Countries11960-1988) ...... 41 Figgure111.2: Public and Private Consumvtion Ratloes 1959/60-1990/91 ...... 45 Floure 111.3s Public and Private Fixed Caoital Formation Ratiost 1959/60-1990/91 ...... 45 icaure III.4: Government Primary Deficit Financina (for Fiscal Years 1988/89. 1989/90. and 1991J92 ...... 53 Picoure 111.5: Investment-Savina Balance by Sect...... 62
Fiaure IV.1 Percentage Distribution of ExternalFundinq...... 73 Fioure IV.2s Composition of Short Term amn MediLmand Lona Term Debt ...... 74
Table 111.1: Consolidated Government Bfludaet-NIB-CBE):Deficit Financinu. gutstandinaLiabilities. and Interest Rates . 48 Table 111.2: Inflation Tax. SeionoracaeRevenue and Financial Reoression Tax in Eavot and Other Developina Countries ...... 52 Table II1.3s Goyernment Deficit Financingj Todav and After Stabilization and Financail Reform. . . . . 55 EGYPT
FINANCIAL POLICY FOR ADJUSTMENT AND GROWTH
VOLUMEII - FINANCIAL INTERMDIARIES
TABLE OF C=NTR
Barriers to Entry ...... 4 Licensing of HUw Banka...... 5 Branching Reotrictin...... 5 Foreian Bank Entry ...... 5 Restrictionson Types of -Atvities. * * * Removina Barriers to Entry ...... 9 Barriers to Exit...... 9 Exit Mechanism...... 9 De22sitInsurance...... 10 Credit Controls and Portfolio Restrictions. . . . 12 Reserve and L.auiditX Reauirements . . . . . 12 Bank-Specific Credit Ceilings...... 13 Interest Rate and Other Price Controls...... 13 Interest Rate Controls ...... 13 controls on Tariff Scheules ...... 14 Taxation of Interest Income ...... 14 Prdential Reoulationand Bankina Suoervision . 15 Prudential Regulation ...... 16 gap1tal1/OcuYacy ...... 6 Risk Concentrations ...... 17 Loan Classification and Provisioning . . . . 17 Foreion Currency Exnosure...... 18 Islamic Bankina...... 19 BankingSupervision ...... 20 Suoervisorv Authority...... 21 Licensing and Corporate Activyitijg . . . . . 21 OnsiteExamination ...... 21 OffaiteSurveillance ...... 22 Powersof the CBE...... 23 Incentive Structure...... 24 InformationDisclosure and Bank Secrecy. . . 25 Financial Condition of the Eovotian Bankina System ..o...... 25 Competition and Market Structure...... 26 Market Structure...... 26 Mlarket Segmentation and Com-etition. . . . . 27 Layal Playina Fil21d...... 29 Operating Efficiency...... 30 ogeratinaRatios ...... 30 Branchina and Staff Levels ...... 33 Solvency and Liquidity. . . . . ; ...... 34 - viii °
S...... 34 iditty * * ...... o . . 3S Managerial Autonomy of Public Sewtor Banks . . . 36 Qm1suiono. . * . .* ...... * .* *. 37 Proposed Reform Program...... a . . . . 37 Phase I ...... * . * * 37 Phase II ...... o. . . . 39 Items Impl.mentud and Ongoing ...... 40 Government Reform Program.* ...... 41 References ...... 42
CHARTER VII XXE INSIMbCE yuUR5T . . . 43 Introxhlction . . . . . * ...... , . 43 The Inurangce Industry in EaoRt ...... 46 Market Structure ...... 47 InsuranceCompanles...... 47 InsurancePools...... 48 Government Insurance Fund...... 4 Private InsuranceFund ...... 49 Intermediariesand Auxlllarles ...... 49
3ntermediarig ...... *. F . 49 SurveX Experts and Los Adiusters . . . . . 50 nd-tr _,velonmentand Market Share. . . . . 50 Performance Indicators ...... 52 Non-Life Insurance ...... 52 Life Insurance . . . . . 53 Solvency ...... 54 eneralAn lvsis ...... S. The Rationale for Insurance Regulation . . . . . 55 Thz Regulatorv Framework in Eavmt...... 58 Regulatory Issues...... 59 Baxrlersto Entry ...... 60 Price Control ...... 60 InvestmentReuirements ...... 60 ReinsuranceControl ...... 61 gapiLtal Reguirements...... 61 Technical Reservee...... 62 MathematicalReserves ...... 62 SolvencyMaraine...... 62 Prcductso ...... 62 Compulsory Rates...... 62 Compulsorv Motor Act...... 63 Analysis of Regulatory Issues...... 64 Recommendations for a New ReauLatorv Framework . 65 The Concept of Sovency .ontrol ...... 66 Necessary Conditions for Solvency Monitoring . . 68 ProRosed Action Plan . . . - . . . & . . . . 69 Short-Term Action Plai ...... 69 Medium and Long-Term Action Plan (Strenthening EISA) ...... 71 A New Insurance Law for Egypt...... 72 Government Reform Program...... 73 - ix -
CHAPTER VIII MAIN UES la SOCIAL INSUACE AND PNSO ECONONIQ ...... a. . ... 75 The ImDact on National Savino ...... 76 The Promotion of Long-Tprm Savins...... 77 Figcal Effegts and Interasnerational Tranosfrs. , 77 Effects on ato and Pruct Maket . . . . . 79. Effects on AQUitv ...... , . . . . * . SO Ejffct on inAni. . 1I...... Domestic Public Debt urndMaturity...... SI International Experience with Contractual sayine,z . o . . o . o . o 9. . t . . 82
CHUTER XX THE SOCIAL INSURANC SYSTEM lN T NATIOA INVESM,NtiBK. . . .B...... 87
Thrg!jSialov.tem Insurance ...... 8 Administration and Coverage . . . e ...... d8 Social Insurance Taxes.* ...... 89 CoveredWages...... o ...... 9 The Self-Emploved...... 90 Eligibility for Benefits...... * 90 Benefit Formulas...... 93 Reference Waae ...... 93 Treatment of Inflation...... 93 Inflation Prior to Retirement. . . . . * . 94 Inflation After Retirement ...... 97 Summaryv...... 97 Actual Benefit Levels ...... O101 Wage and Pension Ditribtuton...... 101 Benefit Trends ...... * ...... 101 Redistribution under Social Insurance. . . . 102 Financial Condition ...... e 104 QoeratinaSuroluses...... 104 General Authoritv Balance Sheet...... 105 National Organisation for Insuranac and Pensions...... * . 106 Analysis of Short- and Long-Term Costs...... 107 DeRend!-_cv Ratio ...... a .. * .107 Outlqo . E...... 107 Outlook for Coverage ...... 111 Princi2al Problems in-the System...... 112 Basic and Variable Waaes . . o ...... 112 Inflation...... 112 Early Pensions...... 112 Low Return on Social Insurance Reserves. * . 113 Inadequate Information for Sound Proaram Manaement...... 113
Possible Reform . . . . . * . * . * . . .* * . 114 Basic/Variable Waae Disti etion...... * 114 Improved Inflation Adiustment...... 115 Lower Contribution Rates ...... 115 Early RetirementProvisionl...... 115 -x -
Governme t Reform Program...... 116 The National Investment Bank ...... 116 The Future of the NIB...... 119 The General Case for Credit Market Intervention. 119 The Form of Intervention...... 120 A Bank for Public Works and the Social Sectors . 122 Summary ...... 123 r:El X lRIVATE PENSION PLA .S. . . . . *...... 127 Introduction...... 127 Penpio2n and Private Annuity Markets ...... 128 Tvzoo of Private engsion Plana ...... 130 Peneion Fundo (PFI) and the Development of Canital Markets ...... 132 Regulatory Framework ...... 133 Status of PF in Evovt ...... 135 Private Complementary Pension Funds (PCPFe). . . 136 LM1 Definitions and-Reaulato Framewark. 136 Aechnlcal Reforms of Actuarial Overslght. . 136 Investments...... 136 Instrument Dlverslflcatlon...... 137 linimumRequired Investment ...... 137 Reforming Diversificatlon Standards . . . . 137 Issuers Diversiflcatlon ...... 138 Ex-ante Authorizatlonfor Transactions. . . 138 valuation of Financial Instruments. . . . . 138 Financial Monitoring ...... 138 TransactionControls ...... 139 Formal Market...... 139 Develooment of PCPFs in Egoyt ...... 139 Beneflts...... 140 Requized Contribution ...... 141 Portabs1sty 7 ...... 141 Private Alternative Pension Funds (PAPFe). . . . 141 RegLigtgation...... 141 Financial Monitorin...... 142 Investments ...... 142 Benefits ann Reauired contgibutions * * * * 144 Old Age Penslons...... 145 Portabilitv ...... 145 General Rules to Pension Fund Investment . . . . 145 Risk Classification (RC)...... 145 Physical Custody of Financial Instruments . 146 Investment Diversification Rules...... 146 Instrument Transaction Rules...... 147 InstrumentTransactions Control and Supervision...... 147 Valuation of Instruments...... 147 Indexation of Instruments ...... 14S Rate of Return of Instruments ...... 148 Reoulatorv Refo-m ...... 149 Plan Formation ...... 149 *.xi -
Adminestratign...... 149 Benefts. o . o . o . o o 150 Vestlnc...... 150 Portability ...... 0 ...... 0150 Terms of Payment . . . .- ...... 150 Indexation ...... 151 zFundin nv...... 151 FutllSs* *@ e @@ @ e * ** ** v151 InvestmentRules ...... 151 PlanlerMination ...... * . . * 151 Reaulatory and Supervslaorv Acency.. .. .151 sUerFvisionand Control...... 152 InformationDisclogur ...... 152 Tax Treatment ...... 153 Timin.g ...... a. . 153 Government Reform Program ...... 153
CHAPTER X &APROPOSAL FOP REFORMING THE EGYPTIAN INSURANCE AND PRIVATE PENSION SYSTEMS...... 155 Ouervewof Bs System ...... *. 155
Advantaaesof the Refomed Sy.tem ...... 158 The Reformed System ...... 160 Basic Public System...... 16a TransitionProblems...... 166 CoomRulsorvPrivate Pension Scheme...... 166 Transitional Problems...... 167 Fiscal Imolicationsof the Reforms . . . . . 168 Voluntary Contributions to Pension Funds . . 170 ReaulatorvFramework ...... 170
CHAPTERxII THESECURITIES MARKET ...... 171 Intr,oducti2a...... 171 Historical DevelonMent of the Securities Market . 171 Summar.. . .' ...... 171 Prior to Nationalization ...... 172 Nationalization...... 173 Reactivation of the Securities Market ...... 174 Listing of Foreicn Currency-Denominated Shares...... 175 Listina of Closelv Held Companies...... 175 Lack of Market Liquiditv ...... 176 Inactive Institutional Portfolio Management. 177 Limited Number of Investors...... 177 Com2arison with International Markets. . . . 177 Leagil and Institutional Imyediments and a ReformAcenda...... 179 Capital Markets Law and Executive Regulations . . 179 General Structure...... 179 Information Disclosure . . . . e . . * * * * 179 Tender Offers...... 180 Stock Exchanees...... 180 - xiL -
Liceneing of Intrmediaries.. , ...... 180 PrudentLal Reoaulation...... 180 Civil LiabLiLty and-_egQge ...... 181 Supervisory Capacity...... 181 Securities Market Operations...... 181 Stock Exghana2 Ownerohlo ...... 181 Unlfication of the Market...... 181 Lietina Reauirea'ents and Fee Structure . . . 182 SfiecuritiesTradlna ...... 182 Clearance and Settlement ...... 182 CustodialSeriesL.e ...... 9.9. 183 Intermediaries...... 183 Incor2oratLonand Foreian Competition. . . . 183 Commlosions and Fees ...... 183 Record-keeDLnaand Client Protection . . . . 184 Accounting Standards...... 184 Mutual Funds...... 185 Supply of Corporate Debt...... 185 Cor-ludina Remarks...... 185
VOIUME II: Figures and Tables
Floure VIII.1; Public Domestic Debt Structure of Eaovt and OECD Countries ...... 84
Fioure IX.l: Effects of Inflation and Career Lenagth on Basic Pension Replacement Rate (Civil Servants). . 00. 0. 0...... 98 Fioure XX.2: Effects of Inflation and Career Lenoth on Basic Pension Replacement Rate INoncivilServants) ...... 99 Fioure 1X.3: Effects of Inflation and Career Lenoth on VarLable Pension Reolacement Rate . 100 Table 1X.1: Insured Population...... 89 Table IX.2: Social Insurance Contrlbution Rates 90 Table IX.3t Maturity Structure of NIB Assets and Liabilities ...... 118 Table 1X.4s NIB Loans Analysis...... 118 Table rX.5: NIB Qoeratina Ratios...... 119
Table X.ls PCPF Investment Diversificatign. . . 140 Table X.2: PAPF Investment Diversification. . . 144
Table XII.1t Cairo and Alexandria Stock Exchanaes: Turnover 1986-1990...... 175 Table X11.2: Stock Exchanae LLtina and Tradina by Tvye of Comoanv at December 31. 1990 . . . 176 Table XII.3: InternatLonal Stock Market Comoarators - 1990...... 178 EGYPT
FINANCIAL POLICY FOR ADJUSTMENT AND GROWTH
VOLUME III - APPENDIXES AND ANNEXES
TABLE OF CONTENTS
Annex I.1 ECONOgMTRIC ESTIMATE...... 3 Demand for Money ...... 3 Balanceof Payment ...... 5 Table ANII.1 - Econometri¢ Results, Money Demand and Balance of Payment Equations...... 8 Figure ANII.1 - Evolutlon of NomLnal Rates . . . 9 Table ANII.2 - IndLcators Used to Estimate Regressions of Table ANII.1 ...... 10
Annex 11.2 FOREIGN RESERVES MANAGEMENT- THE CENTRtL BANK OF EGYPT. . . .* * * *.* * .**. I11 Organizatlonal Structure ...... 11 InvestmentPollcy...... 11 AccountLng, Settlement and Control ...... 12 Recommendatlons: Immedlate Actions...... 13 Credlt Rlsk ...... 13 Currency Dlversificatlon ...... 14 Audlt of Internal Controls ...... 14 Management Reports ...... 14 Training Program ...... 14 Recommendations: Long-Term Directlons . . . . . 15 Investment Objectives...... 15 InvestmentProcess ...... 15
Annex III.,s a CONSISTENT DATA BASE FOR EGYPT ...... 17 Data Series ln Table AIII.2, Appendlx...... 17 Other Varlables for Private Consumption Functlon 18
Annex 11Z.l2 DETERMINANTS OF PUBLIC DEFICIT FINANCING . . . . 19
Anngx IIIJ_j pRIVATE CONSUMPTION SPECIFICATION AND ESTIMATION RESSLTS...... 21 Table ANIII.3.1 - Estlmatlon Results for Real Prlvate Disposable Income ...... 25 Table ANIII.3.2 - Prlvate ConsumptLon Estimation Results ...... 26 Table ANIII.3.3 - Grld-Search Results for Optimal Leads on Permanent Government SavLng. . . . . 27 - xiv -
Annex IV.Zl THE STRUCTURE OF EGYPT'S EXTERNAL DEBT . . . . .,29 Figure ANIV.1.1 - Debt to GNP Ratios ...... 31 Figure ANIV.l.1 - Debt to Export Ratios. . . . 32 Figure ANIV.1.3 - Interest to Export Ratios. . . 33 Figure ANIV.1.4 - Composition of Long Term Borrowings (disburoments) ...... 34 Figure ANIV.1.5 - Creditor Composition of LT Not Disbursements ...... 35 Figure ANIV.1.6 - Net Transfers (net disbursements - interest)...... 36 Table ANIV.1.1 - Creditor Country Composition. . 37
Ann2D V,2t- I.S8UI RELATING TO THE EGYPTIAN DEBT CONVERSION PROGRAM...... 39
Annex IV,.3 THE PARIS CLUB AGREEMENT, 1991 ...... 45 A. For concessional (ODA) debts ...... 46 B. For non-concessional (Non-ODA) debt: . . . . 48 Table ANIV.3.1 - Debt Service Payments Before and After the May 1991 Paris Club Agreement . . . 52
Annex IL.4L PLEDGING OF ASSETS AND FUTURE INCONE STREAMS 9 . 9 . 9 9 . . . . . 9 ...... 9 . . . 9 55 Introduction...... 55 A Liberal Exchange Policy System ...... 56 Economic Agent. Not Allowed to Hold Foreign Exchange Assets ...... 57
Annex V.ls CONSUMPTIONTAX TREATMENTOF SAVING ACCOUNTS . . 61
Annex VI.lt _ ...... 65 Introduction ...... * . . . . .65 Main Features of Deposit Insurance Scheme. . . . 65 Conclusions...... 68
Annex VI2z BANXING SUPERVISION AND PRUDENTIAL REGULATIONS . 69 Introduction ...... 0 .* * 69 Effective Supervision...... 69 Prudential Regulation ...... 71 Conclusions...... 73
Annex VI.3s OPERATING EFFICIENCY - EGYPTIAN BANKS . . . . . 75 operating asset rati ...... 75 operating income ratios ...... 78 Operating equity ratios...... 80 ROE analysis . 81 Conclusions...... 82 Table ANVI.3.1 - Operating Asset }. *_os. . . . . 84 Table ANVI.3.2 - Operating Asset Ratios. . . . .85 Table ANVI.3.3 - Operating Income Ratios . . . 86 Table ANVI.3.4 - operating Income Ratios . . . . 87 Table ANVI.3.5 - operating Equity Ratios . . . . 88 - xv -
Table ANVI.3.6 - Operating Equity Ratios . . . . 89 Table ANVI.3.7 - ROE Analysia...... 90 Table ANVI.3.8 - ROE Analysis...... 91
Annex VII.l: INSURANCE COMPANIES PERFORMANCE...... 93 1. EGYPT-RE: Company ratio ...... 93 2. MISR INSURANCE COMPANYs Company ratios . . . 94 3. MOHANDES INSURANCE COMPANY: Company ratios . 95 4. ARAB INTERNATIONAL INSURANCE COMPANY: Company ratios...... 95
Annex VII.2: MODEL ACT - CHILEN INSANCE LAW...... 97 Authorization...... 97 Activity Reserved for National Entties. . . . . 97 Unconstrained Inourance Abroad ...... 97 Characteristics of the Business ...... 97 Indebtedness Limits ...... 98 Suoervision ...... 98 Reinsurance ...... 98 Reinsurar.ceEntities...... 98 Reinsurance Brokers ...... 99 Technical Reserves...... 99 Investment Norms ...... 100 Eliaible Investments ...... 100 Limitations on Investments ...... 101 Model Texts of Policies and Clauses . . . .102 Prices. Premiums and Fees Freely Set . . . 102 Transfer of Portfolio Between ComPanies . 102 Classiflcation of Insurance Companies' obligations and Risks...... 102 Agents and Adlusters in the Insurance Business . 103 Insurance Brokers ...... 103 Claims Adjustments...... 103 Reoulation of Insurance Companies . . . . 103 Liauidation of Insurance Comoanies. . . . . 103 Settlements and Bankruptcv...... 103
Annex X.ls A REGULATORY FRAMEWORK FOR THE PRIVATE PENSION SYSTEM IN EGYPT ...... 105 Summary...... 105 System Benefits ...... 105 Manaaement and Operation of the System. . . 105 Pension Contributionby Members ...... 106 Pension Fund Investments...... 107 Risk Classification ...... 107 Control and Supervision ...... 108 General Rules...... 109
SECTION 1 ...... 110 PENSION-FUND INSTITUTIONS...... 110 Pension Fund Management Institutions (PFMI). . . 110 Minimum Canital ...... 111 - xvi -
,ca,sh Resrve ...... 111 Diologure...... 112 Commisions of Fee Pald to th- Manaqement Institution...... f * * * * * * Q 112 Informationto Members...... 114 PensLon Fundg ...... 114 Profitabilitv Reouired...... 115 Cusltody ...... 116 Indeoendent Members ...... 117
SEcTiOu 2...... l.i.e. . . 118 PENSION CONTRIBUTIONS AND COLLECTION SYSTEM. . . 118 CCONi(ZWIBUTN5...... 118 RenumeratLon and Income Sub ect to Contribution (ISC9...... 118 ISC Limit ...... 118 Thooe who are Bound to make Contrutions . 118 Voluntary Contributions ...... 118 Voluntarv Savine Acgount...... 119 COLLECTION OF CONTRIBUTIONS...... 119 Those who are Bound to Declare and Pay contributions...... 119 Transferof Senarate Accounts ...... 119
OECTION3S . . . . .BNFT ...... 121 OF THE SYSTEM'S BENSFITS ...... 121 OF =HE BENtEoICIARnES . . .Pensi ...... 121 Riaht to an Old-AEr Pension ...... 121 Riaht to an Early gO-d-Age Pengion . . . . . 121 Rliahtto a Disability Pension ...... 121 Riaht to a SurvivorshinPengion ...... 121 OF THE CLASSIFICATIONOF DISABILITY...... 123 Classifyingt >Intittion ...... 123 Incomoatibilitv with Labor Accident Pnesions ...... 124 OF THE FINANCINGO PESIONS ...... 124 Gen2 al VLiew...... 124 InsuranceContribution...... 124 Members Covered by Insuran5 e...... 124 Necessarv CaDital ...... 125 InsuredPensions...... 125 Disability Insurance...... 126 Pensions' Transitoriness...... 127
OF THE OLD-AGE. DISABILITY AND SURVIVORSHIP PENJSINS...... *. . ...128 Forms of Pension...... 128 Life Annuitv ...... 128 Scheduled Withdrawal...... 129 SurvivorshiD Pensions Oriainated by an Active Member...... 130 - xvii -
Surij rahlo Pension. Oriainated by - Pasaive Member...... 130 updatingRemunerations ...... 130 Inherj&Snce ...... 131 Contlributions...... 131 Non-Declared Beneficiaries ...... 131 x= aton ...... 131 STAT'EGUARNTEE ...... 132 State Guarantee for Inaurance ContXibutionsand Life Annuities. . . . . 132
ECT H 4ON * * * * * * * * * * * * * ...... 133 PENSTONFUND INVESTMENTS...... 133 Geneal...... lew 133 Investment Instruments ...... 133 Other Reauirements ...... 136 Pension Fund Current Accounts...... 137 Diversification of Investments per lssuer. . 138 Financial Institutions...... 138 Commercial Bill Issuer Companies. . . . 138 Bond Issuer Comnanies ...... 139 Joint Margins in Commercial Bills and Bonds...... 139 Stock Issuer ComoanieA...... 140 Concentration Factors ...... 140 Other Provisions Concernina Investment Limits ...... 141 Transactions usina the Resources of PensionsFunds ...... 142 other Definitions and Concepts. . . . . 143
$gCTION 5 ...... 145 CONTROLAtD SUPERVISION ...... 145 ReoulatorvAcency...... 145 Oraanization of the Pension Fund Commision. 146
SECTION 6 . . . o...... 148 OF RISK CLASSIFICATION AND OF STOCK COMPANIES IN WHOSE SHARES PENSION FUNDS CAN BE INVESTED . . 148 SECURITIES RISK CLASSIFICATION ...... 148 Transitory Risk Classification Commission- * 148 Duties of Risk Classifvina Commisssion . . . 148 Members of the Classifyina Commission. . . . 149 Administrative Secretariat ...... 150 Risk Classifier ComDanies...... 150 Information Privacy...... 150 Risk Categories...... 151 ScoDe of the Classification...... 152 Terms within which Classification must be made...... 152 InformationRecuests ...... 153 - xviii -
OF THE STOCK COMPANIES IN WHOSE SHARES PENSION FQNDS MAY BE INVESTED ...... 155 Of the Co,manies...... 155 Diversificationof Owne-hi-...... 155 Special Rules that Must be Stioulated in the Bylaws...... 156 Account Insoectors and Risk Cleagiftir Cmonani ...... 156 Investment and Financin_ Policy ...... 156 Matters which Reauire a Sgecial Ouorum. . . 157 Transactions with Related Individuals . . . 157 DLversifigtion contract...... 157
INVESTMENT LIMITS - EXPLANATION...... 159 CREDITINSTITUTIONS...... 159 COQMIuDDta. * . . * . .* .* * * * 159 BONCISSmmeR ...... 160 Comments...... 160 General Comment ...... 160
Table ANX.1: InvestmentLimits...... 161
STATISTICAL APPENDIX Pooe NoR A2lileM.U2 CH,APTERII ...... 165 Table AII.1 - Selected Economic Indicators . . . 165 Table AII.2 - The Impact of Interest Rate Liberalizationon Non-GovernmentNon- FinancialPublic Sector ...... 166 Table AII.3 - Interest and Inflation Rate Differentials ...... 167
&Mngdix CWTER III . . .,*...... *#...... 169 Table AIII.1 - Gross Domestic and Gross National Saving Ratios...... 169 Table AIII.2 - GDP, Aggregate Demand Structure, Government Account and Current Account (1959/60-1976)...... 170 Table AIII.2 - GDP, Aggregate Demand Structure, Government Account and Current Account (1977-1990/91)...... 171 Table AIII.3 - Foreign Saving, Government Deficit and Non-government DefLcit...... 172 Table AIII.4 - ConsolidatedGovernment (Budget-NIB-CBE) Income Statement ...... 173 Table AIII.5 - ConsolidatedGovernment (Budget-NIB-CBE) Balance Sheet...... 174 Table AIII.6 - Determinants of Primary Deficit Financing ...... 175 Table AIII.7 - Government Primary Deficit Financing ...... 176 - xix -
Table AIII.8 - Signorag- Revenue in Egypt and Other Countries...... *. . 177 Table AIII.9 - Financial Repression Tax Revenue in Egypt and Other Countries ...... 178 Table AIII.10 - Primary Deficit Financing Today and After Stabilization and Financial Reform . 179 Table AIII.11 - Actual and Sustainable Public Public Primary Surpluses ...... 180 Table AIII.12 - Comparison of Private Consumption Functions for Egypt Ten Developing Countries ...... 181 Table AIII.13 - Decomposition of Prlvate Consumption Growth According to its Determlnants ...... 182 Table AIII.14 - Effects of Stabilization and Financial Reform on Private Consumption. . . . 183 Table AIII.15 - Effects of Stabilization and Financial Reform on Public and Private Saving. 184
&Mndi CHAPTER VI ...... 18 Table AVI.1 - Asseta of Banking Institutions. . . 185 Table AVI.2 - Total Domestic Claims of Banking Institutions ...... 186 Table AVI.3 - Total Domestic Claims of Banking Institutions ...... 187 Table AVI.4 - Lending to Private Sector . . . . . 188 Table AVI.5 - Bank Operating Ratios ...... 189 Table AVI.6 - Bank Productivity ...... 190 Table AVI.7 - Financial Solvency of Banks, 1986-90...... 190 Table AVI.8 - Liquidity Position of Banks, 1986-90. o . o . 4 ...... 190
^Anyni CHAPTRVII ...... ooo...... 191 Table AVII.1 - Insurance Companies' Ownership . . 191 Table AVII.2 - Insurance Pools...... 192 Table AVII.3 - Insurance Industry Annual Gross Premium...... 193 Table AVII.4 - Non-life Combined Ratios . . . . . 194 Table AVII.5 - Life Insurance Market - Net Gains and Total Income ...... 195 Table AVII.6 - Total Debt in the Sector . . . . . 196
Appendix CHAPTER VIII...... 197 Table AVIII.1 - Public Domestic Debt Indicators (191 .. 9..8 7.) 197
Atmendix CHAPTER IX...... 199 Table AIX.1 - Contribution Rates for Social Insurance...... 199 Table AIX.2 - Basic Pension Increases under Social Insurance ...... 200 - xx -
Table AIX.3 - Average Pensions and Average Covered Wages ...... 201 Table AIX.4 - Distribution of Monthly Pension Amounts ...... 202 Table AIX.5 - Distribution of Insured Workers By Basic Monthly Wage ...... 202 Table AIX.6 - Balance Sheet of Combined Social Insurance Funds (1980-1991): Income and Ougo...... 203 Table AIX.7 - National Investment Bank Assets. . 204 Table AIX.8 - National Inveatment Bank Liabilities...... 205 Table AIX.9 - National Investment Bank Assets. . 206 Table AIX.10 - National Investment Bank Assets . 207 Table AIX.l1 - National Investment Bank - Loans Analysis...... 208 Table AIX.12 - National Investment Bank - Profit and Loss Statement ...... 209 Table AIX.13 - operating Asset Ratios...... 210
*oR2n,df CHAPTER X...... 211 Table AX.1 - Private Insurance Funds ConsolidatedBalance Sheets ...... 211 Table AX.2 - Private Insurance Funds ConsolidatedIncome and Expenditures. . . . . 211 Table AX.3 - Egyptian Insurance Supervisory Authority ...... * . . . . 212 Table AX.4 - Contributions to Private Pension Funds . . . * ...... 213 Table AX.S - Fiscal Impact of Reforming the SocialInsurance System ...... 214 Table AX.6 - Number of Employees and Workers by Weekly Earning Group ...... 215 Table AX.7 - Annual Income to PF Under Proposed System in Second Pillar...... 216
&Mndix CHAPERXX...T ER... _ X...... I I 217 Table AXII.1 - Summary Stock Exchange Statistics: 1953-1990...... 217 Table AXII.2 - International Stock Market Growth Indices: 1986-1990...... 218 CHAPTER MI BANKINGSECTOR
I. entMdLvn 6.1 Like governmentsin most other ivelopedand developing countries,the Egyptianauthorities are engagingin a fundamentalre- writingof the groundrules goveiningbanking operations. At one level, they are undertakingthe eliminationor substantialrelaxation of economicard structuralregulations, such as interestrate and credit controlsand restrictionson marketentry and diversification.At anotherlevel, they are placinga growingemphasis on prudentialand protectiveregulations that are deemedessential for the smoothand efficientfunctioning of bankingand financialsystems. 1 6.2 In continuingthe trend of strengtheningprudential regulationand levellingthe playingfield for banks,recent amendments to the bankinglaw, promulgatedon June 4, 1992, made a numberof significantchanges: a. Foreignbanks can open "representative"offices and establishjoint-stock subsidiaries that are permittedto deal in local currency; b. New minimumcapital requirements have been establishedfor banks and foreignbank branchesand the CBE can require increasesin a bank'scapital and bank mergersif banks are exposedto financialproblems; C. A "depositinsurance fund" has been createdas a juridical personhaving its own budgetand sanctionscan be takenby the depositinsurance fund ag-.instmember banks which violateits articlesof associationor decrees;
d. A "bankinginstitute" has been createdwith the statusof a juridicalperson and with its own budget. In addition, banks may form a "bankers'association" to upgradethe qualityof bankingand encouragehealthy competition within the bankingsector. In this regard,the CBE may vest the banks with the freedomto determlnetheir own rates of returnon bankingoperations; e. The CBE may removemembers of the board of directorsand seniormanagers of banks who engagein unsafeor unsound practicesand, under certainconditions, may dissolvethe board of directorsand appointa conservatorto managethe bank;
1/ For a brief reviewof the principlesof regulatoryreform and the historicalexperience of differentcountries, see Long and Vittas (1991)and Vittas (1991b). - 2 -
f. Banks must now be audited by two auditors that enjoy the confidence of the CBE. In addition, the banks are not allowed to offer credit facilitiesto their auditors. The external auditors are also under an affirmativeobligation to notify the bank under audit, as well as the CBE, of any shortage, error, or violation discoveredby the auditor. In addition, the external auditors must comment on the adequacy of a bank's internal controls and its valuation (loan loss) reserves. If the reserves are inadequate,the auditor must determine the amount of the estimated shortfall;
g. Public authorities,public sector companies,and public business sector companies are now subject to the 25 percent (of capital) exposure limit and the CBE Las now assumed the powers of the general assembly with regard to public sector banks;
h. Banl-scannot invest more than 100 percent of their capital, in the aggregate, in the shares of joint-stock companies, nor can banks invest in more than 40 percent of the shares of a company's stock.
6.3 Until recently, the financial position of Egyptian banks, especially the public sector banks, was characterizedby very low capitalization,large exposure to foreign currency losses and nonperformingloans, and serious operating inefficienciesresulting from overstaffingand cumbersomeprocedures. The banks were weakened by their lending to enterpriseswhose main objectiveswere the absorption of labor and the provision of low-pricedgoods. The position of the banks has been strengthenedover the past 12 months, although they continue to face considerabledifficulties.
6.4 The Egyptian authoritieshave taken decisive action to strengthen the capital position of large public sector banks through the assumptionof past foreign exchange losses and the injection of new capital; through promulgationof new regulationson capital adequacy, loan classificationand provisioning;and through limits on foreign currency exposure and risk concentrations. Detailed audits of the public sector banks, conducted by teams of experiencedauditors on the basis of guidelines issued by che CBE, have been completed. Action has also been taken to recapitalizecertain small banks in weak financial positions, including the merger of some smaller regional banks into a single, Cairo-based institution.
6.5 The financial position of banks may be affected by the potential adverse impact of the recent reform of macroeconomicpolicies, in particular the rise in interest rates and substantialchanges in relative prices, on both pubolicand private sector companies. Considerablefurther effort is still required to complete the regulatory reform and restructureboth the banks and the state-owned companies in the industrialand commercial sectors. - 3 -
6.6 This chapter reviews the extent of regulatory reform in Egyptian banking, identifies the areas where further action is required and assesses the impact of past measures on the structure, efficiency and solvency of Egyptian banks. The chapter is divided into five sections. In the next section, changes in economic and structural regulations are reviewed. Special emphasis is placed on those regulationo that impair the contestabilityof the Egyptian banking market. section 3 focusees on change. in prudential regulation and discusses the role of effective banking supervision in ensuring the safety and soundness of Egyptian banks. Section 4 presents an analysis of the financial condition and performance of different groups of banks. It discusses the level of competition and efficiency in Egyptian banking and reviews the impact of regulation on these different groups. Special emphasis is placed on the creation of a level playing field for all banks, no discriminationic made between public and private banks, and the importance of managerial autonomy for the public sector banks is stressed. This section also includes an internationalcomparison between banks in some developed and developing countries. The last section concludes with recommendationsfor a future program of reforms and presents the measures the Government will undertake between July 1993 and December 1995 and which will be supported by the Structural Adjustment Monitoring Program (SAMP).
--. Economic and Structural Reoulation
6.7 The structure and efficiency of a country's banking and financial system is often shaped by the nature of its regulatory framework. Ideally, financial regulation should promote the establishmentof contestablemarkets: entry and exit should not be excessively costly; the threat of potential competition should prevent existing institutionsfrom developing anticompetitivepractices; a level playing field should be created for all market participants;individual institutionsshould enjoy considerablemanagerial autonomy and make decisions on economic criteria; and an effective array of prudential controls should be used to discourage imprudent and fraudulentbehavior.
6.8 Contestablemarkets encourage innovation and efficiency even if they are characterizedby a high degree of concentration. Contestabilitymay be limited by high entry costs and large economies of scale, but in banking the nonregulatorycosts of entry are generally far from prohibitive and economies of scale are not as large as in some sectors of manufacturingor in public utilities. Banking and financial markets are highly contestableunless there are regulatory restrictions an new entry and/or product and price controls that inhibit competition.
6.9 Although some of the impedimentsto competition,such as interest rate ceilings and directed credit controls, have been removed with the recent deregulations,the Egyptian banking system still suffers from many restrictive regulations. The deregulationtrend should be widened to remove most of these restrictions,while greater emphasis should be placed on prudential regulation to ensure the stability of the financial system. -4 Barriersto Entry 6.10 Regulatorybarriers to entry includerestrictions on tl- licensingof domesticbanks, restrictions on branching,restrictions on foreignbank entry and restrictionson the types of activitiesthat banks are allowedto undertake.
6.11 Before the implementationof the new economic policies in the mid-1970s,the Egyptianbanking system was highlyregimented. It comprisedfour publicsector banks, each specializingin a different sectorof economicactivity and effectivelyoperating as a specialized divisionof a monobankingsystem similar to that found in the socialist countriesof East Europeand Asia. 6.12 Since the late 1970s,a large numberof joint-venture commercialbanks and businessand investmentbanks have been established.Most of these are joint venturesbetween public sector banks and large internationalbanks or Arab banks. Despitethe large numberof banks,the bankingsystem is highlyconcentrated. This is becausethe publicsector banks are majoritypartners in most of the joint venturesbanks. As a result,the bankingsystem is effectively dominatedby a smallnumber of bankinggroups that are linkedto the publicsector banks and accountfor over 90 percentof the totalassets of commercialbanks. Althoughjoint-venture banks are not, in principle,subject to centralizedmanagement control, their links to the large publicsector banks imply a weakeningof competitviriand a certain segmentationof the market. 6.13 Neitherhigh concentrationnor state-ownershipvould necessarilyimply uncompetitivemarkets and inefficiency.'or example, the Canadianbanking system is highl-concentrated and dom'tutedby six large banks. Nevertheless,studies o:', Canadian banking ha&5 found it to be highlycompetitive. 2 Other bankingsystems, e.g., in tte Netherlandsand Sweden,are also charac:erizedby high conce trationbut reportlower operatingcosts and higherprofits than banks Ju countries with fragmentedsystems, such as the UnitedStates, Italy ar.l1orway.3 The experienceof state-ownedbanks in Franceand Austriaand of the savingsand cantonalbanks in Germanyand Switzerlandalso suggeststhat state ownershipof bankinginstitutions is not necessarilyincompatible with high operationalefficiency. 6.14 It is the combinationof high concentrationand domination by state-ownedbanks that impliesthat competitiveforces may not be as strongand responsiveto changingmarket conditions as mightbe deslred. A key factorin fo3teringcompetition within & concentratedbanking
2/ For empiricaltests of competitionand market concentrationsee Nathanand Neave (1989),Shaffer (1990), and Hannan(1991).
3/ For a discussionof differencesin operatingcosts and efficiency among some developedcountries, see Vittas (1991a). environment is the removal of regulatory restrictionson new entry. By eliminating or minimizing barriers to entry, bank regulat.rscan induce competition among existing banks since market disciplinewill be imposed not only by the number of actual competitors,but also by potential competitors. In addition, reducing the role of direct or indirect state ownership would help enhance both competition and efficiency. This can be achieved by increasing the autonomy of public sector banks and by privatizing first the joint-venturebanks and then, at a later stage, the public sector banks.
6.15 Licensing of New Banks. In Egypt, because of the large number of banks, there is an apparent reluctance to license new domestic banks. However, as already noted, most of the existing banks belong to a few banking groups, with concentrationon a banking group basis probably exceeding 90 percent of total assets. The degree of effective competition is therefore limited. The CBE recently introduced minimum capital requirementsfor new banks. Minimum authorized capital is set at 100 million Egyptian pounds, of which 50 million Egyptian pounds must be fully paid up (correspondingto between 15 and 30 million US dollars). However, these amounts are well-above the minimum requirementsestablished by most developed countries and will serve to dissuade many credible potential applicants. Therefore, it is suggested that the initial capital requirement should not be higher than 30 million Egyptian pounds (10 million US dollars). Entry should be based on objective criteria that, in addition to a minimum amount of capital, should also cover the required qualificationsof management, the probity and financial strength of the proposed owners, and the development of reasonable business plans and projections. Recent amendments to the banking law give the authoritiesthe right to remove board members and senior managers of banks, subject to effective appeal procedures to guard against unfair treatment (see below), but only after the fact. In the case of new banks, the authorities should have the right to approve senior managers and board members prior to appointment.
6.16 Branching Restrictions. The opening of branches is subject to CBE approval, which is perceived to be subjective and to favor public sect r banks. Branching is important in banking because it allows banks to dLversify their sources of funds and to expand into retail banking. Although the costs of building large branch networks are high and few banks will ever want to establishnationwide networks, selectivebranch openings by joint-venturebanks are likely to strengthen the level of competition and eulhanceefficiency. Branching should be free for banks with strong capital and in sound financial condition. For other banks, branching restrictionsshould be seen as a transitionalmeasure, applied until the institutionsare fully recapitalizedand recover their financial health. Once this stage is reached, branching restrictions that lead to market segmentationshould be removed, and branch openings should be decided by individualbanks.
6.17 Foreign Bank Entry. Foreign banks in Egypt are allowed representativeoffices or branches. They can also have a ncn- controlling share in joint-venturebanks. In line with recent changes to the bankinglaw, branchesof foreignbanks can now engagein local currencybusiness. 4 6.18 The impactof foreignbanks dependson the efficiencyand competitivenessof domesticbanks. In some countries,such as Australia and Sweden,where domesticbanks are quite efficientand have responded forcefullyto the challengeof foreigncompetition, foreign banks have been unableto acquirea largemarket share and have endedup with a risky loan portfolio that resulted in substantial loan losses. In other countries,such as Greece,Spain and Turkey,where domesticbanks have been less efficientand less dynamic,foreign banks have had a big impacton corporatebanking business and on new financialsegments, such as leasing,factoring and financialrisk management.Foreign banks have also contributedto the intensivetraining of bankingstaff and to the transferof modernfinancial technology, such as more sophisticated creditappraisal techniques and new financialinstruments. 6.19 Concernabout the role of foreignbanks reflectsseveral, sometimescontrary, fears. First,there is concernthat foreignbanks may acquiredominant positions in domesticmarkets and drive local institutionsthat are less efficientand have fewer capitaland managerialresources out of business. The secondconcern is that foreignbanks may engagein cream skimmingby dealingin profitable segmentsof the marketand capturingeconomic rents resultingfrom existingregulations or the inefficiencyof domesticbanks. A third concernrelates to the strengthof their commitmentto the localmarket. 6.20 The experienceof foreignbank entry in most developing countriesover the last two decadesor so suggeststhat the first concernis not justified. Foreignbanks are unlikelyto acquire dominantpositions in domesticbanking systems, both becausethey are sensitiveto localpolitical concerns and beceusethey may be deterred by the high capitaland informationcosts of buildinga strongpresence in retailmarkets. But, althoughforeign banks are unlikelyto have a stronginterest in retailbanking and in lendingto small firms,they can indirectlyaffect the efficiencyof those marketsby forcing domesticbanks to improvetheir overallefficiency and seek profitable innovationin segmentsof the marketthat were previouslyneglected. 6.21 On the allegationof cream skimming,there is some evidence that foreignbanks reporthigher profits than domesticbanks, but the reasonsfor this are most likelytheir higher efficiency over local banks and the impositionof restrictionsthat provideregulatory rents to foreign banks. The best response to cream skimming is not to protect
W/ The Egyptian branchingapproach departs from the subsidiaryapproach adopted in Mexico. Internationally,there is currently a reconsideration of the merits and demerits of local subsidiariesand branches. In Europe and Australia there is a definite trend in favor of branches,but in the UnitedStates and Canada,there seems to be a preferencefor localsubsidiaries. - 7 -
the position of inefficientdomestic banks, but to remove the restrictionsthat give rise to regulatoryrents and also to stimulate efficiencydrives among domestic banks.
6.22 Concern about the strength of local commitment is perhaps more justified. If institutionsare assumed to retreat from distant markets when they are faced with difficulties,then foreign banks would have a weaker commitmentto local markets than local banks. Foreign banks would retreat from a local market in response to two separate events: when they faced problems in the local market (pulling back from a country experiencingan economic slowdown) and when they faced problems in their home market. In contrast, local banks cannot withdraw from their home market, except if their difficultiesare so serious that they are forced out of business. The recent retrenchmentof American banks from European,Asian and African markets (as well as the Egyptian market, where two major American banks withdrew from joint-venture banks) lends justification to this concern.
6.23 However, the answer to this concern is not to prohibit foreign bank entry, but rather to adopt policies that ensure, first, that foreign banks have a sufficientlystrong commitment to the local market and, second, that the domestic market is not dominated by foreign Institutions. The first objective can be achieved by requiring foreign banks to establish local subsidiarieswith a minimum capital requirement similar to that applied to domestic banks. Although there are some economic arguments in favor of allowing foreign banks to operate through branches, requiring the establishmentof local subsidiarieswould enhance the ability of national authorities to exercise greater financial control and supervisionand would place domestic and foreign banks on a more equal footing.
6.24 The second objective can be achieved by requiring that the ownership of large private domestic banks be widely dispersed. For instance, a legal requirement could be imposed to the effect that no one person or group would be allowed to hold more than 10 percent of the capital of large private banks, which could be defined in terms of assets (say, 5 or 10 billion Egyptian pounds or more), share capital, gross income or employment. When the four large public sector banks are privatized, they could be covered by these ownership restrictions. This measure would ensure that large private domestic banks would not fall under the ownership and control of any individualgroups, including foreign banks. In addition, local subsidiariesof foreign banks that exceed a certain threshold limit could be required to offer a certain proportion of their share capital to the public. The specific limits and thresholdvalues for these regulationswould have to be set after careful considerationof market needs in terms of competition, innovationand efficiency.5
2/ Such limits have long been applied in Canada and have also been considered in Mexico. - 8- 6.25 Restricti2nson TiMes of Activities. In severalcountries, bank legislationimposes restrictions on the scope of operationsof commercialbanks. Thus, ln the UnitedStates, there is a legal separationbetween commercial and investmentbanking (weakened by concessionsfor some types of investmentbanking operations), between bankingand insurance,and betweenbanking and commerce. Japan also Imposessimilar restrictions, although these are less bindingbecause of the existenceof large conglomerategroups with interlocking shareholdingsin commercialbanks, insurance companies and securities firms,as well as in industrirland commercialcompanies.
6.26 In most other developedcountries, there is a growingtrend towardsuniversal banking, which allowscommercial banks to engagein investmentbanking and fund managementactivities, to operatemutual funds and to act as brokersin securitiesutarkets, insurance and the travelbusiness. In recentyears, many Europeancountries have also allowedcommercial banks to enter the insurancemarket (and vice versa), while in severalcontinental European countries, banks have traditionallybeen allowedto hold equitystakes in industrialand commercialcompanies. 6.27 One of the argumentsfor allowinguniversal banking and links betweenbanks and insurancecompanies, as well as for permitting equityholdings in industrialcompanies, relates to the potential economiesof scope that may resultfrom the combinedoffer of these services. However,universal banking also involvespotentially greater risks and raisesmany problems: conflictof interest,abuse of market power,adverse selection and moral hazard. Universalbanking is more difficultto superviseeffectively than more specializedinstitutions. For this reason,and in order to safeguardthe smooth2unctioning of the paymentand creditsystem and protectthe interestsof small savers,the authoritiesof many countriesincreasingly require investment banking, securitiesbusiness and insurancfoperations to be conductedthrough separatesubsidiaries, either of the parentbank or, preferably,of a holdingcompany. In eithercase, universalinstitutions are expectedto have strongercapital backing than commercialbanks with narrower functiors. 6.28 In Egypt,commercial banks are generallyallowed to operate as universalinstitutions. The large publicsector banks have substantialequity holdings in industrialcompanies, mostly public sectorcompanies. It is not, however,clear whetherJoint-venture banks are equallyallowed to investin industrialequities, although domestic privatebanks, such as the Nile Bank, have extensiveinterests in industrialconcerns. In view of the growinginternational trend towards universalbanking, it may be inappropriateto imposea legal prohibition on universalbanking at this juncture. However,measures should be taken to requirehlgher levels of capitalizationfor universalbanking lnstitutionsor to establishtransparent holding company structures, wherebybanks would engagein securities,insurance and other business throughseparately capitalized subsidiaries of the holdingcompany. It is also importantto ensurethat prudentialregulations, such as limits on risk concentrations,are based on total claims,including loans, equityholdings and off-balance-sheetitems, and that effectivebanking supervisionis not hamperedby the existenceof universalfinancial institutions. 6.29 RemovingBarriers to Entry. Removingbarriers to entry is one of the most importantregulatory reforms facing the Egyptianbanking system. The authoritiesshould give considerationto all measuresthat could reducethe segmentationof the bankingsystem and enhanceits contestability.These includelicensing new domesticprivate banks, deregulatingbranching and foreignsubsidiaries and branches,and allowingall banks to engagein universalbanking, provided they have strongcapital backing. 6.30 A measurethat would have a great impacton the degreeof effectivecompetition, would economizeon capitalcosts and would also generateimportant revenues for the publicsector is the privatization of the stakesof large publicsector banks in the numerousjoint-venture banks. Existingminority partners and privategroups of investors interestedin enteringthe bankingmarket could be invitedto bid for particularbanks. Openingthe biddingprocess to other potential participantswould force existingminority partners to increasetheir offeringprice, to the benefitof publicfinances. 6.31 To ensurethe continuingoperating efficiency of joint- venturebanks and to encouragethe entry of foreignbanks, existing minorit"partners could be selectedif their price was within a given margin,say 10 percentor 15 percent,of the highestbid. In addition, measureswould need to be taken to ensurethe continuationof management contractsor their replacementby adequatealternative arrangements. Howeverit is accomplished,reforming the ownershipstructure of the large numberof joint ventures,not only in bankingbut also in industry and other sectors,is an essentialand high priorityreform measure in what is known in Egypt as the policyof "privatizingthe private sector." Barriersto Exit 6.32 Exit Mechanisms.Competition and efficiencyalso require the establishmentof effectiveexit mechanisms.Financially weak banks, which are allowedto operatewith the explicitor implicitbacking of the authorities,can have seriousdetrimental effects on the soundness of the bankingsystem. Weak banks are known to underminecredit standardsand to bid excessivelyfor deposits. They tend, thus, to contaminatethe rest of the bankingsystem. Exit may involvecessation of operationsand outrightclosure, or it may involvea mergerwith strongerinstitutions. However, in the lattercase, care must be taken to ensurethat the new institutionsproceed with effective rationalizationplans that cover a recognitionof loan losses,the closureof redundantbranches and the eliminationof overstaffing. - 10 -
6.33 The importance of efficient crisis resolution mechanisms was highlighted by the recent failure of the Bank of Credit and Commerce Misr (BCCM), a joint-venturebank that was 49 percent owned by the collapsed Bank of Credit and Commerce International(BCCI). Other Danks were asked to contribute 0.5 percent of their deposits to a fund that would be used to cover the deposit liabilitiesof BCCM and would constitute the establishmentof a deposit protection fund for future insolventbanks.
6.34 Egyptian authoritieshave been considering the establishment of a deposit insurance fund since 1989. One outgrowth of the BCCM case has been to make such a fund a reality. Recent amendments to the banking law formally establish a deposit insurance fund (see below) and strengthen'therole of the CBE in (i) calling for a replenishmentof bank capital, and (ii) arranging suitable bank mergers. The CBE has already taken action to merge some smaller regional banks into a stronger Cairo-based institution. However, the provisions of the recent amendments still fall short of empowering the CBE to take actions (i) to restructure insolventbanks by writing off bad assets against shareholders'capital and carving out the remaining bad assets through bonds or an alternative technique, or (ii) to liquidate insolvent banks outside a normal bankruptcy process.
6.35 Deposit Insurance. As noted above, recent amendments to the banking law established a "Fund for Insurance on Deposits Operating in Egypt and Registered With the Central Bank of Egypt". Perhaps the strongest argument that can be put forward for a deposit insurance scheme is that it will transform an implicit protection of the deposits of public sector banks into an explicit scheme that would cover the deposits of all banks.6 However, it is important to establish a deposit insurance scheme with clearly defined rules and procedures. For a potentially undercapitalizedbanking system, a vaguely defined insurance fund may create more problems than it can solve. The timely exit of insolvent institutionsis important to foster healthy competition. Preventing individual institution insolvenciesmay destabilize the financial system by distorting risk-taking incentives and undermining market discipline.' The experience of the US savings and loan industry exemplifiesthe importance of allowing timely exit.
6.36 The Egyptian Deposit Insurance Fund should have very well- defined powers; its purpose should be to protect small, unsophisticated investors rather than mismanaged institutions. Providing insurance coverage to most bank depositors would destroy an important external i/ For a detailed discussion of implicit and explicit deposit protection schemes, see Talley and Mas (1990).
7/ The distorted incentive effects of mispriced insurance schemes are widely discussed in the literature. See, for example Kareken and Wallace (1978), Sharpe (1978), Pyle (1983, 1984) and Kane (1985, 1989). - 11 -
discipline on bank risk-taking. Without insurance,depositors, especially large ones, have strong incentivesto monitor the financial condition of their banks. The possibility that depositorsmay withdraw their funds gives banks an incentive to avoid excessive concentrations in risky and illiquid assets and to stay well capitalized. Without such market discipline, it is difficult for regulators to ensure safe and sound banking practices.
6.37 The effective monitoring of banks by their large depositors presupposes adequate disclosureof informationon the financial condition of different banks. In Egypt, informationdisclosure on banks appears to be limited because existing bank legislationprevents the official publication of informationbeyond what is included in published annual reports and accounts. However, bank legislationshould not be an obstacle to the publicationof data on the financial condition of banks, or on the financial strength of their large shareholders.
6.38 Despite the potentiallyadverse effects on risk-taking incentives, there is a worldwide trend in favor of adopting explicit deposit insurance schemes. For the recently established deposit insurance fund, the authoritiesmust decide the basic features of the insurance scheme and related activities. These include such issues as whether the system should be compulsoryor voluntary; the amount of protection offered (usually small deposits are explicitly covered, while protection for larger deposits is discretionary);the use of coinsurance (i.e., should there be total or partial protection for small deposits); the degree of prefunding; the base of premium assessment;and the use of fixed, or risk-based,premiums, as well as the powers that must be granted to the authorities to ensure effective failure resolution mechanisms.8 An effort is now underway to address many of these issues in the Fund's articles of association.
6.39 A question facing the Egyptian authorities,which raises several complex issues, is whether to extend coverage of the insurance scheme to deposits denominated in foreign currencies. Doing so would clearly increase the attractivenessof maintaining such deposits with banks in Egypt. To the extent that these deposits would have been kept with banks overseas, there may be some benefits for Egyptian banking (e.g. a greater volume of intermediation)and for financing foreign trade operations of Egyptian companies. However, to the extent that foreign currency deposits would have been held as Egyptian pound deposits, insuring foreign currency deposits would affect the currency composition of deposit business. The costs would then include a small loss of seignorage for the Egyptian government and potential foreign currency losses (assumingthat compensationof depositorswould be given
j/ Annex VI.1 provides a more detailed discussionof the issues raised by deposit insurance and the options available to the authorities. - 12 -
in foreign currencies'). An important factor would be what could banks do with foreign currency funds. If lending to companies oriented towards the non-traded goods sector were discouraged,as it should be, banks in Egypt would be able to use foreign currency deposits only for financing the tradeable goods sector and would have to place any excess with banks overseas. Thus, the benefits from encouraging foreign currency deposits with banks in Egypt would be smaller than might appear at first sight and might not justify the costs. However, the argument appears finely balanced. Internationally,Turkey provides insurance coverage to foreign currency deposits, but other countries (e.g. Argentina) do not.10 If Egypt decides to provide insurance coverage to foreign currency deposits, it is important that the CBE obtains sufficientcontrol on the portions of these deposits placed overseas, otherwise it may find itself overexposed. One way to do this would be for the banks to deposit these excesses in foreign currency funds at the CBE, which would in turn place them abroad.
Credit Controls and Portfolio Restrictions
6.40 As discussed in Chapter II, despite the removal of directed credit controls, Egyptian banks continue to be subject to restrictions on their portfolios. These include the impositionof reserve and liquidity requirementsand, until recently, credit ceilings. In addition, the banks are subject to a number of other controls, such as limits on foreign currency exposure and limits on loan concentrations, that are motivated by prudential corsiderations.
6.41 Reserve and LiquldityRequirements. Reserve and liquidity requirementsare imposed on both local and foreign currency deposits. Banks have to observe a reserve ratio of 15 percent on local currency deposits in the form of noninterest-bearingreserve balances with the CUE, as well as an additional liquidity ratio of 20 percent, which can be in the fort of excess reserve balances, net interbank deposits, treasury bills and commercialbills. For foreign currency deposits, the reserve and liquidity ratios are 15 percent and 25 percent, respectively,both in the form of interest bearing accounts. These two ratios are relativelyhigh by internationalstandards and clearly operate as a tax on bank intermediation.
6.42 The high overall reserve and liquidity ratios may indicate concern about the low capitalizationand solvency of some banks. Rather than penalize all banks, a better way to tackle this problem would be to i2/ Covering foreign currency deposits would create some administrative complicationsif premiums are paid in foreign currency and reserves are held in foreign currencies. An alternativesolution is to pay compensationin local currency (which would also imply premiums and reserves in local currency)but then the insurancecoverage would be deficient, especially if the exchange rate is overvalued.
I/ See Talley and Mas (1990). - 13 - take measuresto strengthenthe solvencyof weak banks. Under normal circumstances,solvent banks shoulddetermine their own liquidity requirementsin the light of theirbusiness and maturitymix. During crises,the centralbank is trustedto provideaccommodation to solvent banks and to generalizedruns on the bankingsystem. Continuing liquidityproblems are consideredto be an indicationof a bank's underlyinginsolvency. This shouldbe controlledby capital requirementsand loan provisioning. 6.43 Currently,banks in Egypt maintainexcessively liquid positions;a resultof the high, tax-freeinterest rates availableon risk-freetreasury bills and the high risks and uncertaintyassociated with lendingto industrialand commercialcorporations. High reserve and liquidityrequirements should only be used as a transitional regulationuntil the bankingsystem is well capitalizedand a strong bank supervisionsystem is in place. If progressin these areas continues,and providedthe fiscalaccounts permit, the CBE should considera phasedreduction of these ratiosand a remunerationof reservebalances, since interest-free reserves when market rates are as high as 20 percentrepresent a high level of bank taxation. The ultimateobjective would be to removereserve requirements altogether and to rely on open marketoperations for conductingmonetary policy. (See ChapterII.)
6.44 Bank-sRecificCredit Ceilings. The deregulationof interest rates was initiallyaccompanied by the impositionof bank-specific creditceilings. These ceilingswere perceivedas temporarymeasures to maintaincontrol over domesticcredit expansion and supportthe anti- inflationarystance of currentmacroeconomic policies. However,bank- specificcredit ceilings distorted competition and had undesirable effectson innovationand efficiency.They may have had a particularly adverseeffect on banks that financelarge investmentprojects that need prearrangedtranches of financein line with work progress. There was also concernthat the allocationof creditceilings may have discriminatedin favor of publicsector banks. The Egyptianauthorities have very recentlyremoved bank-specific credit ceilings and are continuingto developtheir capabilityto implementindirect methods of monetaryand creditcontrol, which would enhancethe efficiencyof bankingintermediation. Bank-specific credit ceilings clearly became redundantwhen activemoney and governmentbond marketsdeveloped and made possiblethe use of market-basedinstruments for controlling monetaryand creditexpansion. InterestRate and Other Price Controls 6.45 InterestRate Controls. Egyptianbanks used to be subject to an array of interestrate controls. However,most of these controls have been removedin recentyears as part of the progressive deregulationof the bankingsystem. Currently,two main controlsare still in force: one concernsthe prohibitionof interestpayment on demanddeposits and the other specifiesa minimum,but relativelylow, rate of interestpayable on savingsdeposits. The firstprovides, - 14 -
intentionallyor otherwise,strong protection to the public sector banks since it prevents th3 joint-venturebanks that lack extensive branch networks from competing effectively in the market for corporate demand deposits. The second control ostensiblyaims to protect the interests of small savers, although the minimum level is highly negative in real terms. In fact, the stipulationof a minimum rate may provide an excuse to the public sector banks for repressingcompetition and paying a low rate of interest.
6.46 The deregulationof interest rates has resulted in a substantial increase in deposit and lending rates. The double liberalizationof interest and exchange rates and the greater confidence in the reformed macroeconomicpolicies of the authorities appear to have induced both a repatriationof capital and a conversion of dollar deposits into Egyptian pound deposits by both the household and corporate sectors. In conjunctionwith the application of credit ceilings, the partial reversal of the dollarizationof the economy has increased the liquidity position of banks.
6.47 Another important factor in interest rate liberalizationhas been the reluctanceof the large public sector banks to adjust fully interest rates on existing loans. Although loan contracts allow banks to increase their loan rates, they appear to have refrained from adjusting them fully to market levels to prevent an upsurge in defaults. Furthermore,interest rates on interbank loans have remained below TB rates. In general, banks appear to engage in an informal,but effective, coordinationof interest rate increases,although the effectivenessof such informal coordinationis likely to weaken as smaller banks intensify their efforts to attract nonbank deposits.
6.48 Controls on Tariff Schedules. The deregulationof interest rates represents the removal of an important layer of banking regulations. However, restrictiveregulations continue to apply on the pricing of other bank services. At present, the tariff schedules for most banking services are subject to very detailed regulation set by the Egyptian Bankers Association and endorsed by the CBE. This is based on a 71-page booklet that has a table of contents running for 9 pages and contains 62 pages setting maximum and minimum prices for all kinds of banking services. Clearly, in a deregulatedsystem, individualbanks should be free to set their own tariffs.
6.49 These cumbersome regulationshave an additionalnegative impact on the effectivenessof prudential supervision. Since ensuring the enforcement of detailed tariff schedules requires bank examiners' time, this practice wastes the already limited resources of the regulators. Deregulationof tariff schedules would release resources that could be put to more efficient use in prudentialbank supervision.
Taxation of Interest Income
6.50 At present, all interest income on loans to non-performing borrowers is treated as taxable income without regard to its ultimate - 15 -
collectability. This tax treatmentserves to overstate taxable income and, thus, the taxes ultimately paid to the tax authorities. In most countries, interest income which is being suspensed, or where the loan has been placed in a non-accruingstatus and Interest in recorded in a memoranda account, is not considered as taxable income unless the interest is actually collected. The fact that banks must pay taxes on interest income which may never be collected serves as a disincentiveto banks to follow more conservativeprudential treatment calling for timely recognition of problem borrowers and tbe non-accrual of interest income. (See Chapter V.)
6.51 In addition, tax policies do not recognize charges for provisions to loss reserves as a tax deductible expense. This policy is consistent with some countries, such as the United States,11 where only actual losses are recognized as expenses for tax purposes. However, there is also another approach used widely throughout the world whereby the provision expense attributed to specific loans is considered a tax deductible expense. The effect of this is to encourage more timely recognition of expenses and better matching of income with the costs of doing business. A certain amount of losses are, after all, a normal cost of the banking business. Still, a third approach, permits the deduction as taxable expenses, all specific provisions and general provisions up to a certain percent, say 1 percent of total loans outstanding.
6.52 Given the need for Egyptian banks to build loan loss reserves, it may be advisable to adopt a policy that provides incentives to the banking system by permitting some portion of provision expense to be deducted from taxable income as an expense of doing business. The reserves so established,however, should not be considered a part of capital but, rather, a contra account to loans.
III. Prudential Regulation and Banking SuDervision
6.53 Prudential controls aim to reduce the risk of systemic failure and avoid the disruptionscaused by financial crises. They re4uire financial institutionsto be adequately capitalized and professionallymanaged as well as to diversify their risks, adopt proper accounting policies and report their true financial position. Prudential controls place particular emphasis on effective supervision and on "fit and proper" tests of the managers and owners of financial institutions.
fl/ Prior to the Tax Reform Act of 1986 banks were permitted to deduct provision expense in accordance with various averaging methods, subject to a maximum ceiling. After passage of the Tax Reform Act, banks were forced to recapture the amount of valuation reserves recorded in the tax books. Thereafter, only actual losses were deductible as expenses for tax purposes. - 16 - 6.54 Prudentialcontrols are necessarybecause financial institutionsare susceptibleto both imprudentand fraudulentbehavior. Experiencein both developedand developingcountries has shown that both publicand privatefinancial institutions make mistakes,and their decisionsare imperfectand prone to excesses. Market-basedfinancial systems,like publicones, are subjectto fraud,mismanagement and instability.A main concernof prudentialregulation and supervisionis to preventsystemic failures and financialcrises without imposing rigidityand underminingefficiency in the financialsystem. PrudentialRegulation 6.55 Regulatoryreform in Egypt,as in most other developedand developingcountries, is placinggrowing emphasis on prudential regulationand supervision.The guidelinesagreed internationally by the Basle Committeeof bank regulatorsare graduallybeing adopted. Regulationscovering capital adequacy, loan classificationand provisioning,and foreigncurrency exposure have been issuedby the CBE, althoughimplementation is gradual. 6.56 CaoitalAdequacy. A new regulationon capitaladequacy has been promulgated.This is based on the.risk-basedcapital requirements agreedby the Basle Committeeof bank regulators.In anticipationof this regulation,the capitalof the large publicsector banks was recentlyincreased. Althoughthis took the form of governmentbonds ratherthan an injectionof cash, it has contributedto a substantial improvementin the capitalratios of the publicsector banks. 6.57 The new regulationstipulates that banks with capital adequacyof less than 7 percentin December1990 be given a periodup to December1993 to meet new capitaladequacy standards and that banks with capitalratio between7 percentand 8 percenthave to meet the new standardsby December1992. Althougha commondeadline for all banks would have been more in line with the creationof a level playingfield, the differenceof one year is unlikelyto have largediscriminating effectsagainst those joint-venture banks that alreadymeet their requiredcapital standards. 6.58 Capitaladequacy depends on an objectivevaluation of assets and especiallyon a properlevel of provisioniogagainst nonperforming loan and equityclaims. Internationalguidelines of the Basle Committee also addressequity holdings of internationalbanks and securitiesfirms in determiningcapital adequacy. To capturethe risk in a specific equityand the risk of a broad marketmove, the Committeeapplies a two- tier capitalcalculation, which can be representedin algebraicterms as Ox + y." In this formulax representsthe gross positionand y representsthe net position. A risk weightof 50 percentfor x and 100 percentfor y are applied,respectively. In this way, institutionscan be subjectto a capitalrequirement on their equitypositions that is - 17 -
higher than 8 percent,21 This requirementgenerally applies to all equity holdings. However, bank supervisors, at national disoretion, can exclude equity positions held as long-term investments. Equity investmentsexcluded in this mannerwould be subjectto 100 percentrisk weighton book value. Consideringthe largeequity holdings of Egyptian banks, it is importantto determinetheir capital adequacy based on risk-weightedassets, including equity holdings as well as loans. 6.59 Risk ConcentrAtions.To discouragelending to insiders, banks are prohibitedfrom grantingany creditfacilities to membersof theirboards of directorsor to the auditorsand shareholdersin zheir auditingfirms. They are also barred from extendingto a singleclient creditfacilities of any kind exceeding25 percentof theirpaid-up capitaland reserves. Recentamendments to the bankinglaw bringpublic authorities,public sector companies, and publicbusiness sector companieswithin the scopeof this lendinglimit.
6.60 However,the effectivenessof the creditlimits to indlividualborrowers is underminedby the lack of consolidated acco.tntingstatements. To be meaningful,the limitsshould apply to groupsof relatedcompanies on a consolidatedbasis. In addition,in view of the substantialequity holdings of publicsector and some privatebanks, the limitsshould apply on all claimson individual clients,including equities, and not just on creditfacilities. At present,it is conceivablethat the bank couldhave an equityinvestment in a companyequal to 100 percentof the bank'scapital and a credit exposureequal to 25 percentof its capital. Thus, the bank couldbe exposedto an amountequalling 125 percentof its capitalto a single client. Therefore,to close this loophole,the authoritiesrecently introducedan overallbank exposurelimit to a singlecustomer to 30 percentof the bank'scapital and reserves.
6.61 Loan Classificationand Provisioning.To ensureappropriate levelsof provisioningfor loan losses,the CBE has issuednew regulationson loan classificationthat are consistentwith internationalpraftice. The new regulationshave been appliedsince July 1991 and providefor a phase-inperiod. Thu& far, the new regulationshave had a positiveeffect in bringingabout greater disciplinein lendingpractices. Bankers are now beginningto understandthe costs of makingbad loans. 6.62 In the short-run,howevsr, the new regulationsmay adversely affectlending for long-terminvestment projects where a temporary inabilityto pay may be causbdby projectoverruns in terms of
DZ/ For example,a bank holdinga long positionof 100 would have a capitalrequirement against that position of 12, comprisedof 4 for the gross position(lOOx.04) and 8 for the net (lOOx.08).If that same bank adds shortpositions of 50, reducingits net positionto 50, its capitalrequirement would drop to 10, comprisedof 6 on the gross position(150x.04) and 4 on the net (50x.08). - 18 -
completion time, which may in turn delay the generation of project revenues. Bankers will need to pay more attention to the proper structuring of such loans to anticipate possible delays and reasonable cost overruns. For loans in which a temporary lack of cash flow is anticipated at the loan's inception, it is permissible to allocate portions of the loan proceeds as interest and contingency reserves which can later be drawn against to pay interest or reasonable cost overruns. However, major delays and excessive cost overruns signify well-defined problems and warrant classificationof the loan and provisioning.13
6.63 Another concern, expressed by private bankers, is that the applicationof loan classificationand provisioningcriteria may put private and joint-venturebanks at a considerabledisadvantage vis-a-vis public sector banks. The CBE has issued instructionsrequiring banks to treat private and public sector companies equally and to recognize government backing for loans only when an explicit letter of guarantee has been issued by the Ministry of Finance. Otherwise, nonperforming loans to puolic sector companies should be provisioned and interest accrual suspended as for similar loans to private sector companies.
6.64 Private sector banks express concern that letters of guarantee may allow public sector banks to defer their loan provisioning and, thus, appear to be more profitable than their private sector rivals. This may undermine the competitiveposition of private banks in the market for corporate deposits. It is understood that no letters of guarantee have been issued in at least the last three years. If any letters of guarantee to cover loans to public sector companies are issued in the future, it is important, in order to achieve fairness for all banks, that they should be based on criteria and conditions that are clearly stipulated and objective.
6.65 Foreign Currency Exposure. Commercial banks in Egypt, especially the public sector banks, used to suffer from a large foreign currency exposure. This arose from the use of foreign currency deposits for the financing of imports and was incurred at the behest of the authorities. For a number of years the losses were unrecognizedand carried as other assets on the banks' balance sheets. Data on the published balance sheets of the four large public sector banks show an increase in their other assets from 4.2 percent of total assets in June 1987 to 13.6 percent in June 1990. The rise of 9.4 percent would correspond to 5.7 billion Egyptian pounds, a sum that was seven times the reported capital and reserves of the banks at the time.
6.66 In early 1991, the Government made up the losses suffered by the commercial banks through the issue to them of bonds denominated in
3/ In implementingthe new loan classificationrules, the structure, repayment pattern and future prospects of existing long-term loans for investment projects would need to be carefully re-examined before ascertaining their status and determining any loss provisions. - 19 -
US dollars for a total amount of US$2,090 million, which correspondsto 6,090 million Egyptian pounds. Of this amount, LE 3,015 million was used to cover the foreign exchange losses, and the remaining LE 3,075 million was used as capital injection. The foreign currency bonds earn interest in US dollars at LIBOR and have a maturity of 10 years.
6.67 In addition, the CBE has issued new regulationsmandating tight limits on foreign currency exposure. For instance, the foreign currency assets of banks cannot exceed 105 percent of their foreign currency liabilities (and vice versa), while thelr net asset or liabilLty position cannot exceed 20 percent of their capital. ThLi regulatLon is clearly motivated by prudentialconsiderations, although it appears to inadvertentlypenallze the joint-venturebanks wlth capital denomlnated in foreign currencles. In applylng the ratlo, either the foreign currency capltal of banks should be added to thelr foreign currency llabilitiesor an equlvalent amount should be deducted from thelr forelgn currency assets.
6.68 It ls sometlmes argued that allowing banks to count thelr foreign currency capltal ln calculatingtheir foreign currency exposure would permit them to invest thelr foreign capital in foreign assets (e.g., forelgn currency deposits with their head office). This would raise questions about the purpose of bank capital. However, the narrower version of this regulatlonwould not prevent joint-venture banks from placing domestic currency deposlts with their head offlce. Questions about the nature of bank capital would remaln, but banks with foreign currency capital would be forced to assume a foreign currency exposure.
6.69 An alternativeway of dealing with this situation is to require the joint venture banks to place foreign currency assets in the Central Bank at an amount equal to their foreign denominatedcapital. The funds held by the Central Bank should be remuneratedat market rates. Since the assets and capital would offset each other, this would eliminate the concern that the foreign capital may cause a foreign currency exposure.
6.70 Islamic Banking. There are a few banks that operate on Islamic principles,which allow profits to be distributed to depositors but do not permit the use of fixed-interestdeposit and lending instruments. In fact, some of the big banks have subsidiariesor specially designated branches that offer services based on Islamic principles.
6.71 In the late 1970s, Islamic finance companies were set up in large numbers to collect and manage the remittances of Egyptian workers abroad and the savings of small investors. These companies paid profit- related returns, sometimes at very high rates, and invested their funids in trade finance not otherwise available to importers,in foreign exchange transactions in the parallel market and in foreign investments. The companies were not required to conform to banking regulations and did not come under the supervisionof the CBE. - 20 -
6.72 With the passageof time, these institutionsfaced increasingdifficulties. They were unableto maintaintheir initial high returns,and to stem withdrawalsthat would have causedsevere liquidityproblems, several of them startedto pay high dividendsto existinginvestors out of the funds paid in by new investors. When the inflowof new funds sloweddown, these institutionswere unableto sustaintheir high dividendsand were faced with a liquidityand solvencycrisis that forcedthe Egyptianauthorities to intervene. 6.73 A law regulatinginvestment funds was passedin 1988. It restrictsinvestment fund businessto joint-stockcompanies, imposes minimumcapital standards and vests regulatoryoversight with the CapitalMarket Authority (CMA). The adverseexperience of Islamic investmentfunds has underminedthe confidenceof the savingpublic in collectiveinvestment institutlons and is hamperingattempts to develop mutualfunds in the Egyptianfinancial system. This experience illustratesthe need for adequateregulatlon and supervision,not only of banks but also of nonbankfinancial intermediaries. 6.74 The operationsand performanceof Islamicbanks and Islamic bank brancheshave not given rise to any problems. The difficulties experiencedby the Islamicfinance companies and investmentfunds are attributedto the absenceof adequateprudential regulation and supervision.This deficiencyof financialregulation has now been remedied.
BankingSupervision 6.75 The experienceof many countriesduring the 1980s (e.g.,the UnitedStates, Norway, Sweden, Finland, Chile and Turkey)has shown that stimulatingcompetition in the financialsystem without adequate prudentialregulation and supervisioncan be dangerous. This is especiallytrue if some of the institutionsare not well capitalized. The Egyptianauthorities have alreadytaken severalmeasures to improve both the frameworkof prudentialregulation and the effectivenessof supervision.However, further significant strengthening of banking supervisionis crucialfor the successof the regulatoryreform and the reorientationof economicpolicies towards the privatesector. 6.76 Effectivebanking supervision must combineoff-site surveillancewith on-siteinspection." 4 The formerinvolves the submissionof regularreports, the assessmentof the financialposition of differentbanks and peer performancereviews. To be effective,off- site surveillanceshould be computerized.Bank examinationsrequire highlytrained and experiencedstaff. The CBE, as the main supervisory authority,should be able to hire high calibrestaff and train them to becomeexperienced supervisors and examiners. It shouldalso be able to retainexperienced officers through appropriate compensation packages.
JA/ Annex VI.2 providesa more detaileddiscussion of the mechanicsof effectivebank supervision. - 21 -
However, training staff is likely to take considerabletime. In the meantime, the CBE is following the example of several continental European countries in relying on examinationsconducted by experienced external auditors under its own guidelines and terms of reference. The following sections discuss the role of the various bank supervision departments and the major issues confrontingbank supervision.
6.77 SupervisoryAuthority. The Bank Control Department of the CBE is responsiblefor supervisionover the Egyptian banking system. It is organized on a functional basis in four divisions, three of which are directly involved in bank supervisionactivities: Banking Affairs (licensingand other corporate activities),Statistics and Follow-Up (offsite monitoring),Inspection (onsite examination),and Credit (monetarypolicy). The Department employs a staff of more than 220.
6.78 Supervision is performed through off-site monitoring of bank performance and visits to the banks to review their financial condition. Off-site monitoring and surveillanceis centralizedwithin the Bank Control Department at the CBE, but responsibilityfor onsite inspection is divided. The Central Audit Organization (CAO), in conjunction with external auditors, inspects the public sector banks, and the CBE is responsible for all other banks. However, this division of responsibilitiesmay lead to differentialtreatment and the application of different standards. Although public sector banks are audited both by the CAO and external auditors, it is not clear that these auditors place the same emphasis as CBE inspectorson ascertainingthe financial condition of bank borrowers or on assessing the adequacy of loan provisions. In this context, the CBE should be assigned primary responsibilityfor supervising and inspecting all types of banks, including the public sector banks. The role of the GAO should, accordingly,be limited to verifying the compliance of public sector banks with rules applying to public sector institutionsprovided these do not conflict with establishedrules of banking prudence.
6.79 Licensing and CorporateActivities. Licensing of new banks is the responsibilityof the Banking Affairs Department. This Department is also responsible for approving applicationsfor other corporate activities such as the establishmentof branches and subsidiaries,mergers and acquisitions,and increases in capital stock. At present, it employs a staff of 26. In addition to approving applicationsfor corporate actions, the Departm nt also maintains the register of banks.
6.80 Onsite Examination. Onsite examinationsare the responsibilityof the Inspection Department. This Department is the largest of the Bank Control departmentsand currently employs a staff of 96. Traditionally,bank inspectorshave tended to focus on ensuring compliance with the extensive array of credit controls and tariff schedules. More recently, greater emphasis has been placed on assessing bank solvency and liquidity, although the frequency and intensity of on- site inspectionsmay not be as high as required by the new banking environment. - 22 -
6.81 Duringthe past year, improvementin the qualityof onsite Inspectionshas been notedby membersof the localbanking community. However,all partiesagree that furtherwork is requiredto upgradethe skillsand knowledgeof examiners. In addition,at present,banks are being inspectedonly once every threeyears. This is too infrequentas a-meaningfuldeterrent to unsoundand unsafebanking practices. The recentpromulgation of regulationsfor the classificationof assets, provisioning,and suspensionof interest,and the adoptionof the BIS capitaladequacy requirements, requires close attention by the examiners to challenge,where appropriate, the bank'sclassifications and related provisions,to ensureconsistent application of the classification criteriaamong banks, and to enforcecompliance with the substanceof the regulations.Therefore, it may be advisableto conductspecial targetedexaminatior,s to ensurethat assetsare beingproperly classified,adequate provisions established, interest on non-performing assetssuspensed and to ensurethat capitaladequacy measures are being met.
6.82 Currentexamination practices are movingto better assessmentof asset qualityand bank solvency. However,due to a lack of acceptableaudit activitiesin some bank3, the examinersare often requiredto performbasic audit activitiessuch as confirming transactionsthrough negative or positiveverification and reconciling correspondentbank accounts. Theseactivities are time consumingand generallynot cost effective.In this regard,there is a need to strengthenthe abilityand independenceof internaland external auditorsso that the examinerscan placegreater reliance on their findingsand move examinationactivities even furtherto focusmore on the assessmentand appraisalof bankingrisks. Examinationsshould also becomemore forwardlooking, rather than a "snapshot"of a bank's conditionat a singlemoment. This requireseven greateremphasis on appraisinga bank'ssystems for identifying,measuring, and controlling risks in an uncertainenvironment.
6.83 OffsiteSurveillance. The Statisticsand Follow-Up Departmentis responsiblefor prudentialoffsite monitoring of the bankingsystem. This Departmentcurrently employs a staff of 73. 6.84 Banks are requiredto submita varietyof prudentialand statisticalreturns to the Departmenton a weekly,monthly, or quarterly basis. In total,these returns number close to 20. Upon receipt,the variousreturns are reviewedby the examinerswithin the Statisticsand Follow-UpDepartment on a bank-by-bankbasis. In general,changes in balancesfrom one periodto the next are analyzedand, where appropriate,the bank is contactedfor an explanation.The aggregation of the returnsforms the basisfor analysisof trendsand developments in the bankingsystem for monetarypolicy purposes.
6.85 The CBE'sboard of directorsis regularlyinformed of currentdevelopments in the bankingindustry through reports prepared by the Bank ControlDepartment. In addition,in cooperationwith the ResearchDepartment, the Statisticsand Follow-UpDepartment prepares - 23 -
the annual report submittedby the CBE to the Peoples' Assembly as required by law.
6.86 At present, there is a need to improve the ability of the Department to quickly compile information,calculate ratios, and compare performance against peers. In addition, there is a need to strengthen the Department'sability to conduct more sophisticated"what-if" type analyses and to assess trends in industriesto which the banks are large lenders. For the most part, returns are currently reviewed manually and calculationsare made using hand-held calculators.
6.87 Given the importanceof supervision for a banking system operating in a competitiveenvironment, Egyptian bank supervisionshould be strengthened. For this reason, a comprehensiveprogram of technical assistance is being developed.15 A good supervisory system requires a well-defined supervisory framework,adequate resources and technology for the supervisors to obtain and monitor information in a timely fashion and sufficientauthority for the supervisors to enforce their decisions.
6.88 It is also important when supervisingbanks and implementing prudential regulations to ensure that all financial institutionscomply with the stipulatedrules. Public sector banks should not come under pressure to lend or to provide equity to insolventpublic sector companies at the behest of their sponsoringministries. Even if full provisions are made against such lending, they would undermine the effectivenessof prudential regulations,would distort competition and would result in a continuingmisallocation of resources. Decisions to support ailing public sector companies for economic or social reasons should be taken at a different level and should involve budgetary transfers of one sort or another. (See Chapter II.)
6.89 The new prudential regulationson liquidity, capital requirements,asset classificationand provisioning rules, and foreign exchange exposure are all intended to improve the regulatory framework and, with the qualificationsnoted above, indicate a move in the right direction. In addition, improving disclosurerules would increase transparencyand make supervisioneasier, not only for the regulators but also for the general public. Encouraging the development of private rating agencies would also improve the disseminationof informationand help establish market discipline.
6.90 Powers of the CBE. Supervisorsshould also have sufficient authority'todeal with mismanaged institutions. As already noted above, recent amendments to the banking law give more authority to the CBE in removing incompetentor abusive managers and directors and in calling
w/ The technical assistance program is being supported under the "TechnicalAssistance Project for Privatizationand Enterprise and Banking Sector Reform" credit, approved by the Bank Board in June 1992. - 24 - for increasedcapital. However,powers for dealingwith crisis situations,early intervention,and resolutionmechanisms to prevent bank failuresand lossesto small depositorsare not yet well-defined. 6.91 As a resultof the recentamendments to the bankinglaw, the Governorof the CBE shouldbe notifiedwithin thirty days of decisions regardingthe appointmentof board membersand generaldirectors of the banks, as well as of the directorsin chargeof credit,investment, or foreignoperations. The Ministerof Economyand ForeignTrade is empowered,on the adviceof the Governorof the CBE, to removeany board memberor directorif the DepositInsurance Fund or the bank'sassets are in danger. Affectedparties may submita complaintto the Minister withinsixty days of notification.These provisionsaim to protectthe bankingsystem from personsthat are not deemed"fit and proper"to act as managersor board membersof banks. However,the legal procedures appearcumbersome and unclear. In principle,the CBE shouldhave the power to approvechanges in the controlor ownershipof a bank with immediateeffect, but subjectto an appealafter the fact to an executiveboard of appeals. The lattercould be entitledto hear cases and reach final decisionsand could consistof representativesof the CBE, the Ministryof Economy(MOE) and ForeignTrade, the academiaand the businesssector. 6.92 IncentiveStructure. Even if supervisoryregulations are adequate,and the above conditionsare met, the lack of an appropriate incentivestructure may preventregulators of financialinstitutions from doing theirjob properly. Therefore,it is also importantto protectsupervisors from politicaland bureaucraticpressures. For example,in the UnitedStates, regulators of depositinstitutions often face pressuresfrom politicians,their regulatoryclientele, and lobbyists. As appointedofficials, regulators face pressurefrom politiciansto leave problemsunsolved since tacklingthem openlywould cause conflictwith variousconstituencies and adverselyaffect the chancesof winninga reelection.Following a cover-upstrategy keeps involvedconstituencies and politicalaction committees willing to pay tributeto politicians.One of the most challengingaspects of the upcomingfinancial reform in the US is how to improvethe incentive structuresfor regulatorsand politicians.16 6.93 In structuringthe supervisorysystem, it is importantthat Egypt learn from internationalexperience. Bank regulatorsand supervisorsshould have the necessaryincentives to avoid conflictsof interest. This is possiblethrough very well-definedsupervisory rules, transparency,the necessarymandate for regulatorsto performtheir dutiesand periodicindependent checks on regulatoryactivities.
16/ For a detailed discussionof the incentive structurefor the regulatorsof depositinstitutions in the UnitedStates and a reform proposalsee Kane (1989). - 25 - 6.94 InformationDisclosure and Bank Secrecy. As alreadynoted, disclosureof informationon the financialcondition of banks,beyond what is includedin publishedannual reports and accounts,is discouragedby existingbank legislation.17 In most countries,bank secrecyprovisions aim at protectingthe interestsand privacyof individualdepositors and borrowersof banks. Sometimes,bank secrecy provisionsare appliedin cases where there is concernthat the disclosureof negativeinformation might lead to a depositrun on these banks, impairtheir abilit,to raise fundsin the money and capital marketsand have a potentiallyadverse impact on the stabilityof the bankingsector. 6.95 The disclosureof detailedfinancial information is essentialfor listedbanks that may also be subjectto periodicreviews by ratingagencies. Such disclosurewould informthe investingpublic and depositorsabout the financialcondition of banks that raise capital funds and depositsfrom the public. Banks in financialdifficulty shouldbe protectedby the operationof a depositinsurance scheme and by an effectivesystem of supervisionand failureresolution procedures that would preventdifficulties of individualbanks both from getting out of controland from spreadingto the rest of the bankingsector. 6.96 Bank secrecyprovisions should also not apply to large shareholdersof banks,who shouldbe requiredto disclosethe level and originsof their wealth. In effect,bank legislationneeds to be amendedto ensurethe privacyof individualcustomers of banks,without underminingthe effectivenessof prudentialregulation and supervision.
IV. Financial Condition of the Egptian Banking Syste 6.97 The financialcondition and soundnessof Egyptianbanks, especiallythe publicsector banks, has been in doubt for some time. This has emanatedfrom the low capitalizationof banks,the accumulation of large forei-ncurrency losses, the exposureto nonperforming enterprisesin both the publicand privatesectors, and substantial operatinginefficiencies resulting from overstaffingand inadequate investmentin computersand electronicbanking technology. The financialcondition of joint-venturebanks and foreignbanks has been less seriousbecause of theirlimited exposure to publicsector companies,their nonincurrence of foreignexchange losses and their higherequity capital. However,all banks operatingin Egypt are likely to experiencea deteriorationof their financialcondition in light of the macroeconomicpolicy reforms and the industrialrestructuring that will ensue.
D3Z/ Article 63 of Law 163 of 1957 stipulatesprison sentencesand/or fines for any official charged with executing the law, i.e. officialsof the CBE, who "disclosesany data or information obtainedin exercisinghis functions". - 26 -
6.98 The Egyptian authoritieshave already taken several important steps to improve the financial position of different groups of banks and, especially, the condition of the four, large, public sector banks. As alreaee noted above, these measures include the recognition of foreign curre; y losses and the injection of new capital in the four public sector banks. In addition, various regulationshave been issued setting up new standards of capital adequacy, asset classificationand provisioning, and limits on foreign currency positions. Audits have been completed and additional provisions have been miadefollowing guidelines from the CBE. However, the apparent large exposure of banks to nonperforming loans will not be fully resolved until industrial and commercial companies are properly restructuredand put on a financially and commerciallysound footing. Banking reform and restructuringmust go hand in hand with industrial restructuring,otherwise ehe banks are in danger of continuing to support technically insolvent and nonviable firms and incurring equally large losses in the future.
6.99 The analysis in this section focuses on four areas: competition and market structure; operating efficiency; solvency and liquidity; and the managerial autonomy of public sector banks. Special emphasis is placed on the creation of a level playing field for all types of banks and on the elimination of explicit and implicit discriminationin favor of public sector banks.
Competitionand Market Structure
6.100 Market Structure. The Egyptian banking system consists of 98 banks, namely: 4 public sector banks; 40 private and joint-venture commercial banks; 11 business and investmentbanks; 22 foreign banks16 (still operating in foreign currency business only); and 21 specialized banks (2 real estate, 1 industrial and 18 agriculturalbanks). These numbers include three Islamic banks working according to the same rules as the others. Many of the banks are joint ventures between one of the public sector banks and major internationalor Arab banks. Private commercial banks and business and investment banks were initially chartered under different laws, but currently there is little difference in their business mix and operations.
6.101 The large public sector banks account for 55 percent of total bank assets. Other commercial banks have 22 percent, and business and investment banks have 16 percent, giving them a combined total of 38 percent. Ihe remaining 7 percent is accounted for by the specialized banks. The share of the public sector banks has increased in recent years, both because of the decline in the level of lending undertaken by
18/ Foreign banks operate through branches. This term is used rather than "foreign bank branches" because a foreign bank may have more than one local branch. A local subsidiary of a foreign bank would legally be a domestic bank, albeit under foreign ownership and control. 27 -
some foreign and joint-venturebanks and because of the recent recapitalizationof the large banks.
6.102 The dominance of purely public sector institutionsis underscored further if account is also taken of the role of the (NIB). Although as argued in Chapter IX on social insurance, the NIB is far from being a financial institution in the proper sense of the term, it accounts for the vast resources mobilized by the social insurance funds. The share of the public sector banks in an augmented total is around 45 percent. However, adding the 20 percent of total financial resources accounted for by the NIB and the 5 percent share of specializedbanks gives a total share for all public sector institutionsof 70 percent. Joint ve:iture-banks,several private banks and foreign banks account for the remaining 30 percent kTable AVI.1, Appendix).
6.103 Market Segmentationand Competition. The banking market is highly segmenited,and this has a stifling effect on competitionand innovation. Retail business is dominated by the large public sector banks, which have relatively large branch networks -- between 150 and 350 branches each -- and raise retail deposits from the saving public. Because of restrictionson the expansion of branch networks, branch density is low by internationalstandards. There are about 1,500 branches for a total population of nearly 54 million people, correspondingto less than 28 branches per million peiple.
6.104 The product mix of most of the other banks is tilted towards wholesale business and upscale customers. An interbank market has emerged in recent years. Although it is open to all banks, it appears to be dominated by intergroupbusiness. Following the deregulationof interest rates, interbank rates have increased from 8-9 percent to 16-18 percent. The large banks, which are net suppliers of funds to the interbank market, have benefitted from the increase in interbank interest rates at the expense of the joint-venturebanks that have traditionallybeen net users of interbank funds.
6.105 Most bank lending is directed at larger enterprises in both the public and private sector. Lending to small firms is limited by the lack of adequate informationand collateral. A limited credit guarantee scheme is used by some of the larger public sector banks to promote small business lending.
6.106 Financial innovationhas been limited and has been mostly restricted to deposit instruments. The offer of modern financial services in leasing, factoring and investmentbanking has suffered from the absence of enabling legislationand the weakness of the securities markets.
6.107 The market for corporatebanking services is highly segmented. The large public sector banks mainly cater to the needs of public sector companies, although they are also playing a growing part in serving the private sector, especially smaller and medium-sized firms. The joint-venturebanks specialize in providing short-term - 28 -
working capital and trade finance, where they have a strong comparative advantage because of their use of more modern financial instruments and operating methods and their greater access to foreign currency funds and internationalbanking networks. The joint-venturebanks are particularlyactive in the market for large- and middle-marketprivate sector companies, although they also deal with public sector companies, especially those with heavy demands for trade-relatedfinancial services, which cannot always be met by the main public sector banks. The local branches of foreign banks, especially those of American banks, increasinglyfocus on fee-based services that include, among other things, trade-relatedfinancial services, advice on mergers and active participation in debt-to-equityswaps.
6.108 The segmentationof the market and the continuing dominant role of public sector institutions,in both the financial and industrial sectors, have resulted in an effective crowding out of the private sector in the credit market. In fact, one of the most persistent criticisms of the Egyptian banking system is the limited access of the private sector to credit facilities. An analysis of the total claims of all commercial banks (both the public sector banks and other commercial banks) shows that claims on the private sector represented, in June 1991, 35 percent of total domestic claims, down from 42 percent in June 1990 (Tables AVI.2 and AVI.3, Appendix).
6.109 A large part of the fall is attributed to the transfer of foreign-currency-denominatedgovernment bonds to the public sector banks to cover the unrecognizedclaims arising from past foreign currency lossesi9 and to inject new capital in public sector banks. In addition, demand for credit by the private sector has been subdued because of the high interest rates (relativeto expected inflation) and the repatriationof capital (e.g., partial dedollarization).
6.110 Both business and investmentbanks and the specializedbanks lend over 70 percent of their credit funds to the private sector; for the whole banking system the claims on the private sector represented43 percent of all domestic claims in June 1991, down from 50 percent in June 1990. However, if the resources accountedby the NIB are also taken into consideration,the share of the private sector collapses to less than 29 percent.
6.111 The commercial banks accounted for 63 percent of lending to the private sector; the business and investmentbanks, for 19 percent; and the specializedbanks, for 17 percent of the total (Table AVI.4, Appendix). Unfortunately,detailed data to ascertain the share of the public sector banks in lending to the private sector are not readily available. If the structure of lending by nonpublic-sectorcommercial banks is similar to that of business and investmentbanks, then the
12/ These were previously registered as other assets, but after their recognitionare treated as claims on the government. - 29 - share of the publicsector banks would be about 29 percentand that of the other commercialbanks about 34 percent. 6.112 Level playingField. One of the main obstaclesto greater competitionin Egyptianbanking is the apparentor potential differentialtreatment of publicand privatebanks, although the authoritiesstress that all banks are treatedequally without any discrimination.Public and privatebanks are, in principle,subject to the same regulations,but privatebankers express concerns that in applicationand enforcementof certainregulations, there is room for discrimination.A relatedissue is the uniformtaxation of different instrumentsand institutions,which is addressedin ChapterV of the report. 6.113 Many of the areas of potentialdiscrimination have already been alludedto. A prime exampleis the allocationof creditceilings, where there is concernthat the ceilingsare assignedin a way that favorsthe larger,public sector banks. Publicsector banks also benefitunduly from the continuingprohibition of paymentof intereston demanddeposits. 6.114 In the past, branchauthorizations have tendedto discriminatein favor of publicsector banks, which appearnow to be the main beneficiariesof the deregulationof loan and depositrates. Althoughjoint-venture banks are unlikelyto engagein a massive expansionof theirbranch networks, several indicated their willingness to doublethe numberof branchesover the next few years,if branching becamemore liberaland evenhanded.This would increasecompetition for both the corporateand so-calledmiddle market. 6.115 Publicsector banks also benefitfrom captiverelations with publicsector companies. If they are net borrowersfrom a publicsector bank, these companiesrequire the permissionof theirmain bank before they can use depositfacilities and otherbanking services (such as the openingof lettersof credit)of other banks. The close relationship with publicsector companies is not necessarilyadvantageous to the publicsector banks, which have sufferedlosses and interestsuspension on nonperformingloans to such companies. Nevertheless,private banks are deniedthe opportunityto providenoncredit fee-based services to publicsector companies, unless the latterobtain the approvalof their main publicsector bank. 6.116 Joint-venturebanks are at a disadvantagein buildingclose relationshipswith corporatecustomers because, unlike domestic banks, they are not allowedto hold equitystakes in industrialand commercial companies. Publicsector banks also benefitfrom the requirement imposedon alternativepension funds to place depositswith public sectorinstitutions (Chapter X). 6.117 Finally,the supervisorybodies of privateand publicsector banks are different. Althoughthe primaryresponsibility for supervisingthe bankingsystem lies with the CBE, publicsector banks - 30 -
(as well as the joint-venturebanks wi'h more than 25 percentdirect state ownership)are auditedby the CAO and externalauditors. There is concernthat standardsof supervisionmay not be equallyrigorous. This concernis also relatedto the effectof the new regulationson loan classificationand provisioning.If publicsector banks are allowedto benefitunduly from governmentletters of guaranteecovering their loans *totechnically insolvent public sector companies, while joint-venture banks are forcedto complyfully with provisioningregulations with regardto their loans to privatesector companies, the resultwould be to force privatebanks to reportlower profitsand, thus,weaken their competitiveposition. In fact, one argumentin favor of deposit insurance is that it would transform an implicit system that effectively protectsthe depositsof publicsector banks into an explicitsystem that would protectthe depositsof all banks. 6.118 To establisha fully competitivefinancial se3tor, it is importantto ensureequality in the designand implementationof regulations.Not only shouldthe overlyrestrictive regulations be removed,but the playingfield shouldalso be level for all the participantsin the game. OperatingEfficiency 6.119 OperatingRatios. Data on the operatingefficiency of Egyptianbanks are not readilyavailable. The analysiscontained in this reportis based on publiclyavailable data for a sampleof 24 banks that includesthe 4 publicsector banks, 5 large joint-venturebanks, 8 small and medium-sizebanks and 7 foreignbanks. The data cover the period1986 to 1990 and do not reflectthe recentchanges in the financialstructure of the largepublic sector banks. The data have many shortcomingsas they are not based on commondefinitions and accountingpractices. However,as noted below,their most important weaknessis the lack of informationon the extentof nonperforming assets. 6.120 Three types of ratiosare frequentlyused: operatingasset ratios,which relaterevenues and expensesto averagetotal assets; operatingincome ratios, which relaterevenues and expensesto gross income(defined as the sum of net interestincome and net noninterest income);and operatingequity ratios, which relaterevenues and expenses to averageequity. Althoughthese are subjectto many shortcomings emanatingfrom differencesin capitalstructure, product mix and accountingconventions across countries, among individualbanks and over time, their use can offer a rough indicationof efficiency,provided they are supportedwith detailedknowledge and understandingof banking structuresand practicesin particularcountries. 20
V/ A more detaileddizcussion of the meritsand demeritsof different bank-operatingratios, drawing on Vittas (1991a)and also offering more extensiveinternational comparisons, is containedin Annex VI.3. - 31 -
6.121 Egyptian banks reported low interest margins over the period 1986-90 (Table AVI.5, Appendix). These margins were the result of the past regulation of interest rates and the narrow spreads imposed by the authorities. The interest margin of the public sector banks was particularly low at 1.66 percent and was caused by greater exposure to lending to public sector companies. The interest margin of large joint. venture banks amounted to 2.3 percent; the margin of small and medium banks amounted to 2.6 percent. These were low to moderate by internationalstandards.
6.122 Among the countries reviewed for this report, only the large commercialbanks in Greece and t%.egiro landesbanks in Germany reported lower interest margins than the Egyptian public sector banks. In the case of the German banks, this is explainedby the wholesale nature of their business. For the Greek banks, the low interest margin reflects the nonaccrual of interest on their large volume of nonperforming loans.
6.123 Egyptian banks generated considerablenoninterest income through regulated fees and commissions. The share of fee-based income in their total gross income compared well with that of large US and UK commercial banks. However, their gross income margin was moderate, except for the large public sector banks where it was rather low by internationalstandards.
6.124 The pre-tax return on assets (ROA) of the largs joint- venture banks and the small- and medium-sizedbanks, at 1.48 percent and 1.13 percent, respectively,was quite high, while that of the foreign banks and the large public sector banks was in the middle range among banks in several developed and developingcountries. The satisfactory ROAs, despite the relatively low gross income margins, is explained by the low operating costs of Egyptian banks. However, the returns on equity (ROEs) of Egyptian banks are far from satisfactory,as discussed further below.
6.125 Operating costs amounted to 1.1 percent of assets for the large public sector banks and to 1.75 percent of assets for the small- and medium-sizedbanks. The cost/income ratio for these two groups of banks was only around 40 percent against over 60 percent for banks in most other countries. Operating costs are also likely to be quite low for the other groups of banks. The low costs are attributed to the limited range of services offered by Egyptian banks and the related limited spending on modern banking technology,as well as the low level of wages and rents.
6.126 In contrast to their low operating costs, Egyptian banks made large general provisionsfor loan losses, for depreciationof fixed assets and, perhaps also, for future pension liabilities. Provisions amounted to 40 percent of gross income for the large public sector banks and to 30 percent for the small- and medium-sizedbanks. In terms of total costs, the large joint-venturebanks reported a very low ratio of 62 percent, whereas the other groups of banks had ratios ranging between - 32 - 72 percentand 79 percent. These comparewith internationalratios of between75 percentand 85 percent. 6.127 The analysisso far suggeststhat the joint-venturebanks and the small-and medium-sizedbanks were more efficientand more profitablethan the largepublic sector banks. Hovever,the latter reporteda much highernominal pre-tax ROE of 37.6 percentagainst slightlyless than 25 percentfor the large joint-venturebanks and 16 percentfor the small-and medium-sizedbanks. This was becausethe publicsector banks operatedwith a very high leverageof nearly53 times their equity. Had their leveragebeen closerto that of the joint-venturebanks, theirROE would have been less than 17 percent. 6.128 Adjustingfor inflation,which averaged20 percentper year duringthe five-yearperiod, the real pre-taxROEs of Egyptianbanks rangedfrom low to negative,with the exceptionof the publicsector. banks,which had a real ROE of nearly15 percent. Data for banks in other countriesshow that Turkishcommercial banks also reportedhigh nominalROEs of 55 percentbut, in fact, achievedreal ROSs of only 2 percent. The lowestreal ROEs among the banks reviewed,in all cases negative,were registeredby commercialbanks in Portugaland Greeceand by foreignbanks and smallcommercial banks in Egypt. At the other end of the spectrum,the highestreal ROEs were achievedby the UK building societies,the Germansavings banks and the commercialbanks in the Netherlands,Germany and Canada. 6.129 In general,the operatingmargins of Egyptianbanks were not adequatet- achievesatisfactory real returnseven beforeallowing for any unprovLed nonperformingassets. To improvetheir profitability. the banks,especially the publicsector banks, need to improvetheir cost/incomeratios and/or increase their gross incomemargins. 6.130 The publicsector banks could increasetheir spreadsby fully adjustingto marketlevels the rates chargedon loans to public sectorcompanies. However,their abilityto do this would dependon the financialcondition of publicsector companies. In the short run, an increasein lendingrates might cause a deteriorationin nonperforming assets,but, in the long run, any such losseswould have to be covered by budgetarytransfers. 6.131 The above analysisdoes not incorporatethe effectsof the 1991 reformin bankingregulations or the recapitalizationof the public sectorbanks. However,as a resultof the deregulationof interest rates and the increasein interbankrates, the interestmargins of publicsector banks must have improvedconsiderably at the expenseof those of joint-venturebanks. In addition,the banks will earn interest on the governmentbonds that were transferredto them to cover their foreignexchange losses and increasetheir equitycapital. - 33 - 6.132 The combinedresult of thesechanges in improvingthe interestmargin of largebanks is likelyto be significant.2 1 On the otherhartd, the publicsector banks may have ti increasesubstantially theirprovisions against unrecognized nonperforming assets to public sectorcompanies, if the new ruleson loan classificationand provisioningare appliedequally to all banks. The net impactis difficultto predictwithout more detailedinformation of the roundness of the banks' loan and equityportfolios. The detailedaudits of public sectorbanks, which are to be completedin late 1992,should provide a betterand forward-lookingassessment of the soundnessof thesebanks. 6.133 Branchingand StaffLevels. Egyptianbanks have relatively smallbranch networks (Table AVI..6, Appendix). Bank Misr, the bank with the largestnetwork, has 342 branchesagainst 280 branchesfor the NationalBank of Egypt,which is the largestcommercial bank in termsof totalassets. None of the joint-venturebanks has more than 20 branches. The smallbranch networks reflect the orientationof banks towardswholesale and corporatebusiness, although the largepublic sectorbanks mobilize substantial deposits from individualsavers. 6.134 In line with theirbusiness and productmix, Egyptianbanks have high numbersof staffper branch. The joint-venturebanks report around50 staffper branch,while the publicsector banks have 38 staff per branch. Thesefigures are high by comparisonto the staffinglevels of most internationalbanks with extensiveretail operations. In general,commercial banks in Britain,Germany, France and otherOECD countrieshave about25 staffper branch. However,banks specializing in retailbanking, such as the UK buildingsocieties or the savingsand cooperativebanks in severalcontinental European countries, have much lowerlevels of staffper branch (around10). Thus,an expansionof branchnetworks by Egyptianbanks to improvethe qualityof services offeredto theirpersonal customers should not entaila proportionate expansionof staff.
6.135 The greaterinvolvement of the largepublic sector banks in retailbusiness is confirmedby data on the averagesize of assetsand depositsby branchand by staff. On all counts,the largepublic sector bankshave loweraverage levels than the largejoint-venture banks, the small-and medium-sizedbanks or the foreignbanks. This suggeststhe need for the largepublic sector banks to operatewith higherspreads in their lendingand depositbusiness. However,without more detaileddata on the breakdownof the businessmix betweenretail and wholesale,it is not possibleto draw definitiveconclusions about the relativeoperating efficiencyof differentgroups of banks.
,/ Clearly,the improvementwould have been even greaterhad the banks fully adjustedtheir lending rates to marketlevels. - 34 -
Solvency and Liquidity
6.136 Solvency. Concern about the low capitalizationof Egyptian banking has recently been mitigated by the capital increase of the public sector banks, although this was effected through the issue of government bonds rather than the injection of cash. However, it appears that several smaller banks may continue to suffer from low capitalization.
6.137 Assessing the solvency of banks requires detailed informationon the soundness of their asset portfolios. Data on the level of nonperformingloans are not published. For some banks, it is believed that these represent a high proportion of loans. For the public sector banks, a crucial factor is the treatmentof loans to, and equity stakes in, loss-makingpublic sector companies that may be unable to service their loans and may resort to additional bank lending to meet their payrolls.
6.138 An analysis of the balance sheets of different groups of banks shows that the large public sector banks had, on average, over the period 1986-90 loans amounting to 43.9 percent of their total assets, against which they held provisions equal to 5.3 percent of total assets, or 12.1 percent of loans. The banks made an annual provision equal to 1.2 percent of assets, or over 2.7 percent of loans outstanding. Adding their equity capital shows that the banks covered 16 percent of their loans before the recent increase in their capital. Adding their investments,which for the most part consist of equity stakes in public sector enterprises,gives a total exposure of 57.1 percent of assets. Provisions and bank equity amounted to only 12 percent of total exposure. The data for the other groups of banks show higher levels of coverage against bank loans, mainly resulting from their higher capitalization(Table AVI.7, Appendix). These range from 27 percent in the case of large joint-venturebanks and small- and medium-sizedbanks to 35 percent for foreign banks.
6.139 Assessing the sufficiencyof the level of provisioningof Egyptian banks is difficult because provisions may cover other uses such as future pension liabilities,while the practice of carrying doubtful loans on the balance sheet, even if they are fully provisioned,inflates the book value of loans and does not allow a distinctionbetween general and specific provisions. More importantly,the level of truly nonperformingloans may be substantiallyhigher than the cover provided by the present level of provisions and capital reserves.
6.140 Concern about the insufficiencyof provisions and about the true financial condition of Egyptian banks stems from four considerations. First, there is the past practice of debiting loan accounts with interest accrued but unpaid for over six months. Although such interest is credited to a suspense account and is not taken into income in the profit and loss statement, the practice tends to inflate - 35 -
loans outstanding.22 Second, there is the failure to write off loans, even when they are fully provisioned,until a court decision is obtained. This also inflates the book value of loans. Correcting the level of provisions for these two factors would leave a much smaller cushion than is implied by the published data. Third, nonperforming loans to public sector companies and public authoritiesare highly unlikely to be covered by sufficient provisions because of the implicit or explicit backing of the Government. The anticipated adverse impact on the finances of public sector companies from the macroeconomic adjustment policies that are currently under implementationsuggests that nonperforming loans to public sector companies are likely to increase substantiallyin the near future, unless the Government is able to provide financial support to these companies and implement an effective restructuringprogram. Fourth, nonperforming loans are also likely to increase among private sector companies, especially in sectors that are more exposed to the adverse impact of the current economic recession.
6.141 Detailed audits undertaken in many developing countries with similar structural problems to those facing the Egyptian economy usually find that nonperformingloans exceed 30 percent of book loans. Nonperforming loans are classified as substandard,doubtful and loss, and the distributionbetween classes clearly varies from country to country. However, after taking account of the realizable value of collateral, an average provisioningof 60 percent against nonperforming loans would not be far off the mark. This would imply that provisions should be equal to 18 percent of the book value of loans. Under these assumptions,the data shown in Table AVI.5, Appendix, suggest that the level of provisions may be adequate for the smaller Egyptian banks but insufficientfor the large public sector banks.
6.142 To establish the true financial condition of commercial banks, detailed audits based on a forward-lookingassessment of their assets are needed. Special audits were being conducted by teams of Egyptian auditors associated with the large internationalauditing firms following CBE guidelines,and should be completed in late 1992 and early 1993. At the same time, action needs to be taken to restructure industrial and commercial companies that are in financial difficulties and to close down nonviable entities. The functioningof the legal system, especially with regard to bankruptcy procedures and mechanisms for the liquidationof collateral and the recovery of debts, should also be improved.
6.143 Liquidit_y. Currently, the banks maintain large liquid positions, a result of the impositionof tight credit ceilings; the process of (partial)dedollarization and the conversion of dollar deposits into local currency deposits; the high, tax-free interest rates available on risk-free treasury bills; and the high risks associated with lending to industrial and commercial corporations. Except for the
2.21 This practice was officially halted in 1991. - 36 -
public sector banks, these appear to exceed the required reserve and liquidity ratios.
6.144 Data for 1990 show that the public sect r banks invested 33 percent of their assets in liquid assets (cash and due from banks, including their reserve balances with the CBE); the large Joint-venture banks invested a staggerLng 61 percent (up from 55 percent in 1985); the small- and medium-sizedbanks invested an equally large 54 percent; and the foreign banks invested no less than 81 percent of total assets (Table AVI.8, Appendix). The liquidity ratios would be much higher if expressed as percentages of deposits. In the case of foreign banks, the high liquidity position is partly explained by the placing of foreign currency deposits of residents in internationalbanking centers and partly by their involvementin interbankbusiness conducted in foreign currencies.
Nanagerlal Autonomy of Public Sector Banks
6.145 As already noted, public ownership of banks is not necessarily incompatiblewith operating efficiency. There are several public sector banks, especially in continental European countries, that report high operating efficiency. However, an important feature of efficient public sector banks is their managerial autonomy and the freedom from government interferencein their decision-making. A strong argument for bank privatizationin many countries is the fact that public sector banks are more prone to government interferencethan private banks.
6.146 To strengthen the managerial autonomy of public sector banks in their credit, planning and staffing decisions, it is important to separate the role of government as shareholder from that of regulator. The CAO should represent the interests of the Government as shareholder, while the CBE should have full responsibilityfor prudential and monetary regulation. The relationshipsbetween public sector banks and the CAO should be based on monitorable performanceplans with clear objectives and accountabilityprocedures. An independentboard of directors should be appointed for each bank, consisting of experienced professionals and businessmen. The board of directors should have the power to appoint the senior management of the banks, who would be accountable to the board.
6.147 To enhance their operating efficiency, the banks should adopt detailed institutionaldevelopment plans covering such fundamente: areas of banking operations as the management of financial resources (asset and liability management, credit policies, internal inspection procedures); the management of human resources (recruitmentand compensationpolicies and training); and the management of physical resources (the developmentof branches and other infrastructureand the utilization of computers and bank automation). If the Government wishes to use public sector banks as a channel for financing activities that the banks would not support on the basis of their own financial criteria, such operations should be undertaken on a fee basis with the - 37 - associatedcredit risks formallyremaining with the Go 'Nrnmentand coveredby transfersfrom the budget.
6.148 Strengtheningthe managerialautonomy and accountabilityof publicsector banks would pave the way for theireventual privatization. It would also presupposeprogress in tacklingnonperforming assets of publicsector enterprises and in ensuringthat both publicand private sectorcompanies respond to undistortedincentives and relativeprices. the privatizationof the publicsector banks would also increasethe contestabilityof the market.
V. ConclusiQns
6.149 Much of the reactionby the Egyptianbanking system to the deregulationof interestrates appears to have followeda patternthat is found in most cases of radicalfinancial reform. The selective impactin favorof largepublic sector banks; the rise in bank liquidity;the attemptto coordinateinterest rate increases;the growingconcern about nonperforming loans; the pressureof overstaffing, the need to modernizebanking practices; the desirefor financial innovation;and the need for more effectivestaff training have been observedin othercountries that have adoptedprograms of financial reform'such as Indonesia,Sri Lanka,Turkey, Tunisia, Hungary, Mexico and ChiLe.
6.150 The gradualapproach adopted by the Egyptianauthorities is in line with the experienceof most countriesthat have implemented successfulreform programs. The realizationof the full benefitsof the reformrequires, on the one hand, the removalof existingbarriers to entryand exit and of priceand productcontrols and, on the other,a significantstrengthening of prudentialregulation and banking supervision.An importantissue is the eliminationof any discriminationin favorof publicsector banks. ProposedReform Program
6.151 To ensurethe successfulcompletion of the reformprogram, the authoritiesmust be committedto applya detailedplan with clear objectivesand sequentialactions that would strengthenthe confidence of both the publicand the commercialbanks. The detailsof such a plan and the sequencingof differentactions can only be determinedafter carefulstudy of the politicalfeasibility and the benefitsand costs of alternativecourses of action. The proposedreform program could/should includethe followingactions:
Phase I a. Grantingadditional powers to the CBE to carry out its supervisoryfunctions, but subjectto an executiveboard of appeals.
b. Furtherstrengthening the systemof prudential regulationand supervision.This shouldcover implementaticnof the new regulationson capital - 38 -
adequacyand asset classificationand provisioning.It shouldalso includethe completionof forward-lookingaudits, conducted by externalauditors under guidelinesissued by the CBE, and the capitalizationof banks,as appropriate. c. Developingappropriate policies, including adequatecompensation packages, for recruiting and trainingable staff and for retaining experiencedofficers in bank examinationand supervision. d. Developingopen marketoperations and phasing out bank-specificcredit ceilings. e. Improvingthe functioningof creditcontrols, if bank-specificcredit ceilings are not phasedout withinthe next 12 months,by exemptingfrom ceilingscredits financed by long-termfunds and introducinga systemfor auctioningand trading creditquotas. f. Clarifyingthe rules of the depositinsurance schemeto createeffective exit mechanismsfor insolventbanks (the detailsof the schemewould need to be specifiedafter carefulstudy of the implicationsof alternativeoptions). g. Strengtheningt,e formalmanagerial autonomy of public sector banks and enhancing their operatingefficiency by establishing institutionaldevelopment plans, encouraging training,and modernizingprocedures and banking technology. h. Removingrestrictive regulations that inhibit competitionwithout encouraging prudence, such as the controlson tariffschedules, the prohibitionof interestpayment on demand depositsand the minimumrate on savings deposits. i. Promotinga levelplaying field for all participantsby removingdiscriminating practicesand regulations.
J. Authorizingthe full entry of foreignbanks throughthe establishmentof local subsidiaries. k. Privatizingthe publicstake in Joint-venture banks. - 39 -
Phase II a. Lowering reserve and liquidity requirementsand remuneratingreserve balances with the CBS. These measures should be taken after full assessment of their monetary and budgetary implications.
b. Liberalizingbranching rules for banks with strong capital positions.
c. Licensing new domestic banks on the basis of objective criteria, such as minimum capital, qualificationsof management, financial strength of owners, and detailed business plans and projections.
d. Restructuringpublic sector banks and considering the case for privatizing some or all of them.
e. Introducinglimits on individual shareholdings to ensure the independenceof large domestic banks.
f. Requiring local subsidiariesof foreign banks that exceed a certain size to go public and offer shareholdingsto resident investors.
g. Strengtheningthe capitalizationof universal banking institutionsor requiring the creation of transparentholding company structures with separately capitalized subsidiaries.
g. Clarifying or modifying bank legislation to allow greater and more frequent public disclosure of informationon individual banks.
h. Enacting a new comprehensiveand modern banking act.
6.152 The basic objective of the reform program would be the creation of a modern, competitive,stable and efficient banking system, based on market principles and solvency monitoring. However, banking reform, and especially the restructuringof the public sector banks, would have to move hand in hand with the restructuringof the real sectors of the economy.
6.153 The Egyptian authoritieshave already developed a detailed plan with clear objectives to complete the program of financial reform. This covers the following: - 40 -
IteMs Implementedand Ongoing
* Revision of outstanding ratios for reserve and liquidity requirements.
* Liberalization of interest and exchange rates.
* Implementationof capital adequacy standards.
* Introductionof asset classificationand provisloning in accordance with internationallyaccepted guidelinem.
* Implementationof foreign currency exposure ratios.
* Establishmentof deposit insurance scheme.
* RRecapitalizationof public sector banks.
* Reinforcementof the powers of the CBE through amendment of the banking law.
* Authorizationto branches of foreign banks to engage in local currency business.
* Detailed audits of public sector and other commercial banks.
* Restructuringof problem banks.
* Removal of all bank-specificcredit ceilings.
* Staff training for the implementationof open market operations and indirect methods of monetary control.
Government Reform Program
6.154 The authoritiesplan to implement the following reform program which will be supported by the SAMP:
* Liberalizationof banks, fees and charges.
* Privatizationof all public bank owned shares in joint- venture banks.
* Begin a privatizationprogram by identifyingand privatizing of one major public bank.
* Implementationof a program to remunerate and reduce reserve requirements,subject to controllingliquidity through indirect monetary control.
* Publicationof branching criteria ensuring equal market access to solvent private and public banks. - 41 -
* Permittingbank customers to choose banks freely without the permission of the current bank or without settling all balances.
* Introductionof a program to reduce overall bank exposure to a single customer through loans, equity holdings and guarantees, to 30 percent of the bank's capital and reserves.
In addition, the Technical Asslstance Project for Privatizationand Enterprise and Banklng Sector Reforms aims at strengtheningthe CBE. modernizing the payment system, assisting with the privatizationof banks and strengtheningthe Banking Institute.
6.155 This representsan impressivelist of reform measures. However, the authorities should also glve considerationto measures outlined above that are not yet included in this list. 42 -
References
Benston, George et al. (1986): Perspectiveson Safe and Sound Banking, HIT Press, Cambridge.
Kane, E (1985): The Gathering Crisls ln Federal Deposit Insurance, Cambridge, HA, MIT Press.
Kane, E. (1989): The S&L InsuranceMess: How Did It Happen?, Cambrldge, MA, MIT Press.
Kareken, J. and N. Wallace (1978): "Deposit Insurance and Bank Regulation: A Partial EquilibriumExposition," Journal of Buslness.
Long, Millard and Dimitri Vittas (1991): Financial Regulation - Changing the Rules of the Game, World Bank, PRE Working Papers, WPS 803, November.
Nathan , A. and E. Neave (1989): "Competitionand Contestabilityin Canada's Financial System: Empirical Results," Canadian Journal of Economics, August 1989, 579-594.
Polizatto, Vincent (1990): Prudential Regulation and Banking Supervision,World Bank, PPR Working Papers, WPS 340, January.
Pyle, David (1983): "Pricing Deposit Insurance: The Effects of Mismeasurement,"Federal Reserve Bank of San Francisco and University of California,Berkeley, 1983.
Pyle, David (1984): "Deregulationand Deposit InsuranceReform," Economic Review, Federal Reserve Bank of San Francisco, ?? 1984.
Shaffer, S. (1990): A Test of Competition in Canadian Banking, mimeo, Federal Reserve Bank of Philadelphia,June.
Sharpe, W. (1978): "Bank Capital Adequacy, Deposit Insurance and Security Values," Journal of Financial and Qualitative Analysis, Proceedings Issue, 1978, 701-718.
Talley, Samuel and Ignacio Mas (1990): Deposit Insurance in Developing Countries, World Bank, PRE Working Papers, WPS 548, May.
Vittas, Dimitri (1991a): Measuring Commercial Bank Efficiency: Use and Misuse of Bank Operating Ratios, World Bank, PRE Working Papers, WPS 806, November.
Vittas, Dimitri (1991b): The Impact of Regulation on Financial Intermediation,World Bank, PRE Working Papers, WPS 746, August. CHAPTERVII
THE INSURANCEMARK E
I. Introducti2n 7.1 Insurancebusiness is dividedinto two main sectors: generalor nonlifeinsurance and life insurance.The primaryfunction of all insurancebusiness is to provideprotection against financial loss from predictable,but uncerxain,events. Becausethey accumulate technicalreserves and other fundo to meet their obligationsfrom future claims,insurance companies also play an importantpart as financial intermediariesin the mobilizationand allocationof financial resources. 7.2 Generalinsurance companies provide financial protection to industrialand commercialcompanies as well as to householdsfrom the lossescaused by varioushazards, such as fire and theft. By offering risk-sharingartangements, they can enhancethe efficiencyof trade and industryas well as consumerwelfare. At the cost of a small premium relativeto their risk exposure(the insuredamount of their policies), policyholderscan protectthemselves from the financialconsequences of lossesresulting from particularaccidents. 7.3 Generalinsurance companies provide coverage that is limited to short periods,normally not more than a year. The limitedterm of generalpolicies is dictatedby the difficultyof assessingthe probabilityof lossesover periodslonger than a year. This is related both to the cyclicalnature of lossesand to the uncertainimpact of inflationon total losses. In some lineswhere risk assessmentis very difficult,such as in motor insurancefor young drivers,insurance policiesmay even be limitedto threemonths.
7.4 As a resultof the short-termnature of their policies,the technicalreserves of generalinsurance business are only a fractionof annualpremiums and make littlecontribution to the generationof long- term financialsavings. Generalinsurance reserves must be kept in liquidform and are ideallysuited for investmentin short-term marketablesecurities, such as treasurybills and commercialpaper. Thus, generalinsurance companies can play an activepart in supporting the developmentof money markets. 7.5 Life insurancecompanies cover two types of personalrisks: the risk of prematuredeath and the risk of excessivelongevity. The formeris coveredby variouslife policies,such as whole life and term insurance,while the latteris coveredby annuities. Life insurance companiesalso providean efficientmeans for saving. This is covered by varioustypes of endowmentpolicies that includetraditional policies with a fixed nominalinsured value as well as indexed,participating and unit-linkedpolicies, where the insuredvalue variesaccording to pre- specifiedconditions. 44 -
7.6 Both life policiesand annuitiesmay rangefrom one year to the whole life of the insured. Life policiesinvolve the paymentof a monthlypremium, which may be fixedfor the term of the policyor may be variable. Premiumsare smallestfor pure life-termpolicies, where no paymentis due if the insuredis stillalive at the expirationof the policy,and highestfor participatingendowment policies, where a capitalsum, dependingon the profitperformance of the company,is payableat the maturityof the policy. Annuitycontracts involve a lump sum-upfront payment in returnfor regularpayments, which may be fixed or variable,over a specifiedperiod of time.
7.7 Althoughsome life policies,such as single,premium, one- year policiesor pure life policieswith variablepremiums, do not generateany long-termsavings, most typesof life insurancepolicies contributesignificantly to the accumulationof technicalreserves and other long-termfunds. Their investablefunds, arising both from the creationof technicalreserves and the reinvestmentof profitsto the benefitof policyholders,can be severaltimes their annual premiums. Annuitycontracts also generateinvestable funds since premiums are paid up front. Life insurancecompanies can make a very significant contributionto the developmentof marketsin long-termgovernment, corporateand mortgagebonds and in corporateequities. 7.8 The developmentof the insuranceindustry depends on a numberof factorssuch as the leveland distributionof incomeand wealthof a country;its socialculture and familystructure; the efficiency,solvency and publicimage of insurancecompanies; the tax treatmentof insurancepremiums and benefits;the availabilityof social securitybenefits; the degreeof macroeconomicand politicalstability; and the regulatoryframework. In addition,insurance business is generallysubject to high marketingcosts, which impliesrelatively high intermediationcosts.
7.9 With very few exceptions,the insuranceindustry is not well- establishedin developingcountries. This can be attributedto both demandand supplyfactors. Incomeand wealthare clearly important,not only becausepeople subject to tightfamily budgets may be unable to affordthe requiredinsurance premiums, but also because poorerpeople have littlereal and financialwealth and are thus exposed to littlerisk of financialloss. In addition,in many developing countries,the demandfor insuranceservices may be mitigatedby the traditionalreliance on informalinsurance arrangements, through both extendedfamily and communitysupport, for copingwith majormisfortunes such as disabilityand death of familymembers.
7.10 The distributionof incomeand wealthis also important becausein a countrywith high inequality,the wealthiermembers of societymay be able to take advantageof more efficientinsurance - 45 - policiesin foreignmarkets,I whereas the poorersegments will have littleeffective demand. The existenceof soclalLnsurance institutions offeringfinancial protection through social welfare programs may also dampenthe demandfor insuranceservices, while macroeconomicand politicalinstability, manifested in high and volatileinflation and politicaluncertainty, will also have an adverseimpact on the developmentoY the insuranceindustry, especially life insurance business. Inflationmay cause poor investmentreturns on insurance reservesand will reducethe real value of insurancepolicies unless indexedpolicies and investmentsare used. Politicaluncertainty may also underminethe credibilityof insurancecontracts. 7.11 Althoughgeneral awareness of the need for protection againstpotential financial loss increasesas an economybecomes more prosperous,the demandfor insuranceservices may be frustratedby the inadequatedevelopment and perhapsbad publicimage of the insurance sector. Insuranceoperations are handicappedby high informationcosts and the problemsof moral hazardand adverseselection. Moral hazard2 occurswhen the very act of obtainingan insurancepolicy increasesthe risk of loss by affectingthe behaviorof the insured. Adverse selectiondescribes the processwhereby people with higherrisks (e.g., people in hazardousoccupations or with poor health)are more likelyto seek insurancecover than peoplewith averageor below averagerisk exposure. 3 7.12 To reducethe incidenceof moral hazardand adverse selection,insurance companies design differentiated policies based on elaboraterisk classificationsystems and includespecial provisions for
1/ For instance,in life insurance,people with access to foreign insurancemarkets may benefitfrom lowerpremiums due to both lower mortalityrisks and greaterefficiency. The use of foreignmarkets by some peoplecauses an adverseselection problem for the domestic industry,which may be left coveringthe higherrisk peopleand may be forcedto raise premiums.
ZI In the insurance industry, traditional terminologydraws a distinctionbetween two kinds of specialhazards: the moralhazard and the moralehazard. If an individualcauses a loss to collect the proceedsof an irnsurancepolicy, the loss is said to resultfrom moral hazard. The morale hazard refers to an attitude of indifferenceto loss created by the purchase of an insurance contract (see Dorfman, Mark: An Introductionto Insurance, Prentice-Hall,1982). (In modernparlance, the termmoral hazard is used to cover both situations.)
]/ Adverse selection operates in the opposite direction in the case of life annuitycontracts where people with healthproblems or low life expectancyare less likelyto buy annuitiesthan peoplewith long life expectancy. - 46 -
exceptions and co-insurance. These measures increase the complexity of contracts and heighten the need for consumer protection against the abuse of exclusion clauses by insurancecompanies. Extensive regulation of the insurance industry is often premised on the need to protect the interests of consumers by standardizingcontracts (to reduce information costs) and by preventing insolvencies. The regulatory framework may, however, become oppressive and may inhibit the development of the industry by discouragingcompetition and innovation.
7.13 In markets that are subject to extensive product and price controls, insurance companies are constrained in their ability to develop classificationsystems that distinguishbetween a wider range of risk characteristics. For instance, in Germany, where the insurance business is heavily regulated, standardizedlife policies are only allowed to differentiateby age. Differentiatingby sex or by the smoking habits of the insured is not permitted, even though these are known to be related to the mortality risk of the insured. In third- party automobile liability insurance, the approved German tariff distinguishes four types of characteristic: the level of coverage, the horsepower of the car, the residence and profession of the owner and past loss experience. No allowance is made for the age of the driver, the professionaluse of the car, the number of miles driven per year or the number of motoring offenses of the driver, all of which are taken into account in the less-regulatedUK market.
7.14 These restrictionsresult in a cross-subsidizationfrom low- risk to high-risk consumers. Depending on how premium regulation is applied, they may also cause high prices, allow inefficientfirms to survive and raise the overall operating and marketing costs of insurance companies.4 Other regulationsmay result in unduly low prices for some lines of business. These will not then be offered or, if their offer is compulsory,will be subsidized from other lines of business.
II. The Insurance Industry in Egrpt
7.15 In Egypt, as in most developing countries, the insurance industry is underdevelopeddue to both supply and demand factors. On the demand side, the level of income and wealth of the large majority of the Egyptian people is still quite low, and reliance on informal insurance arrangements is strong. The offer of extensive health and disability insurance and the operation of a retirement scheme by the social insurance system also reduce the demand for some types of insurance. On the supply side, an inhibiting regulatory framevTorkhas
_4/ For a more detai.ed discussionof the regulationand performance of the UK and German insurance industries,see Finsinger, Jorg et al: "Inpu.anze: Competitionor Regulation,A Comparative Study of the InsuranceMarkets in the United Kingdom and the Federal Republic of Germany," Instituteof Fiscal tudies,Report Series No. 19, London, 1985 and Finsinger, Jorg and Mark Pauly, ed-., The Economics of Insurance Regulation,Macmillan, Hora Von;, 1986. - 47 -
impeded the development of the industry,which is characterizedby high concentrationand limited product innovation.
7.16 The developmentof the Egyptian insurance industry has also been hindered by the lack of adequate disclosureof financial information on the solvency and performance of individualcompanies and the failure to establish an effective system of consumer and investor protection. As in most other developingand a few developed ccuntries, the insurance industry has suffered from a generally bad public image and a perception of inefficiencyand indifferenceto the needs of consumers. Although Egypt has not suffered from political instability, the decline in the level of economic activity and the higher rates of inflation during the second half of the 1980s have taken their toll on the insurance sector. The non-neutralityof the tax treatment has also affected the developmentof the insurancebusiness (ChapterV).
Market Structure
7.17 The Egyptian insurancemarket displays very special structural characteristics. The market comprises nine insurance companies, four insurance pools and the Government Insurance Fund. Law 10 (coveringinsurance) assigns the supervision of private insurance (pension) funds, of which there are about 350, to the Egyptian Insurance SupervisoryAuthority. There are no cooperatives,although the law allows them to exist.
Insurance Companles
7.18 The nine companies that operate in Egypt comprise eight direct insurers and one local reinsurer. All are publicly quoted joint- stock companies. There is no separationbetween life and non-life lines: companiesmay participate in both markets.
7.19 Not all of the direct insurers are in th,.same market. Two have been set up as joint-ventureswith foreign investors to operate exclusively in businesses in the Free Zones. These companies are not allowed to offer their services in the rest of the domestic market. The levels of insurance required in the Free Zones, however, are low compared with those in the rest of the market (approximately1 percent of the total market premium). Therefore, only six companies operate as direct insurers in the market. On the other hand, Egypt-Re is the sole, local company specializingin reinsurance. As a state company, it is the dominant pro-.-iderof local reinsuranceand covers the whole national territory, including the Free Zones. Finally, three insurance companies and the local reinsurancecompany are wholly owned by the state. The remaining five companies are private.
7.20 Although the number of state-owned companies and private companies appears to be balanced (four state-ownedcompanies versus five private ones) a large majority of the insurancebusiness is really controlledby the state-ownedcompanies. In terms of annual gross premitnw,85 percent of the total non-life business and 94 percent of the - 48 - life businessis managedby the three state-owneddirect insurers. The remainderis sharedby threeprivate companies. 7.21 These figuresindicate that a significantshare of the sectoris under stste control. Clearly,those companiesthat are consideredto be 100 percentpublic are managedby the state. The stats maintainsan importantindirect presence in all five of the private companies,either through direct ownership by the public insurance companiesthemselves or throughthe privatepension funds, which are in themselvesimportant state organizations(Table AVII.1, Appendix). 7.22 Directforeign ownership is only allowedin those companies operatingin the Free Zones. This exceptionis grantedunder the 'InvestmentLaw," which allowedfor the creationof companiesas joint- ventureswith foreigninvestors to encouragethe creationof companies operatingexclusively in the Free Zones. 7.23 This same InvestmentLaw also encouragedjoint-ventures with foreigninvestors in the bankingsector, but with no restrictionson the local market. Althoughthe law initiallyestablished the same conditionsfor the insurancesector, it was subsequentlymodified to limit foreignparticipation to the Free Zones.
Insurance Pools 7.24 "Insurancepools" are specificallyauthorized under InsuranceLaw 10. They are aisociationsof insurancecompanies that pool specificrisks into a singlefund. The participantsshare income from policysales and any profitsor losses. Currentlythere are four insurancepools in Egypt (TableAVII.2, Appendix). 7.25 All three state-ownedcompanies and Egypt-Reare represented in each of thesepools. A numberof privatecompanies also participate, with the exceptionof those operatingin the Free Zones. In general, thesepools are not important. Togetherthey reprasentonly about 1.2 percentof the total non-lifepremium market. All of the pools appear to be profitable: their loss ratiosrange from approximately4 percent for the nuclearpool to around50 percentfor the cottonpool. 7.26 Two of these pools are of specialinterest. Decennial underwritesthe coWmusory insurancecoverage for third-partyliability on all Egyptiancivil works for a 10-yearperiod. All of the insurance companiesoperating in the marketparticipate in this pool.
7.27 The Nuclearpool, in which all local marketcompanies also participate,was createdin order to enter the internationalreinsurance market for nuclearrisks. This pool is ratherunusual because Egypt has very littleexperience in nuclearrisks and limitedcapital backing. Technicalresults over the last two years have been good,but it should be recognizedthat these types of risk are subjectto catastropheclaims that can give rise to substantiallosses for the reinsurers.This topic is of a great importance in a marketwhere company equity is scarce. - 49 -
Government Insurance Fund 7.28 The GovernmentInsurance Fund is made up from the sale of premiumsaccrued to cover a definedrisk; it is designedto finance claimsarising from policiesunderwritten by the same fund. The law requiresthat these funds be managedby the EgyptianInsurance Authority. At present,there is only one governmentinsurance fund. This fund was set up to covershareholders' fidelity and guaranteerisks (governmentemployees only). The reasonfor creatingthis fund, instead of leavingthe coverageto the market,is the confidentialnature of publicemployees' malpractice suits.
Private Insurance Fund 7.29 Strictlyspeaking, private insurance funds are pension funds. These fundshave been set up by the employeesof organizations and companieswith no equitycontribution requirement. According to Law 10, these funds also come under the EgyptianInsurance Authority's supervision,but they are governedby Law 54 (ChapterX).
Intermediaries and Auxiliaries 7.30 Intermediaries.The qualityof servicesprovided by insuranceand reinsuranceintermediaries is underdeveloped.First, no foreignreinsurance brokers operate directly ta the market,although two foreignreinsurance companies maintain representative offices in Egypt and localcompanies may reinsureinternationally. It was pointedout to the missionthat the marketis liLnitedand the presentreinsurance regulationsdo not attractbrokers. 7.31 On the other hand, insurancebrokers or independentagents are very difficultto find. Most of the insurancebrokers in this marketact as agentsof one company,rather than independently.There is, however,a large numberof brokersfor the size of the market. In June 1990, therewere 5,036 registeredbrokers with the Insurance Authority - almostall of them employeesof the four state-owned companies.
7.32 Privatecompanies have about20 brokerseach. Their smaller r ze, relativeto publiccompanies, does not appearto justifythis great differencein the numberof brokers.
7.33 The remunerationsystem for the state-ownedcompany agents does not encouragethem to be efficient. They are treatedas employees and paid a fixed salarythat may not increasebeyond a certainpoint. Anotherpeculiar characteristic of state-ownedcompanies, according to the informationprovided to the mission,is that all brokersare natural persons. There is not a single,legal person registered as an insurance broker. This confirmsa very low degreeof developmentand competition in this sector. - 50 -
7.34 Survey Experts & Loss Adjusters. As of June 1990, there were 311 survey experts and loss adjusters registered with the Insurance Authority. This figure is in line with market size.
III. DeveloRment Indicators and Market Share
7.35 There are no fully satisfactoryindicators of development of the insurance industry. Internationalcomparisons are complicatedby differences in practice and data coverage, as well as by the development of other forms of contractualsavings such as social insurance institutions,national provident funds and occupationalpension schemes.
7.36 A frequently used indicator is the level of annual premiums in relation to GNP. This indicatormay be distorted by differences In operating costs and investmentperformance across countries. Thus, countries with high operating costs and low investment returns will require a higher level of annual premiums for the same amount of insurance coverage than countries with low costs and high returns.
7.37 Another indicator of development is the ratio of technical reserves and other insurance funds to GNP. This is more important for the life insurance sector, but its relevance may be distorted by differences in accounting practices, such aS the valuation of reserve assets. A third indicator,which is more an indicatorof efficiency than development, is the ratio of reserves to annual premiums. This takes account of differences in operating and investment efficiency but can be distorted by differences in the business mix of insurance companies. For instance, countries with a relatively large proportion of single, premium, one-year life policies will have a low ratio of reserves to premiums, while countries with a large volume of annuities, where premiums are paid up-front, will have a high ratio. A fourth indicator is the value of insured amounts in relation to GNP. This indicator is less useful in the case of "with-profits"and unit-linked life policies, which have a variable insured amount that depends on the investment performance of the underlying reserves.
7.38 An analysis of market figures shows clearly that the level of insurancebusiness has dropped off during the last three years. The indus:ry's size has reduced with respect to the rest of the economy; the life insurance sector is underdeveloped;and the market is highly concentrated. Premium income decreased in real terms by 8.7 percent in FY90 relat.ve to FY88 (Table AVII.3, Appendix), following a drop of 8.7 percent from the previous fiscal year, ending June 1988. This fall in income is even more evident in the case of the non-life market, which decreased, in real terms, by 9 percent during the same period. In the case of the life market, the decrease is less important -- 3.1 percent in real terms.
7.39 The insurance sector's contributionto GDP (measured as premium expenditure)is around 1 percent. This level is one of the lowest among developing countries, and it can only be compared with the level in such countries as Guatemala, Sri Lanka, Senegal, Turkey and - 51 - 'Isxicobefore the 1990/91reforms. In Malta,the Philippines,Thailand andMacao, insurancebusiness makes up about 2 percentof GDP. In Portugal,Cyprus and Chile,this figureis closerto 3 percent. Some of the shortfallcan be explainedby the large proportionof the population whichis cc ered by socialinsurance schemes, life insurancebusiness (whichis not includedin these figures),and by the Government'spolicy )f "self-insuring"government buildings. Howeverthese factorsdo not Fullyexplain the shortfall. '.40 The insuranceindustry's small role in the Egyptianeconomy Lsreflected in the gross premiumper capita,which is about US$5 a year LnEgypt. This figureis one of the lowestin all the developing :ountries.The only countrywith a lower figureis Sri Lanka,at US$3 )er capita. The per capitagross premiumin countrieshaving similar -xpendit&'resin terms of GDP is considerablyhigher: Mexico (US$29), ;hile(Us$44), Thailand (US$19) and the Philippines(US$17). 1.41 With regardto marketconcentration, as mentionedabove, the -henomenonis particularlyserious; 85 percentof the market,in terms of direct premiums, is managed by three of the state-owned companies. 'naddition, two of the market'sbiggest companies represent almost 70 percentof the totalmarket. '.42 An analysisof the non-lifemarket premium per branch .ndicates: Mi A high concentrationis presentin every branch, withoutexception. (ii) A surprisingconcentration of some lines of business existsin a singlecompany. Misr Insuranceholds practically 100 percent of the local aviation market, and its main clientis EgyptAir, the state-owned airline. In the engineeringbranch, Al Chark holds 61 percentof the market. Al Ahleiahas 42 percentof the compulsorymotor act market. (iii) In the rest of the market,companies in the sector remainrelatively balanced, with respectto their total shares. .43 This high concentrationin certainbusinesses denotes that here are seriousmarket imperfections and an absenceof conditionsthat ncouragecompetition among companies. It is not unusualfor a private ompanyto try to take those insurancesthat have, in the past, been anagedby a state-ownedcompany, especially when the latterowns part f the privatecompany in question. .44 Implicitand explicitagreements are presentin some types f insurance,such as those associatedwith the CompulsoryMotor Act. wo private companies do not show any sales; at least one of these Dmpaniestransfers the obligatoryinsurances to the state-owned - 52 -
company,creating cross-ownership. This is done, whetheror not the insuranceis a bad businessrisk for the companies. PerformanceIndicators 7.45 The financialposition of the insuranceindustry can be measuredby the level of its equityand by the level of profitability and operatingefficiency. The Egyptianinsurance sector has been characterizedby generaldeterioration in resultsand high debt-to- equityratios. Its leverageposition, while stillworrisome, has improvedover the last few years. 7.46 The balancesheets and operatingstatements used in this study were correctedfor inflation,to determinemanagement and efficiencyoperating indicators. 5 These adjustmentsonly provide approximations,albeit good ones, of the managementindicators and operatingresults. They are a substitutefor monetarilycorrected balance'sheets,which is a subjectof gre&terrelevance. Moreover,the formatsin which the companieshave presentedtheir statementsto the InsuranceAuthority is not standardized.In many cases there are errors in the figures,which requiredadjustments before any comparisonof the balancesheets of differentcompanies could be made.
7.47 One of the greatestlimitations in this study is that the aggregatefinancial statements of insurancecompanies reflect both life and non-lifebusiness. The technicalanalyses and opinionsregarding these companies'solvency are limitedbecause financially distinct businessesare lumpedtogether. Even if this limitationis taken into account,the conclusionsof the study indicateareas of great concern. Non-LifeInsurance 7.48 Operatingefficiency is measuredin insuranceby two complementaryratios. The expenseratio, which relatesadministrative costs and net commissionspaid to the level of retainedpremiums, and the loss ratio,which measuresthe percentageof earnedpremiums that are paid back to the insuredin the form of claimsfor losses. An efficientinsurance industry should operate with a low expenseratio and a high loss ratio. Becauseof the investmentincome earned on technical reserves,the combinedratio, which adds togetherthe expenseand loss ratios,may well exceed100 percentof the level of retainedpremiums. In a competitiveindustry with a reasonablecapital base, the combined
j/ The informationobtained for this study is drawn mainly from the InsuranceAuthority's Igarbooks and the insurancecompanies' annual reports, which are published in English. Company financial statementsare publishedonly once a year. At the time of this mission,there was still no officialinformation available regarding companyresults for FY91. - 53 - ratiowould tend to be equal to 100 percentplus half the rate of return on technicalreserves. 7.49 The Egyptianinsurance sector exhibits relatively high, and widelyfluctuating, levels in loss ratios (TableAVII.4, Appendix). The expenseratio was historicallylow by usual standardsuntil 1990,when expensesmore than doubledto 17.3 percent. This increasewas mainly due to the abolitionof a contributionfrom brokeragefees, in addition to a disproportionaterise in administrativeexpenses. 7.50 The combinedratio has been the main indicatorused to assessperformance in the non-lifesector. Technically,as already noted,.it shouldnot be higherthan 100 percent. It does not, however, take into accountthe profitsgenerated by the companyon its investment portfolio,which are part of its income. In some cases,the company also adds the returngenerated on the investmentof receivedpremiums, estimatingit at half of the prevailingrates of interest. (No financialreturns are recordedfor investmentof the company'scapital.) This means that the businessmay continueto be viableup to combined ratiosof 105 percent,which is consideredreasonable by international standards. 7.51 The availableinformation considers some adjustmentsbetween yearlyaccounts, but these adjustmentsdo not constitutea full monetary correctionof the results. A simplesimulation carried out via certain adjustmentsshows that the true combinedratios are somewhatlower. This resultconfirms that the technicalstanding of the non-life companiesis sound. The only elementof real concernis the increasein the expenseratio, which, as indicatedabove, arises mainly from an increasedexpense in the "cost of intermediation"account, which has stoppedbeing the traditionalsource of incometo the companies. Life Insurance 7.52 Due to the natureof the business,the combinedratio is not an adequatemeasure of life insurancemanagement or efficiency.The main insuranceindicators relate to changesin capitaland surplus. Unfortunately,the fact that there is no divisionbetween the companies' capitalin the life and non-lifebusiness has made it impossibleto calculatethe gross and net changesin capitaland surplusratios. These ratiosare the most commonmeasure of the improvementor deteriorationin a company'sfinancial condition during the year.
7.53 The availableinformation available provides a basis for determiningthe net gains to total incomeratio (excludingcapital gains and losses). This ratio is a conservativemeasure of the company's profitability.The life insurancebusiness has been contributingto the sectorover ti-elast four years. This contributionhas been in constant decline,however, which, technically, is a bad sign. 7.54 The publishedinformation shows that the life insurance marketsuffered losses in the last two years. This mistake,however, is - 54 -
mainly Jtueto the fact that the figures have not been corrected for inflation.6 With the latter running at about 20 percent p.a., it means that a s:ctor that technicallymakes a profit can show losses in its operating statements. The life insurance sector, however, has rapidly been losing profitabilityover the last three years. It was good during 1987 and 1989 (about 22 percent p.a.); it was acceptable in 1989 (about 13 percent); but the 1990 results (about 2 percent) are cause for concern (Table AVII.5, Appendix).
7.55 The operating statements show that this fall in profitability is mainly due to a proportional increase in the reserve fund account that is in line with increases in total premiums. The decline in profits does not necessarily reflect altered solvency, as companies hold proportionatelylarger reserves than in earlier periods. This change was explained to the mission as a means by which to protect the insured capital against the effects of inflation.
7.56 Finally, serious confusion is caused both in the sector and in the official figures by the lack of adjustment for inflation (monetarycorrection) in the financial statements. Furthermore,no measures are being taken to insure capital against the effects of inflation.
Solvency
7.57 The leverage ratio, which shows the level of total liabilitiesto the equity capital, varies by type of insurance company. General insurance companies that do not accumulate substantial technical reserves, tend to have lower leverage ratios than life insurance companies that have to build up substantialreserves. Even among life companies, those with a higher pro'nortionof annuity business tend to have higher ratios than those with a greater proportion of ordinary life policies. This is because annuity premiums are collected in one single payment up front and require the maintenance of higher reserves against future obligations than life policies that collect premiums on a regular basis. Once again, although the companies in Egypt have a single capital base, they are permitted to combine life and non-life businesses; this combination introduces important distortions.
7.58 The leverage ratio in Egypt, although it has been falling from 30 in 1980 to 14 in 1990, is still high by any international standard (Table AVII.6, Appendix). This is especially so when compared with similar business structures,despite the increasing capitalization in this sector in recent years.- In Mexico, where life and non-life lines are also handled by the same companies, the debt-to-capitalratio is about four. In Chile, where the lines of business are run separately, the maximum leverage ratios are 15 for life insurance companies and 5 for non-life. In general, a leverage ratio of 3 is
5/ For instance, in the Market Yearbook for 1989/1990,one of the main accounts, the Reserve Fund, is not adjusted for inflation. - 55 -
acceptablefor non-lifeinsurance companies while for life companiesit can vary up to 15, dependingon the mix of businessbetween annuity and life policies. It shouldbe noted that,to some extent,the capital base of Egyptianinsurance companies is understated.Technical reserves which appearon the balancesheets include reserves which implyno obligationstowards policy holders, assets are valuedat book rather than marketvalue, and capitalizationhas been improvedsince 1990. 7.59 DespiteEgyptian companies' low capitalrequ' ments,their returnto capitalhas been close to 20 percentover the last few years. Correctingfor inflation,return to capitalin FY89 was closerto 7 percentand practicallynil in FY90. IV. GeneralAnalysis
7.60 The above analysisindicates a technicallywell-managed marketwith scarcecapital and excessiveregulation and state participation.In termsof grosspremiums, the market is in decline, indicatingdeteriorating efficiency and technicalresults over the last few years. On the otherhand, thereappear to be few qualitativeor quantitativedifferences between the stateand privatecompanies, ospeciallyregarding claim ratios. The expenseratios are higher in the privatecompanies, but this reflectsoperational volume ratherthan ownership(Annex VII.1.)
7.61 The generalrise in expensesthroughout the market is in greatpart due to the suddenloss of reinsurancecommission income, which traditionallyhas been an importantsource of income. Companies, especiallythe smallerones, have to pay more attentionto their expenses. The industry'sand companies'loss ratioswould be considered unusuallylow in a competitivemarket and are only possiblebecause the Egyptianmarket is so highlyregulated. A key problemin the marketis the generalhigh leveragingof the companiesin which thereis no foreignparticipation. This high leveragingcontrasts with the low debt to equityratios seen in the Arab InternationalInsurance Company (in the Free Zones).(Annex VII.1.)
7.62 Thereis a pressingneed to reprocessthe financial statementsof all the companies.At present,the marketis being managedwith imperfectinformation, which may lead to ill-informed policydecisions.
The Rationalefor InsuranceRegulation
7.63 Like banks, insurancecompanies may be subjectto extensive regulations.Some regulationsaim to correctfor variousmarket imperfectionsand are, for this reason,desirable. For instance, regulationsthat primarilyaim to protectthe interestsof consumersand investorsand to safeguardthe soundnessand solvencyof insurance companiesfall under this heading. Other regulationsare more difficult to justifybecause they tend to createmarket distortions and inhibit the developmentof the industry. These includeregulations that prevent 56 -
the entry of new competitors,impose restrictions on the freedomof insurancecompanies to developnew productsand designtheir pricingand marketingpolicies, and force companiesto investtheir reserves in low- returngovernment securities or high priorityactivities.
7.64 Close insuranceregulation and supervisionare justifiedby the high informationcosts associatedwith insuranceproducts. Insuranceproducts are contractualundertakings to pay a certainsum of money when a loss-producingevent occurs. Insurancecontracts are complexbecause they have to specifythe natureof the loss-producing event and the circumstancesunder which its occurrencewould triggera paymentunder the contract;they also must determinethe amountto be paid and specifythe responsibilitiesof the insured,in terms of the level of premiumsto be paid, any risk sharingarrangements, such as co- insuranceand deductibles,the disclosureof materialinformation, and any actionsthat are requiredto reducethe risk of loss.
7.65 High informationcosts arise from threemain sources: (i) the complexityof contractualterms and conditionsof coveragethat put consumersat a considerabledisadvantage against insurance companies and their agents;(ii) the wide varietyof risk characteristicsof the insuredthat cause problemsfor both consumersand insurancecompanies; and (iii) the difficultyof assessingthe financialsolvency of insurers. These areas are closelyinterrelated. For instance, variationsin risk characteristicsmay resultin productdifferentiation that increasesthe complexityof insurancecontracts and makes them difficultto compare,especially for nonprofessionalconsumers. 7.66 The need to deal with the problemsof adverseselection and moral hazardforces insurance companies to use detailedprovisions for exceptionsif certainconditions are not met. These provisionsare not, however,easily understood by the publicat large. Moreover,they are often writtenin arcanelanguage and hiddenin the fine print of insurancepolicies. Thus, when insurancecompanies reject claims on the groundsthat they are not covered,policyholders accuse insurance companiesof seekingexcuses to renegeon their contractualobligations. 7.67 The use of standardizedcontracts may reducethe level of complexityand help consumerscompare the cost and coverageof competing polic'es. Encouragingmarket practitioners to take the lead in promotingstandardization through trade associations is preferableto standardizationimposed by governmentedict. However,to ensurethat this does not lead to cartelbehavior with adverseeffects on product innovation,contract standardization should be limitedto existing contractsand shouldbe subjectto reviewby the regulatoryauthorities. Contractstandardization should not be equatedwith the use of uniform contracts,irrespective of differencesin risk characteristics,and shouldnot inhibitproduct innovation and competition.
7.68 Concernfor the financialsolvency of insurersstems from two sources: a fear that some insurersmay offercoverage at low premiumsand fail to maintainsufficient reserves to pay futureclaims - 57 -
and a fear that reservesmay be investedin speculativeassets, which may also adverselyaffect the abilityof lnsurersto meet futureclaims. Insolvenciesmay then result, causing losses to policyholders and underminingconfldence in the integrityof insurancecontracts. 7.69 Regulatorsintervene because nonprofessional investors finC it hard to assessthe financialsolvency of individualinsurance companies. Two extremeregulatory approaches exist in Egypt for preventinginsolvencies. The most pervasiveinvolves extensive governmentintervention to preventlnsurers from engagingin ruinous competitionand runninglosses, on the principlethat if one does not sufferlosses one will never go bankrupt. This approachrequires detaLledgovernment intervention covering the followingareas: (i) settingprices for the policiesto be sold, which also means governmentapproval for the policiesthemselves. Under this approach,prices should ensure that the least efficientinsurer in operationis able to, at least,break even; (ii) settingcommissions to be paid to sales agents,and preventingthese commissions from being reimbursedto the insurer(if not, pricesare partiallyfree in fact); (iii) preventingthe entry of new insurerswhenever this means too much competition; (v) avoidingcompetition with foreigninsurers (both directcompetition and throughreinsurance); and (vi) settingvery strictrules for investments,so as to minimizeinvestment risks. 7.70 The alternativeapproach is to allow companiesto engage activelyin competitionbut to enforceclear rules on financialsolvency that will help preventbankruptcies. Solvency rules shouldstipulate the requiredlevel of equitycapital and technicalreserves and should providefor close monitoringof investmentperformance and adequacy. To be effective,solvency rules must be activelyenforced. As in banking, activesupervision involving both off-sitesurveillance and on-site inspectionhas an essentialpart to play. Companiesthat do not comply with the rules must be stoppedfrom sellinginsurance before they become insolventand can no longermeet their obligations. 7.71 Both approachescan be effectivein terms of preventing insolvencies,as long as the regulatoryauthority ls effective. However,both theoryand practicalexperience suggest that the regulatoryscheme based on solvencymonitoring is more efficientin terms of overallcosts to society,as it keeps incentivesfor efficiency and innovation. - 58
7.72 The regulatoryapproach is very much the same for life insuranceas for non-lifeinsurance. The main pointsof differenceare the fact that reinsuranceis less relevantfor life insurancebusiness since the risks assumedare more homogeneousand predictableand have, therefore,less need for reinsurance.On the other hand, becauselife insurersmanage substantial long-term savings, they requiremore detailedinvestment regulations. Another important issue for life insuranceis the valuationof long-termreserves, that is, the mortality tablesand the discountrates used to computethe presentvalue of futureliabilities to policyholders. V. The RegulatorvFramework in EgyDt 7.73 The insurancemarket is highlyregulated through fixed rates,brokerage commissions and reinsurancediscounts and commissions. Law 10 regulatesthe insurancemarket in Egypt. This generallaw grants broad powersand a high degreeof discretionto the supervising organizations.The law is not sufficient,however, with regardto technicalconsiderations. Important issues have been decidedby executiveregulations, which in many caseshave as much or greater weightthan the law itself. These regulationsoften come in the form of decreesissued by the MOE, which, in the same manner,regulate investmentsand, particularly,reinsurance. 7.74 Law 10 definesin extraordinarilydetail the partiesthat may be directlyor indirectlyrelated to the insurancemarket. All institutionscome under the controlof the InsuranceAuthority, with which, in most cases,they must register. There is often littleor no justificationfor some of these institutionsto come under the Authority'scontrol. 7.75 This legal frameworktakes into accountdifferences between varioustypes of companies. The rules are not the same for all the players. There are three kinds of companiesin this sector: state, privateand privateoperating in the Free Zones. These companiesare ruled by three differentbodies of laws: the State-OwnedCompanies Law, Law 203, 1991; the PrivateCompany Law, Law 159, 1981; and the InvestmentLaws, Law 43, 1974 and Law 230, 1989. 7.76 One of the advantagesof the recentLaw 203 has been to bring the legal dispositionsof the state companiesinto line with rules applyingto privatecompanies. By introducingthe possibilityof transferringstate companiesto the privatesector and reducingthe overstaffingplaguing these companies,the dispositionsmark a step forward;they are not, however,enough to createa free market. Most of the rules and institutionsend up, in practice,protecting the big state-ownedcompanies, relegating the small privatecompanies to second place. 7.77 Moreover,the law ensuresthat publiccompanies are to be auditedby the CAO and privatecompanies, by independentand specificallyauthorized auditors. This situationhighlights the 59 -
different criteria currently applied to insurance company balance sheets, making it difficult to compare financial statements and, thus. lowering the levels of transparencyin the market.
7.78 This regulatory frameworkhas led to an environment where standard skills in the sector, such as the development of a competent sales force, product design, fast-turnaroundto meet consumer requirementsand the maximizationof reinsuranceprograms and operationalcontrols in the sector, especially in state-owned companies, are limited. On the other hand, private companies are commercially cautious and not very aggressive.
7.79 The market structure outlined above is understandable,given the high concentrationof state-ownedcompanies and the low and timid incidence of private companies, despite their competitiveadvantages in terms of organizationalefficiency. Unlike other countries with a developing insurance market, however, the Egyptian market displays a high degree of sophisticationin its rules and in the calibre of its work force. This is important since a company's capacity to correctly determine its technical liabilitiesand pricing is important to market development.
Regulatory Issues
7.80 The Egyptian market is under the control of EISA. EISA depends, by law, on the MOE. (Absolute independenceis found in very few countries.) There is also a formal controlling institutioncalled The Supreme Council of Insurance, the main objective of which is "to decide the general targets of the insurance activities and to approve the policies needed for achieving those targets." The council effectively limits EISA's autonomy.
7.81 EISA informed the mission that it had not met with any interferencewith regard to its routine work. Law 10, however, which establishes the Authority's main objective, states that the Authority shall "secure the execution of the economic and social targets of insurance activities." These targets are set by the Supreme Council, which is formed by representativesof those who, in turn, are supervised by the Authority (including the chairmen of the boards of insurance and reinsurance companies).
7.82 EISA must have a board formed of at least 11 members, out of which only 2 may work for the institution. (Most of the remaining members work for other public institutions,mainly related to the financial sector.) The board's roles are establishedby law and mostly involve deciding on which topics should fall within the purview of EISA.
7.83 Law 10 also states that insurance companies have the right to create associationsthat, among other things, may set tariffs and prices (which are subsequentlyto be proposed for EISA approval) and issue standard policies. This frameworkprovides neither adequate -60 -
control, nor the balances necessary, to build a sound basis for the development of the insurance sector.
7.84 Barriers to Entry. Entry barriers are high. In the main, they are not due to high equity requirements,nor to the requirements for setting up a new company. Instead, barriers are created ,y the InsuranceAuthority's power to decide whether or not it is convenient for a new company to enter the insurancesector. Such power, given under Law 10 allows the Authority to deny entry into the sector, without legal recourse. The Authority is currently of the opinion that there are enough companies in the market, and, therefore,new entries should not be authorized. There are records to show that recent applications to operate new companies have been prescnted and rejected.
7.85 Participationby foreign capital is forbidden in local insurance companies operating in the domestic market. However, The Investment Law does authorize their participationin companies operating in the limited market of the Free Zones. Under Law 10, insurance companies are also not allowi;dto take on foreign professionalsor employees.
7.86 Price Control. The rates of insurancepremiums are fixed and approved by EISA. These tariffs are usually proposed by the Insurance Federation through one of its technical committees. These proposals are generally approved, in so far as EISA representativestake part in the committees. Two exceptions to this rule exist. In the field of engineering,with regard to specific risks, prices are proposed by each of the individual companies. The price of compulsory insurance, on the other hand, is set by law -- especially for motor act insurance. The fJvernment also sets the level of commissionspaid to sales agents and the fees and commissionspaid to local reinsurers.
7.87 Investm3nt Requirements. This is another important area that is not covered by the law. The types of investment required to back technical reserves and the limits on diversificationby issuer and type of investment are set out in administrativeregulations issued by the MOE. These regulationsdraw little distinctionbetween investments required on government bonds and cash in banks, when referring to the backing for life and non-life insure.ncL.sreserves. The rest of the investmentsand their limits are th'_same for either type of business.
7.88 With regard to total technical reserves, however, the regulation provides minimum levels of investment on some instruments and maximum limits on others -- i.e., government bonds and certificates. There is no upper limit set, however, for foreign or domestic bank deposits. The maximum levels, though, are not of great importance since, in the c&se of governmentbonds, they represent 3 percent of total reserves, while in the case of certificates,they represent 22 percent of total reserves in life and lE -drcent in non-l:;febusiness. It is worthwhile noting that there is no minimum for bonds issued by the National Investment Bank (NIB), but there is a maximum of 15 percent for - 61 - the total reservesof both groups. In practice,few insurancecompanies have NIB bonds in their Investmentportfolios. 7.89 Finally,it is Importantto point out that the investment systemap 1,lLcableto companiesoperating ln the Free Zonesdiffers completelyfrom the systemfor companiesoperating in the domestic market. The main differencels that Free Zone insurancecompanies may not investin securitiesissued in local currency. 7.90 Reinsurancedontrol. The only local relnsurerwas granted monopolypowers through an executiveregulation. This regulationstates that, for practicallyall operations,the insureris obligedto cede 30 percentof the premiumin a local reinsurancecontract. The only exceptionto this rate is for fire insurance;the companyis able to determinethe amountto be retainedbefore ceding 30 percentof the excessto the local reinsurer.The local reinsurerretains the right to decidewhether or not to acceptthis initialamount, and if it is not accepted,the directinsurer is free to go with anotherreinsurer, including a foreign one. As a second step, a direct insurer ziayalways offer the rest of its reinsuranceprogram to other local companies. If anothercompany takes the business,the insurermay resortto the foreignreinsurance market, but operatingonly with companiesauthorized by EISA. 7.91 Reinsurancerates are set by the Government.In general, they are lower than the rates obtainedabroad. Howeverif, for any reason,a directinsurer were to obtaina lower rate than that paid internally,it would have to returnthe dlfference(the supposedly overpaidrate) to the localreinsurer. On the other hand, if the 30 percentcompulsory premium was not accepted,at first,by the local reinsurer,thus grantlngthe directinsurer the right to use a foreign reinsurerservice, a certalnpercentage of the rate obtainedby the directinsurer would still be due to the local reinsurer. 7.92 It shouldbe understoodthat all this has been done with a view to increasingthe levelsof retentionin the marketin order to reducethe amountof foreigncurrency leaving the country. Nevertheless,the levelsof retentionIn non-lifebusiness have fluctuatedaround 35 percent. This is simllarto the levelin Chile, where no restrictionsexist on eithernational or foreignreinsurers. 7.93 CapitalRequirements. A minimumcapital of LE 2 million (aboutUS$600 thousand equivalent) is requiredin Egypt to set up an insuranceor reinsurancecompany, of which at leasthalf must be paid at the start of operations.This level of requiredcapital is relatively low, by internationalstandards. In Chile,for example,the minimum level of paid-upcapital is US$900thousand for reinsurers.In Mexico, the minimumcapital is US$1 millionfor llfe insurance;US$250 thousand for healthand accidentinsurance; and US$750thousand for one line of generalinsurance business, rising to US$1 millionfor two linesand to US$1.25million for three or more lines. The minimumcapital for reinsurarceis US$750thousand. - 62
7.94 Technical Reserves. Non-life technical reserves are defined according to internationalstandards. The insurance company;s main source of technical liabilitiesare included in these reserves, which include an uncommon, but very sound, reserve called a "loss ratio fluctuation reserve."
7.95 MathematicalReserves. The assessment of life insurance company mathematicalreserves is done according to the standard actuarial rules. There are two important parameters; the mortality rates and the technical discount rates of the actuarial flows. Egypt does not have any of its own mortality tables and relies cn tables from the UK. Local experts consider this acceptable,but they estimate that the tables are conservativefor Egypt. New mortality tables based on Egypt's own experience are currently being studied. Under the prevailing conditions, the technical discount rates used are also a concern. The annual rates fluctuate at around 5 percent in nominal terms, while the average annual inflation rate is about 20 percent. Although the securities market does not make it easy to project discount rates with any degree of certainty, the 5 percent rate is extremely conservative.
7.96 Independentof other correctivemeasures that can be taken to protect insured capital from the effects of inflation, the combinationof very conservativemortality tables and negative real technical discount rates is an important factor in making life insurance in Egypt very expensive.
7.97 Solvency Margins. Article 39 of the Law provides a limited type of solvency criteria for non-life business. It requires an increasing level of capital for increasing levels of income: "At any time, the total value of insurer's or reinsurer'sassets should exceed liabilitiesby at least 10 percent of the net general insurancepremiums in the previous financial year. In any circumstances,however, the excess of assets over liabilitiesshould not fall below the company's prid-up share capital." This regulation is a first step in recognizing t''. need for solvency controls on insurancecompanies. However, it has p;oven to be insufficient,at least to date, given the high leverage in the sector. It is not usual to find solvency controls and price controls along with the market conditions seen in Egypt, given the use of two opposite philosophiesof supervisionin controlling the technical aspects of the market.
7.98 Products. All products sold in the market require prior EISA approval, even though the majority of these products were proposed by the Insurance Federation. Few new products have been introduced in the market of late.
7.99 Compulsory Rates. There are three compulsory insurances in the market: motor insurance, third-partyliability insurance for contractors and third-partyliability insurance for building lifts. Motor insurance,undoubtedly the most important insurance, is discussed in the following paragraphs. Third-party liabilitypolicies cover a - 63 -
contractorfor 10 years after a civil work has been constructed. The total premium income of these policies was about US$1.5 million for FY90 with very few claims. These policies also cover the risk of accidents in building lifts.
7.100 CompulsolyMotor Act. This insurance is obligatory for all licensed motor vehicle owners. It is the most important of the compulsory insurance programs in terms of premiums, as well as in terms of the financial impact on the market. This insurancepolicy providis third-party liability (TPL) coverage with respect to the victims in road traffic accidents. Its main characteristicis cnat there is no ceiling on indemnif4ication.If no agreement is reached between the victims and the company, the problem must be taken to court, which not only determines the responsibilitybut also sets the amount of indemnification.
7.101 This mechanism is ineffective,and there are a considerable number of related lawsuits. The premiums on this insurance do not cover the claims, making motor insurance a loss-makerduring the last few years.
7.102 The price of motor insurance is set by law,7 and adjustmentsare slow and untimely. There appears to be a conviction that this insurance should fulfill a social function, and companies should, therefore, be willing to incur financial losses in providing it. The current premium for motor insurance is low by any international standard for obligatory motor insurance,particularly considering the unlimited indemnity coverage.
7.103 Although all companies in the market are obliged to sell this insurance,none of the three private companies have a share i.iit. Only the three state-ownedcompanies provide motor insurance. More than 40 percent of the total sales and the correspcondinglosses are concentratedin one company.
2/ Some of the annual premium rates charged are:
1. Private cars up to 1.500 c.c. LE 21.65 (US$7 approx.) more than 4.500 c.c. LE 47.25 (US$16 approx.)
2. Taxis up to five persons LE 32.80 (US$11 approx.) for each additionalperson LE 5.25 (US$2 approx.)
3. Public Transport Buses for each person up to 20 LE 7.90 (US$2.5 approx.) for each additional person LE 4.90 (US$1.5 approx.) minimum LE 118.15 (US$36 approx.) - 64 -
Analysis of Regulatory Issues
7.104 The regulatory framework is one of market control -- i.e., price and reinsurancecontrols, and entry barrlers -- rather than the promotion of competition whlle monitorlng solvency. Further, most of the regulations issued by law and through executlve regulations are intended to avoid foreign currency costs. In these circumstances,the industry tends to close Itself to the internatlonalinsurance market, and the degree of competLtivenesssuffers dramatically. This problem explains the very special network of relatlonshipscreated by Law 10 to structure the regulatory bodles. The same law, by allowing related ownership and such market agreements as the pools, ensures that some lines of business operate outside of normal competitivemarket conditions.
7.1O5 The low degree of participationin the national economy (gross premium expenditurerepresents 1 percent of GDP) and the high concentrationobserved in this sector (state-ownedinsurance companles have 85 percent of total income premium) are, ln large part, the result of the regulatory framework. Although this frameworkhas helped insurance companies avoid bankruptcies, it has been an important factor in limiting the industry's development. The administrativebarriers to s.Atry are responsible for the high degree of concentration;no companies ha-v enrered this sector recently despite several applications. In addition, the InvestmentLaw only allows those lnsurance companies operating in the Free Zones to form Joint-ventureswith foreign investors.
7.106 The regulatory framework does not protect policyholdersfrom the effects of inflation, especially those holding long-term insurance policies, e.g., life insurance. Some companies try to offset this deficiency by giving policyholdersparticipation in the company's results. The companies themselves are not protected from inflation. The securities market does not provid' securities that assure a real interest rate. Furthermore,the real rates observed in investment securities have, of late, been systematlcallynegative. This situation is improving slowly as Treasury Bills become available and in response to financial sector reforms.
7.i07 On the other hand, the underdevelopednature of the capital and securities markets, together with the low volume of investment securities available, makes it difficult to impose differentiated investment criteria on the life and non-life businesses. As mentionel above, the current investment rules draw practically no distinction between the two llnes of business. It ls not enough, however, to propose differentiatedinvestments. The law allows a company that has only one capital base to participate in both lines of business with different technical and financial risks. This capital must be sufficient to cover all losses. - 65 -
7.108 EISA publishes separate market figures for life and non-life insurances;for the sake of presentation,however, it dssociates the company's capital base with the figures presented for non-life business. In practice, it is impossible to determine which part of a company's capital corresponds to which type of business. The effect of this misrepresentationis seen most clearly in monitoring the solvency of non-life insurance concerns. The life insurance companies are protected by technical discount rates; it may, therefore,be presumed that when these reserves are in order and backed up by assets for which the yield is small, tnere is no risk of insolvency. The development of the life insurance business under these conditions,however, has been very slow.
7.109 To sum up, the regulatory framework hinders the development of the financial sector as a whole. Moreover, while some progress has been made in the banking sector, the insurance sector is still under- capitalized and over-regulated. This situation is partly due to a lack of clarity in the technical treatment of the insurance sector, which retards progress. It may also partly be due to a lack of understanding as to the contributionsand secondary effects -- such as the protection of individuals and fixed assets from some risks, the development of the securities market, greater financialdepth, and better resource allocation -- that accompany a developed insurance sector.
VI. Recommendations for a New RegulatorZ 7ramework
7.110 The current framework is not conducive to modernizing the insurance sector. Competitivenessand organizationalefficiency must be increased so that market-orientedservices can be offered at a reasonable cost, without unduly reducing the level of solvency. At the same time, the interests of consumers could be protected through better solvency monitoring, on the one hand, and through a more effective system of consumer protection on the other. The latter should give consumers the right of redress against malpracticeby insurance companies.
7.111 Essentially,there are two regulatory systems operating in these markets. One of them is based on strict solvency monitoring, leaving most of the technicalvariables, including the sector's pricing structure, irethe hands of the insurance companies. The other system is based on the balanced control of technical variables, with a view to reducing the chance of companies incurring losses that would put their capital base at risk. Both systems have the same objective, which is to avoid insurance company insolvency.
7.112 The current framework in Egypt ensures that conditions are identical for all those companies operating in the market, in terms of prices, sales commissions,reinsurance requirements, discounts and profit commissions. These aspects are often based on historical information,which in some way guarantees that the pricing structure is able to cover the cost of claims, as well as other costs in order to generate acceptable profits. - 66 -
7.113 This type of regulatory philosophy has two important conceptual errors, however. First, in the insurancebusiness, nobody is able to assert that what was adequate in the past will also be adequate in the future. Second, economic regulationsstifle competitionand innovation: creativity in generatingnew products often falls off, weakening companies' efforts to reduce costs, to provide better service, to find the best conditions for reinsurance,and encouraging the use of marginal sales techniquos (which go against business ethics). All these effects may lead to a systematic deterioration in the sector's efficiency,which is finally paid for by the policyholders.
7.114 Under this type of regulatory system, not only are the policyholdersvulnerable, but serious market distortionsmay be introduced, such as high levels of concentration,monopoly tendencies and the survival of inefficientcompanies.
7.115 However, Germany and Switzerlandhave thriving insurance sectors, and both follow the market control approach. In fact, sophisticated regulators may encourage innovation and efficiency,while maintaining orderly conditions and fightin% deceptive packages. The problem is the short supply of sophisticatedregulators and the long-run risks of regulation capture. Thus, stagnation and deteriorating efficiency need not always follow the market control approach. On the other hand, finnneial deregulationin Anglo-Americanmarkets has not been an unqualified success. It is also possible to have destructive competition and imprudent expansion.
The Concept of Solvency Control
7.116 Monitoring insurancemarket solvency means ensuring an adequate level of certainty that companies can meet, at any moment, their obligations to their policyholders. These companies, however, must be absolutely free to decide under what conditions they do business.
7.117 Prudential regulationsshould focus on maintaining a high level of solvency in the sector, without limiting the market's possibilities for business development,so as to ensure an efficient and competitivemarket. Prudential regulationsshould be drawn up as a 'bankruptcycontrol program." The only way of establishingan adequate regulatory framework, in this sense, is to highlight the main risks of insolvency faced by an insurancecompany so that the regulations can be drafted to try to minimize these risks.
7.118 It is important to have periodic access to timely and accurate financial statements that show a company's capital situation. The true value of each company's assets and technical and financial liabilities is critical to determiningits capiral base. Choosing which solvency ratios are to be used then becomes only a minor problem. Alternative approaches are: the solvency margins used in Europe, the early warning ratios used in the United States, or definition of maximum levels of technical and financial indebtednessaccording to each local - 67 -
mar.-:t'sreality. The applicationof these ratios is simply the automatizationand standardizationof this control. Hence,the local insuranceindustry's relative levels of financialrisk are limited throughthe owners'capital contribution. 7.119 The real problemin solvencymonitoring is not so much determiningwhich ratio to use, but gainingadequate information. It has taken about six years to produceacceptable measures of solvencyin countriesthat have adopteda soivencymonitoring approach. 7.120 Propersolvency monitoring requires that companiessplit their equityinto life and non-lifebusinesses, with separatebalance sheetsand individualcapital contributions. Credit insurance should also be kept separatefrom other lines of business. Differentbusiness shouldnot be subjectto the same financialrequirements and bankruptcy risks. The regulationsmust be differentor else the bankruptcycontrol programwill be ineffectiveand highlyconfusing. 7.121 The followingare the most importantbankruptcy risks, some of which are specificto certaintypes of companies: Mi) The risk of loss in the value of assets. (ii) The risk of loss due to incorrectproduct pricing. (iii) The risk of loss due to marketprice reductionsin very competitiveproducts. *iv) The risk of loss due to changesin the interestrate. (v) The risk of loss due to inadequate reinsurance programsfor catastrophicrisks. (vi) The risk of bankruptcydue to managementerror and inefficiency. With these risks in mind, most of the controlsencourage the undervaluingof assetsand the overvaluingof liabilities. 7.122 The acknowledgmentof bankruptcyrisks leads to the publicationof financialand accountingregulations recognizing their existenceand ensuringthat they are referredto in some way in the insurancecompanies' financial statements. ihe introductionof conservativeaccounting principles, capital contributionspolicies and other prudentmeasures will resultin capitalrequirements sufficient to reducethe risk of bankruptcyto an acceptablelevel. 7.123 The higherthe risk of bankruptcy,the greaterthe capital requirementsneed to be. Highercapital requirements, however, will not totallyeliminate the risk of bankruptcyin the sector. Nor is the capitalrequirement without costs, especially in developingcountries where capitalcost requirementsare obviouslypassed on by the companies to the policyholders.The regulatoryauthorities should, therefore, ensurethat the legal and regulatorycapital requirements are reasonable,without lesing sight of the aim of protectingthe policyholders.This very difficultbalance depends on the conditions and the natureof individualmarkets. - 68 - NecessaryConditions for SolvencyMonitoring
7.124 In additionto the prudentialframework already mentioned, a successfulsolvency monitoring system requires the followingconditions: (i) an autonomousinsurance superintendency with the power and expertisenecessary to take immediateaction; (ii) the periodicand timelyrelease of companyfinancial statements; (iii) the use of balancedcriteria in the preparationand presentationof financialstatements;
(iv) the use of consistentcriteria for externalauditing companies;
(v) the existenceof developedand transparnt financial mArkets;and (vi) accessto comprehensiveand timelyinformation on the financialsituation of each company. 7.125 The most importantelement in this systemis the insurance superintendency'scontrol of solvencymonitoring. This functionis quitedifferent from that exercisedthrough price controlin regulated markets. Technicaldepartments in chargeof settingand applyingprices will tend to disappear,along with those controllingthe local companies'reinsurance programs. These departmentsmust be replacedby staff able to conduct complex financial analysis. This staff must be capablenot only of reviewinga company'sbalance sheet and applying ratios,but also of anticipatingmarket trendsand takingappropriate measures. Trainingand specializationprograms for the staffof the ..egulatorybodies are, therefore,very important. 7.126 Finally,the independenceof the regulatorybodies is of utmostimportance; any kind of interferencewith theirperformance must be avoidedat all costs. They must be given total autonomyto issue resolutionsconcerning the companiesthat are in trouble,as well as to issueany regulationsthat are needed. They must be independentof otherstate authorities.
7.127 Any successfulderegulation in the securitiesmarkets goes hand in hand with the developmentof a strongcapital market. Companies can investin securitiesand, in this way, contributeto the best allocationof resources.A transparentsecurities market also helps companiesvalue their investmer-scorrectly. Such stronginstitutional investorsas insurancecompanies are an importantelement in the developmentof the securitiesmarket. Life insurancecompanies and pensionfunds are especiallyimportant, since they are the main purchasersof financialsecurities. In Chile,for example,the total amountof investmentsmanaged by insurancecompanies as of December1990 - 69 - (measuredas the totalamount of investmentsin the securitiesmarkets) reached7.4 percent,of which 6.7 percentagepoints correspond to life insurancecompanies alone.
7.128 The organizationsthat regulateinsurance companies (and those regulatingpension funds) should coordinate their efforts with thoseof the CapitalMarket Authority. The developmentof thesemarkets givesrise to and enforcescomplementary/coordinated actions in the developmentof coherentrules and conditions. VII. ProiosedAction Plan
7.129 The Egyptianinsurance market is in a criticalstate, in which marginalmodifications cannot ensure successful development. The proposedeconomic deregulation of the insurancemarket and strengthening of prudentialregulation will changethe systemof marketcontrol to one of marketfreedom and solvencymonitoring. Tnis proposalaims to developan insurancemarket that will not only provideprotection to assetsand individuals,but will also convertitself into a key element in the developmentof the securitiesmarket. 7.130 The followingissues must be addressed: (i) insurance businessis excessivelyconcentrated in a few statecompanies; (ii) the sectorshows clearsigns of stagnation,despite its reasonablelevels of efficiencyand technicalperformance; (iii) there is one dominant reinsurer;(iv) the sectoris not transparentenough; and (v) supervisionis under-developed. Short-TermAction Plan
7.131 The short-termaction plan requiresmodifications to some laws and regulations.However, there is a need to studythe implicationsif regulatorychanges before they are effected.
1. Measures to lmprove overconcentrationand under- capltalization:
(i) modifyEISA admissioncriteria in orderto allowthe entry of new companies; (ii) eliminateownership ties betweeninsurance companies (ownersbeing shareholdersof other insurance companies),especially in view of the few companies operatingthe marketand the dominationof the market by state-ownedcompanies. Small cross-shareholdings, which will be excludedfrom net assetswhen calculatingsolvency margins, could be allowedif the numberof companiesincreases significantly; (iii) eliminatepractices that inhibitfree competition. The four insurancepools and the GovernmentInsurance Fund shouldbe eliminatedas soon as possible; - 70 -
(Iv) undertake studies of the companies' financial condition and viability, especially those with a significantmarket share, in order to determine the causes of low capitalizationand widely differing results. This effort would require access to adjusted and audited historical accounts; and
(v) modify the Investment Law to give foreign capital access to the domestic market through joint-ventures. All the companies with restricted operations should be included.
2. Measures to increase competition and efficiency:
(i) deregulate some of the socondary prices in the market. The commission rates for brokers should be deregulated as soon as possible. This should be accompaniedby a requirement for disclosure to consumers. Also, allow legal persons to be classified and operate as brokers;
(ii) liberalize premium rates gradually, starting with the rates on low volume business and insurancecontracts for legal persons. Both parties should be allowed to determine prices in accordance with their own technical evaluationsof the risks in the direct and reinsurancemarkets. The aim of this measure is to increase the existing list for some very specific engineering risks;
(iii) encourage companies to develop their own management informationsystems. Draft rules to introduce the concept of public procurement on insurance coverage above certain amounts;
(iv) study legal ways of reducing overstaffing in state companies.
(vj facilitate the employment of foreigners;
(vi) remove product and price controls through the introductionof regulationsproviding protection to consumers from possible imprudent and fraudulent behavior on the part of unscrupulous individual insurers or brokers. The appointmentof an independent insurance ombudsman to investigate complaints from nonprofessionalconsumers and to exert pressure on insurancecompanies to respond to legitimate complaints should be considered as a means for improving the public image of the industry and enhancing public confidence in the integrity of insurance contracts; and - 71 -
(vii) improve the obligatory insurances currently in existence. It appears that compulsory motor insurance will continue as is. Fundamental changes are proposed in third-party liability insurance, which often requires arbitration in court, for a more objective type of coverage, payable whenever a person is injured in a road accident. The level of coverage under this new insurance should have a fixed limit. Finally, in view of the type and technical characteristicsof this coverage, the companies should establish their own prices. They would then compete for business and offer the best possible price to the insured parties.
3. Measuresto Improvethe relnsurancesystem:
(ij eliminate all current obligatory ceding requirements, together with price controls in the reinsurance market; and
(ii) improve the system of registrationand monitoring under which local companies are allowed to operate.
4. Measuresto Improvethe sector'stransparency:
(i) regulate companies' presentationof their financial statements. Require monetary correction for inflation and begin studying the legal modificationsneeded to require that only independentand external auditors audit the companies' financial statements, regardless of whether the company is public or private.
(ii) provide auditors with minimum guidelines as to their requirements,obligations and attributions;
(iii) study the feasibilityof companies presenting financial statements at least twice a year; and
(iv) establishwinimum guidelines for publishing balance sheets and annual company reports.
Medium And Long-Term Action Plan (StrengtheningEISA)
7.132 The aim of these proposals is to change market conditions gradually in order to establish a basis, within a reasonable period of time, for a fully deregulatedmarket. Detailed studies are required, however, before more drastic measures are adopted. The structure of EISA must be studied and defined, keeping in mind the degree of independenceand autonomy needed to work effectively in the new environment. Standards for solvency monitoring need to be studied and defined in relation to the requirementsof the Egyptian market. At this stage, it will be necessary to separate life and non-life insurance activities in different companies. - 72 - 7.133 Investment'egulation end reserverequirements must be set for both life and non-l.fecompanies. These regulationsshould take into accountsolvency risks associatedwith each line of business. These conditionsshould be introducedby law and not merelyby decree, as is the case with investmentregulations. 7.134 To promoteefficiency, the companiesoperating in the market shoulddo so withoutsubsidies or distortionsof any kind. Although this study does not discussprivatization, it is clear that private ownershipwill promotecompetition. There are no marketfailure argumentsthat justifygovernment ownership of inazurancecompanies.
7.135 The successof this projectdepends, to a large degree,on the abilitiesof personnelEISA. Staff training,therefore, should be given top priority. A New InsuranceLaw for Egypt 7.136 The actionplan is impossiblewithout a changein Law 10, togetherwith a seriesof modificationsto regulations,especially decreesissued by the MOE. Thesemodifications should be undertakenin accordancewith the priorityassigned to each of thA subjectsand actionsin the plan, especiallyover the short-and medium-term. 7.137 A partialchange in the InsuranceLaw (Law 10) will not be adequate. The new law shouldinclude all the changesin a singlepiece of legislation,regardless of the date the elementscome into force. The law shouldalso includetransitional periods and conditionsthat will give this industryths necessarytime to adjustto the changes. 7.138 In order to incorporatethe principalelements of the proposedregulatory framework, the new insurancelaw should:8 (i) establisha regulatorybody autonomousand independent of the ministries; (ii) be expliciton such mattersas tha rules governingthe degreeof discretionallowed to the Insurance Authorityor other similarauthorities. The law shouldnot, however,go into detailsthat can be dealt with in regulations,given the powersconferred under the same law; (iii) separatethe capitalof companieswishing to participatein both life and non-lifebusiness. They could be constitutedas separate,independant companies;or as affiliatedsubsidiaries of the same group;
j./ A model is presentedin Annex VII.2. - 73 -
(lv) eliminate ditforentlaltreatment of private and state- owned companiea;
(v) monitor the solvency of the insurancemarket while leaving the companies free to determlne thelr own rates, prLce. and commLssLons;
(vi) elLmlnate most reinauranc-controls, leavLng companio free to decide on theLr own programo, whlle retalning some condltlons,especlally for foreign reLnsureras
(vli) forbid oroas-ownershLpof shares ln order to lncrease the transparencyand fair play in the Lndustry;
(viii) elimLnate the authority currently given, by law, to companles to associate and form prlce cartels and monopoly conditionsl
(ix) clarify the conditions for entry lnto and exit from the market in order to limit the authorities' diecretionarypower in the industry;
(xi) define the conditions for the 1i A'stryso that all companies are on equal terms and have equal access to the lines of business they choose;
(xLL) free access to foreign investors Lntere3ted in entering the insurance business without imposing restrictionson geographicallocation or lines of busLness; and
(xii) develop a transparentmarket by placing the maximum posesibleinformation at the public's disposal, especially information regarding the insurance companies operatlng in Egypt.
Government Reform Program
7.139 The authoritiesplan to implement the followinq reform program which will be supported by the SAMPt
* Submit to Parllament and seek approval for a new Insurance Law and Executive Regulationsbased on international prudential standards.
* Strengthen the Egyptian Insurance Supervisory Authority's solvency monitoring capacity.
* El$minate discriminationagainst private companies, allow market entry by new domestic firms, and facilitate roinsurance. - 74 .
* Deregulate insurancepremia.
* Allow foreign entry.
* Begin a comprehensiveprivatization program by zompleting the sale of public sector shares in joint-ventureinsurance companies, by selling one public sector insurance company and by bringing a second to the point of sale.
7.140 This represents an impressive list of reforms. However, the authoriies should also give consf.erationto measures outlined above that are not yet included in this list. CHAPTER VIII
MAIN ISSUES IN SOCIAL INSURANCEAND PENSION ECONOMICS
8.1 This chapter provides a framework to the discus-ions on issues in social insuranceand pension systems in Egypt, which are covered in the next three chapters. It discusses the main effects of reforming contractual savings arrangementswith specific reference to a switch from a defined benefit (DB) social insurance system kSIS) to a defined contribution (DC) pension system.1 Of particular relevance are the effects on saving generation,savings cemposition, intergenerational transfers, labor and product markets, ineividual and social equity, the financial solvency of the social insurance system, and domestic public debt and maturity. The chapter ends with the presentationof the internationalexperience with contractual savings.
8.2 Financial institutions,firms and social insurance institutions generally offer two types of pension plans, DC and DB plans. In a DC plan, the level of pensions depends solely on the accumulated contributionsby employers and workers and on the investment performance of the fiund. In a DB plan, the level of pensions is determined according to a formula that usually takes into account salary and years of service. While DC plans are generally fully funded, DB plans can be overfunded, fully funded, partially funded or unfunded.
8.3 In Egypt, the pension plans sponsoredby the SIS are funded, DB plans. In effect, they are overfunded.2 The method of finance for unfunded, DB pension plans is pay-as-you-go (PAYG),meaning that the benefits received by current retirees must be equal, on average, to the contributionspaid out by current active workers. To maintain this balance, contributionshave to be changed periodicallyto take account of increases in the number of beneficiariesrelative to active workers, changes in real wages and inflation (to the extent that price increases affect real pension benefits).
8.4 The availabilityof social insurancebenefits tends to reduce the scope of insurancecompanies and private pensior.plans. The retirement pension program, for example, is a substitute for voluntary pension programs. Survivorship pensioLis are a compulsory form of collective life insurance. In addition, most pension programs behave like annuities in that they insure beneficiariesagainst the longevity risk, i.e., they pay benefits until beneficiariesdie. 3 Finally, social insurance institutionscrowd out other types of private insurance by providing mandatory health, disability and work-injury insurance coverage.
-1/ This type of reform was implemented in Chile in 1980.
2/ See Chapter I, Footnote 3, and Chapter IX. Except when the beneficiariesof death pensions are orphans. In this case, benefits terminatewhen beneficiariesreach adulthood. - 76 -
I. The Imoact on National Savinn
8.5 The impact of CSIs on national and household saving is one of the hottest debates in the area of public economics. Under one view, the SIS, compantypension funds and life insurancepolicies represent a particular institutionalform of saving that has no effect on total saving as consumers would substitute it for other forms of saving. Another view maintains that consumers would not compensate completely for this form of saving, leading to an increase in total saving. Under this view, the introductionof social insuranceand pension schemes would allow consumers to opt for earlier retirement,which would require continuing with a higher rate of saving than if retirement plans were unchanged. Another reason for continuingwith a high rate of saving is that pension systems, even though they include survivorshipbenefits, can not be bequeathed in the same way as other household assets. As the bequest motive is an important determinantof household saving, the latter would not fall or would fall by a smaller amount. A third view argues that consumers would reduce their other forms of saving by a larger amount because the greater efficiency of CSIs would alIow consumers to achieve the same target level of assets with a lower overall rate of savings.
8.6 These conflicting claims cannot be easily resolved by empirical investigations. In the first place, the impact of this type of saving depends on the credibility of CSIs. A system with low credibilitywould have a lower impact on consumer behavior. Contributionsto a noncredible system would be treated as taxes rather than as forced savings. Whether the total rate of saving increases or not depends on whether the system accumulatesreserves and who are the recipients of current benefits. Some overall increase in the rate of saving is likely.
8.7 Credibility also depends on the age of the social insurance or pension schemes. As new schemes take time to establish a credible pattern of profitable investmentsand adequate pension benefits, the introductionof a compulsory funded pension scheme is likely to increase the total rate of saving since consumerswould take time to adjust their behavior to the promised benefits of the new system. However, contributionswould reduce the level of discretionaryincome, and as consumptionpatterns are unlikely to be adjusted promptly, the overall increase in the rate of saving would be less than the rate of eontributions. In contrast, mature systems would enjoy greater Lredibilityand could cause greater changes in consumer behavior.
8.8 A cursory look at the rate of saving and types of SISs in different countries shows that countrieswith high rates of household saving, such as Italy and Greece, also have SISs. In contrast, countries with funded pension schemes, such as Sweden, the United Kingdom and the United States, have low rates of household saving. However, the determinantsof household saving include many other institutionalfactors, apart from the organizationof social insurance - 77 - and pensionsystems, which may obscurethe impactof concractualsavings schemeson saving. II. The Promotionof Long-TermSavings 8.9 While the quantitativeimpact of contractualsavings on the generation of new aggregate saving is unclear, their qualitative impact on the compositionof nationalsavings (i.e., wealth) is bevond dispute. Contractualsavings cause a shift in favor of long-termfinancial savingsthat can be used to promotethe developmentnf equityand bond markets. This can help fill the gap in the supplyof term financethat existsin most developingcountries. Corporateequities, as well as longer-termdebt securities,can be developedto complementthe short- term instrumentsavailable in the localbanking and money markets. 8.10 In countrieswhere there are no pensionfunds or long-term financialassets on which to save for retirement,people accumulate wealth on whateverassets are trustedto maintainreal value over long periodsof time (e.g.,real estate,foreign currency and consumer durables). By investingin stocks,corporate bonds and long-term governmentbonds, CSIs changewealth composition in favor of financial assets that can be intermediatedlocally to expand the supply of reproductivecapital. In Egypt,this couldhelp to enhanceinvestment productivityand reversecapital flight. On the other hand, CSIs may play aimimportant role in managingdomestic public debt by increasing the demandfor long-termgovernment bonds. This is important, especiallysince the maturityof newly issuedpublic debt is short comparedto other countries. III. FiscalEffects and IntergenerationalTransfers 8.11 Phasingout socialinsurance retirement programs raises fiscalissues. Unlessthe Governmentdefaults on pensions,it must continueto make paymentsto currentretirees while it loses the right to tax currentworkers. Also, the Governmentmust recognizea fair value for past contributionsto the old systemby currentlyactive workers. How the Governmentchooses to financethese liabilitieshas importanteffects on capitalformation, on real interestrates and on the way incomeis redistributedacross generations. 8.12 Socialinsurance reform affects capital formation by redistributingincome from the old to the young generationor, alternatively,from the young generationto futuregenerations. Assume, for example,that in order to preventthe increasein the budget deficit causedby socialinsurance reform, the Governmentincreases taxes to young workers. Under the PAYG system,the young generationis liable for the benefitsof the old generation,and the next (future)generation is liablefor the benefitsof the young generation.With the new capitalizationsystem, current workers would be asked to pay for two retirements,their own and that of the retiredelderly at the time of the switch. On the other hand, the next generationwould be relievedof the obligationof transferringincome to currentlyactive workers when - 78 - they retire. When the implicit intergenerationalcontract is broken and all of the burden falls on current active workers, this generation consumes less and, hence, aggregate saving increases.4
8.13 A totally different scenario results if the government issues debt to finance the social insurance deficit (in other words, if it borrows from the young to take care of the old). In this case, the young and future generations are relieved of the obligation to pay social insurance taxes to support the preceding generations,but they have to sarvice a higher public debt instead. The transferring mechanism is basically unchanged relative to the PAYC case, and so is aggregate saving. In effect, private saving (the accumulationof wealth by young workers to consume upon retirement)is offset by public dissaving (the social insurance deficit) at the time of the reform. Thus, if one of the objectives of social insurance reform is to attain the lowest possible intergenerationalredistribution, an increase in the saving rate would be evidence that the Government failed to attain that objective.
8.14 Would interest rates rise as a result of the increase in the public debt needed to finance the social insurance deficit? Here, the answer depends on investors'perceptions about that deficit. If the public debt is defined so as to include social insurance liabilities, then the increase in the debt resulting from "social insurance d~eficits' is nothing but fiscal delusion. The liability of the Government, i.e., the obligation to pay pensions to current and future retirees, existed before the reform. Converting this liability into bonds and calling it "formal debt" does not alter its substance. Another way of looking at this problem is to analyze its effect on the market for government bonds. Instead of paying social insurance taxes, active workers buy government bonds through pension funds under the capitalizationsystem. The increase in the demand for bonds exactly offsets the increase in supply, leading to no direct effect on interest rates. However, ex post real interest rates would rise if the ,ublic expected that Government to finance the social insurance deficit with the inflation tax. Given the Egyptian Government'sproblem of establishingcredibility with respect to its inflationarypolicy, social insurancereforms that generate potentially large social insurance deficits should, in principle, be avoided.
A/ Alternatively,the old generation c-uld have been forced to reduce consumption to avoid an increase in the budget deficit. This would occur if the Government defaulted on pension promises, leaving current retirees unprotected. Not.Lce, however, that the change in regime is formal only if current workers are asked to support the elderly through family transfers, charity and public welfare. . 79 -
IV. Effects on Factors and Products Markets
8.15 In a PAYG SIS, payroll contributionsdouble as taxes and forced saving. The forced saving nature of contributionsresults from the fact that workers (or their employers) contribute now in exchange for a beviefitlater (either a pension, a survivor's pension or worker's compensation). In this sense, social insurance benefits are deferred compensationsfor labor. If both workers and employers recognize contributionsto be deferred compensations,and if they regard the contingent benefits as equal in value to the contributionssecuring them, then there is no tax on labor and, therefore, no distortion in the labor market. In this case, the employer's wage bill equals the wo,ker's compensation,and there are no further effects in the economy. Generally, however, workers do net regard payroll contributionssimply as deferred compensations. In Egypt, a worker's lifetime earnings and contributionsplay almost no role in determininghis social insurance benefits (Chapter IX). Even though many workers can expect to gain much on balance through participationi.. social insurance, there is little marginal linkage between costs and benefits.5 Thus, most social insurance contributionsare taxes, i.e., a drain on workers, employers and consumers.
8.16 A fully funded, DC pension system removes the distort.ions created by social insurance contributionsas it improves the marginal linkage between contributionsand benefits. As stated above, most workers view their social insurancebenefits as unrelated at the margin to their tax contributions. This means that the 26 percent contribution rate for social insurance in Egypt must be added to the marginal tax rate of the personal income tax in order to compute the total marginal tax rate on earnings. Since the economic waste due to distortionary taxation rises with the square of the marginal tax rate, the social insurance payroll tax rat.ecould be adding significantlyto the distortionarycosts of the tax system. In contrast, in a fully funded, DC pension system, in which individual "tax" contributionswere registered in individual accounts and paid out with market Interest in old age, the Government would simply be providing forced savings accounts for individuals,and, if there were no liquidity constraints,a pound contributed to social insurancewould be viewed as a pound of saving with no distortionaryeffect on labor supply. The linkage, in present value, of marginal benefits in return for marginal contributions in this case is pound for pound.
8.17 Another labor market distortion created by social insurance retirement programs is the lack of early pension rights vesting and portability,which results in restrictionsto worker mobility. In part,
5-/ Any progressivity in the system reduces the marginal linkage while the fact that risk-averseworkers should be willing to pay a premium for contingent annuities raises the marginal linkage. Also, a high rate of time preference tends to reduce the marginal linkage. - so -
this problemis causedby the difficultyof determiningpension rights accrualsin systemswhere the benefitformulae differ. This problem does not exist in the case of personalretirement accounts since the portabilityof savingsis, generally,immediate.
V. Effectson Eguity 8.18 There are two dimensionsto the equityproblem: individual and social. In order to be individuallyequitable, the "deal"offered by socialinsurance t,s to be fair in a positive(as opposedto a normative)sense. Socialequity involves the definitionog a normative goal, such as equitableincome distribution. Basic economictheory suggeststhat the efficientprovision of goods and servicesdoes not necessarilylead to a distributionof incomeor to a burdenof payment that is satisfactoryto the society. In a countrylike Egypt,there will be a strongdesire to removemuch of the burdenof payingfor health care and retirementbenefits from the very poor. Whetherthe SIS is an efficient instrument to achieve this goal is another question.6 Ideally,transfers that distortallocation decisions as littleas possibleare to be preferredto those that distortthem more severely, but in practicesuch transfermechanisms are difficultto design. 8.19 An actuariallyfair pensionsystem requires that workers receivebenefits equal in presentvalue to past contributions.In a PAYG system,participants invest in a public "bond'whose returnis determinedby payrolltaxes to be collectedin the future. Since the pool of workersfinancing tomorrow's retirees is likelyto be larger than today'sworkers because of populationgrowth, the returnof social insuranceretirement programs is determined,in part, by the rate of growthin population.Also, since tomorrow'sworkers are likelyto earn higherreal wages than today'sworkers because of productivitygrowth, the returnis also determinedby increasesin laborproductivity. Hence, the social insurance deal can be fair or not, depending on whetherthe real interestrate (the discountfactor) is equal to or higher than the sum of populationand productivitygrowtrh. In contrast, the deal offeredby personalretirement accounts invested at market interestrates is alwaysindividually equitable. 8.20 Understandingthe redistributiveeffects of the DB system is crucialwhen evaluatingsocial insurance. In some cases,the effects are intentional(e.g., when transfersgo from high to low income households)while in othersthey are completelyunintentional and lead to both individualand socialinequity. Due to the complexityof the i/ Given the size of the informallabor marketin Egypt,taxes on labor are likelyto be more distortionarythan other taxes. Also, Egypt'spoorest workers are in the informaland farm sectors,hence uncoveredby socialinsurance. While these workersdo not receivesocial insurance benefits, they in effect contributeto the benefitsreceived by coveredworkers since part of the incidenceof labor taxes is on consumers. - 81 -
rules governing Egyptian social insurance,it is not surprising to find that the system distributeswealth capriciouslyamong different groups of individuals (Chapter IX). These problems can be corrected,while still add;essing the need for progressivity,by designing a more transparentSIS in which the marginal link between taxes and benefits is perfectly clear to all participants. The taxation of social insurance payments and contributions,as well as income taxation, is also important in determining income distributioneffects.
VI. Effects on Financial Solvency
8.21 In most countries, social insurance retirement plans are not strictly PAYG plans. Such plans would simply pay to beneficiaries the money that was collected each period from payroll taxes. Social insurance plans usually do not have the inherent flexibility of such plans. Instead, they are unfunded, DB plans, where the benefit formulae are not explicitly adjusted to changes in the cash flow of the system. A major problem with an unfunded, DB plan is that it is very susceptible to financial crises. If the benefits are slightly more generous tnan the taxes collected for a period of time, the system quickly runs into a liquidity problem. The financialposition of social insurance depends to a much greater extent on short-run business cycles, long-ruii productivitychanges and demographicdevelopments than a true PAYG system. This, along with the difficultyof foresastingdemographic and economic developments,explains the repetitivefinancial crises of SISs in many countries. Converting the unfunded, DB system into a funded, DC system practically rules out the possibility of liquidity and solvency crises, provided that an effective regulatory and supervisory system is also implemented.
VII. Domestic Public Debt and Maturity
8.22 At actual levels of ex Rost real interest rates, the current level of internal, voluntarilyheld, public debt representedby the TBs outstanding (about 9 percent of GDP) is not high enough to provoke unsustainabledebt accumulation. However, the problem confrontedby the Egyptian authoritiesis their short-termmaturity. Up to r.ow,the total voluntarilyheld debt of the public sector is in bonds of less than one-year average maturity. Most developed countries have a larger share of public domestic debt to GDP than Egypt but in most of - 82 -
them the average debt maturity is significantlylonger than in Egypt.7 (Figure VIII.l and Table AVIII.l, Appendix).
8.23 Therefore, not only has the Egyptian Government to worry about generating resources each year to honor the debt, it will also has to roll it over frequently,and this could happen at interest rates that will vary significantlywith investors'perceptions about inflation, devaluation,and government insolvencyat each time the debt is renegotiated. Knowing this, agents can predict that, rather than selling debt at punitive interest rates when confidence crises arise, fiscal authoritiesmay turn to temporary money financing, thereby increasing the probability of devaluation. The result can be a self-fulfillingcrisis. This outcome can be ruled out if the,.amount of debt maturing during the crisis is sufficientlysmall, a condition that can be met by reducing the stock of public debt, lengthening its average maturity, and/or smoothing the time distributionof maturing issues. The development of CSIs may help to improve these conditions by creating a stable demand for long-term debt.
VIII.InternationalExperience with ContrectualSavings
8.24 In contrast, CSIs, such as pension funds and insurance companies, are major investors in government and corporate securities in several developed, and a few developing,countries. In the Netherlands and the United Kingdom, the accumulatedreserves of pension fund' and life insurance companies represent over 90 percent of GNP; in the United States, Canada and Sweden, they are around 50 percent of GNP (1986). Among developing countries, C7Is are very large in Singapore,where the Central Provident Fund has reserves equal to 65 percent of GNP (1985), and in Malaysia, where the Employees Provident Fund has assets correspondingto 43 percent of GNP (1987). In Korea, there is no national provident fund, and the pension fund sector is underdeveloped; however, reserves with life insurance companies are equivalent to 18 percent of GNP (1988). A similar proportion of GNP is representedby the assets of the private pension plans that have been established in Chile since the 1980s. Adding the reserves of life insur:ancecompanies,
.2/ Only Greece has a debt maturity structure comparable to Egypt. Notice, however, that in addition to the domestic debt, Egypt's public sector has a foreign debt of about 111 percent of GDP that is not included in Figure VIII.I. Neither is included the domestic debt held involuntarilyat below market rates. Both these debts are mostly long term and raises the total public debt to over 120 percent of GDP. No such distinctionbetween domestic and foreign debt arises in the OECD countries shown in the figure. In the case of Egypt, the distinction is necessary because most of the foreign debt has been restructuredand accumulatesnon-market interest rates while most of the voluntarily held domestic debt accumulatesmarket interest rates. - 83 -
which amounted to 4 percert of GNP, raises contractual savtngs in Chile to 22 percent of GNP.
8.25 Developed countries generally follow a three-pillar approach to contractualsavings and social insurance. Social insurance provides a minimum, and increasinglyuniversal, pension to old people; it is funded either from general tax revenue or on a PAYG basis, although a funded SIS is now in operation in the United States. Company-basedpension schemes, the second pillar, provide occupational pensions that are mostly based on funded, DB schemes. However, DC schemes are also w/idelyused in some industries,such as in the constructionsector. The third pillar is provided by personal pension plans. Both company and personal pension plans enjoy considerable fiscal advantages.
8.26 DB, company-basedschemes used to be preponderant in dev6loped countries,but in recent years there has been a growing trand towards DC schemes and personal pension plans. in the United Kingdom, employees now have the right to contract out of both the state earnings- related pension scheme and thieirown company-basedscheme and to t-ansfer their pension rights to personal pension plans managed by commercialbanks, building societies and insurance companies. Similar changes are also being implementedin other European countries such as Spain, Switzerlandand France.
8.27 Social insurance and pension plans are supplementedwith life insurancepolicies that often have a large savings component. Endowment insurancepolicies, either with fixed insured values and fixed returns or with variable insured values and performance-relatedreturns, are widely used in many developed countries. General insurance policies are also used although,because of their short-termnature, these policies do not contributeto the generation of long-term contractual savings.
8.28 CSIs are most advanced in countries such as Singapore and Malaysia that operate national provident funds. The large accumulation of reserves has been stimulatedby an expanded coverage, a high rate of economic growth and positive returns on investmentincome. However, high contributionrates have also been important. Contributionrates were initially set in both countries during the 1950s at 10 percent of wages and salaries, divided equally between employers and employees; these rates have since been gradually raised to 20 percent in Malaysia and to 35 percent in Singapore.
8.29 Several developingcountries also have company-based,DB plans; these plans are probably quite significant in countries such as India, Zimbabwe, Botswana and other former British colonies. However, no data on the size and significanceof such private pension plans are readily available. Countries relying on PAY- SISs are mostly found in Francophone Africa and Latin America (except Chile, which in 1981 introduceda system based on DC, personal pension accounts). These countries have very limited or nonexistent contractual savings. - 84 -
ELgure VLIIII
Egypt: Public DomestJc Debt Structure of Egypt and OECDCountries 140
120
100 - ..- *......
80 - ...... -....
40 6a -~~ .. . _ s!-
40 -*.. *>. . _|||_.
IRELAND ITALY tFTUCfAL DEARI: SPAIN '3EAWY EGYP` BELOIUM NETHERLANDS GREECE U.S.A. U.K. fPANC
I 0Oebt as Xof GDPIMShort Term XOf GDP|
Source: Tab l e AV I I I .1 OECOcountry data 1997, Egypt date 1990
8.30 Life insurance is well developed in Korea where annual premiums correspond to nearly 7.5 percent of GNP; this rate is higher than that of most other countries, includingJapan, although it is lower than in Ireland or South Africa.8 The high level of life insurance premiums in Korea is attributed to the underdevelopmentof other forms of contractual savings and the absence, until recently, of a SIS. Other developing countries that have relatively well developed insurance
Al For a survey of the development of contractualsavings in developing countries, see Vittas, Dimitri and Michael Skully, "An Overview of ContractualSavings Institutions," World Bank, CECFP, mimeo, 1990. Internationaldata on life and general insurance are reported in Sigma, Swiss Reinsurance Company, March 1989. - 85 - sectors include Zimbabwe and a few countrios in the Caribbean region. CHApTER IX
THE SOGIALINSURANC9 SSTE!
AND THE NATION, E9TMENT
I. Introeuction 9.1 Egypt offerssocial insurance t,) an unusuallybroad cross sectionof its activeworkers. Egyptiansoc.;Lal insurance is also quite venerable. The old age insuranceprogram for state werkerscan trace its originback to the middleof the last century. Programsfor other classesof workerswere establishedmuch more recently,however. While socialinsurance, in theory,offers coverage to the great majorityof Egyptianworkers, in practice,the extentof insuranceprotection is very modestfor many workers,especially those involvedin agriculture and the informalsector. As a practicalmatter, the most important social insuranceprograms ar6 those providing benefits to civil servants and to wage 4..dsalary workers in the formalsector. Togetherthese workersaccount for a littleover half of activeEgyptian workers. Programscovering these workers will be the principalfocus of this chapter. 9.2 Low- and average-wageemployees in the formalsector appear to receivereasonably good protectionagainst earnings losses that arise from old aga, disabilityand early death. Accordingto Egyptian administrativerecords, the averagesocial ins-eance pension represents a very high percentageof the averagecovered wage paid to insured workers. Becauseof high inflationand the complexrules that determine initialpension awards, however, it seems likelythat the averagenew award will soon shrinkas a percentageof the averagetaxable wage. 9.3 In spite of the high replacementrates offeredunder the Egyptiansystem, the fiscalposition of the large socialinsurance programsis reasonablysecure over the short and intermediateruns. The main reasonis that socialinsurance contribution rates are extraordinarilyhigh, generatinglarge annualoperating surpluses in the major prograr.: A major problemfor the programsis the investmentof their surplus.s. Operatingsurpluses are placedin the NIB where they are creditedwith a very low nominalrate of return. The NIB, in turn, uses these funds to financethe publicsector investment program. Becausethe socialinsurance reserves earn largenegative returns, it is 'uestionablewhether they will have much value in payingoff the accruingclaims of currentworkers. The SIS essentiallyprovides heaqilysubsidized financing to a wide varietyof publicsector investmeatprojects. Over the longerterm, the financialprospects of the socialinsurance system are a great deal more cloudy. Since the systemprovides relatively generous pensions to retirees,the cost of the systemmay climb to an unsustainablelevel once large numbersof Egyptianworkers begin to reach retirementage. - 88 -
II. The SoCialInsurance System
Administrationand Coverage 9.4 The EgyptlanSIS ia operatedby two dlfferentadministrative bodies. The first is the NationalOrganization for Insuranceand Pensions(NOIP). This agencyadministers pensions and indemnitiesfoL employeesof the stateunder Law 79 (1975),as amendedby La",47 (1984). 9.5 The secondoperating agency is the GeneralAuthority for SocialInsurance (GASI), which administerspensions and indsmnitiesfor four classesof workersunder four differentsets of laws. The most importantgroup of coveredworkers consists of employeesof publicand privateenterprises, who are insuredunder the same laws that protect workersfor the state (Laws 79 and 47). The secondcla4s of workers consistsof employersand c,rtainself-employed workers c'wvered by Law 108 (1976). The third and smallestgroup consistsof Egyptiansworking abroad,who are insuredunder Law 50 (1978). 'rhelast group of workers is comprisedof agriculturaland domesticlaborers, small farmersand certainself-employed workers, all of whom are coveredunder Law 112 (1980).
9.6 The EgyptianSIS insuresall coveredworkers and their familiesagainst the hazardsof old age, disabilityand death. In some cases,however, the amountof insuranceprotection is extremelylimited. In addition,workers covered under Laws 79 and 108 are insuredagainst injuryon the job. Workerscovered under Law 79 are also insured againstearnings losses arising from unemploymentand from illnessthat is unrelatedto work. Finally,Law 79 provideslump-sum indemnities to workerswhen they leave coveredemployment. Under a separate administrativeauthority, workers and pensionersinsured under Law 79 receivehealth insurancebenefits. 9.7 A very high percentageof the Egyptianwork force appearsto be coveredby socialinsurance, at leastnominally (Tabl.e IX.l). Two of the socialinsurance laws createno significantfinancial liabilities for the state or for the socialinsurance authorities. Law 50 insures only a trivialfraction of workersbecause only a smallminority of Egyptiansworking abroad have voluntarilycontributed to the program. Law 112 coversa large fraction(about one-third) of the adult work force,but it pays only very limitedbenefits to pensioners(LE 204 p.a.) and collectsvery small donationsfrom contributors(LE 3.60 p.a.). Neitherbenefits nor contributionsunder Law 112 are adjusted for inflation.Hence, as a practicalmatter people covered by this law receivevery littleinsurance protection. The programsestablished under Laws 50 and 112 will be largelyignored in the remainderof this chapter. - 89 - T_ble IX.1
Egfpt: InsuredPopulation (June30, 1989)
Hillions poUUun£ Laws 79 and 47: State Employees 3.025 22.3 PublicSector Firms 1.886 14.0 PrivateSector Firms 2.,841 21. Total,Law 79 7.752 57.4 Law 108: CoveringEmployers & Self-Emp. 1.194 8.8 Law 50: CoveringEgyptians Abroad .032 0.2 Law 112: CoveringFarmers & Laborers 4.531 33.5 Total,All Laws 13.509 100.0
SocialInsurance Taxes 9.8 By far the most significantsocial insurance is provided under Laws 79 and 47 for employeesof the state and of publicand privateenterprises. These workers and their employerspay very high taxes for socialinsurance, with workerplus employercontributions amountingto 35-40percent of coveredwages (andwith 25 percent assessedsolely for old-age,disability and death insurance).The EgyptianTreasury also makes a small contributionfor old-ageinsurance. The maximumwage that is coveredby socialinsurance contributions is LE 7,500p.a. Workersthemselves pay about one third of social insurancecontributions, while employerspay the remainder.
9.9 Coveredwages. Socialinsurance contributions must be paid on workers'basic and variablewages, up to a separateannual earnings limit for each categoryof wages. A worker's"basic" wage is ordinarily the wage specifiedin the labor contractwith his employer. The amount of the basic wage that is taxablefor purposesof calculatingthe basic pensionis limitedto no more than LE 250 p.m. (LE 3,000p.a.).
9.10 The "variable"wage consistsof overtimepay, bonusesand other variableitems, as well as basic wages in excessof LE 250 p.m. A worker is obligatedto make socialinsurance contributions on variable wages up to LE 375 p.m. (LE 4,500 p.a.). Thus, the maximumearnings level subjectto socialinsurance contributions is LE 625 p.m. (LE 7,500 p.a.). The distinctionbetween basic and variablewages is comparativelyrecent. Prior to 1984,workers and their employerswere liablefor contributionsonly on basic wages. Egypt enactedthe law providingfor socialinsurance benefits and contributionson the basis of variablewages in 1984. - 90 -
Table IX.2
Z412t: Social Insurance ContributlonRates (Percent of Basic Wage)
Insurance Program Workser Eployer Treasury Total
Old-age, Disability & Death 10 15 1 26 Unemployment -- 2 -- 2 Work Injury - 3 -- 3 Sickness 1 4 -- 5 Job Leaving Indemnity 3 2 -5
Total 14 26 1 41
9.11 The contributionrates that are owed by a worker, a privat&- sector employer and the Egyptian Treasury for different types of social insurance are shown in Table IX.2. The contributionrates on the variable wage are identical,except that no contributionfrom variable wages is required for job-leaving indemnity. Public-sectorenterprises pay somewhat lower contributionrates than private-sectoremployers for work injury and sickness insurance. Otherwise, the contribution requirementsare the same (Table AIX.1, Appendix).
9.12 The Self-EmDloved. Self-employedworkers covered under Law 108 are obligated to make social insurance contributionsequal to 15 percent of their self-reportedincome. No distinction is made between basic and variable self-employmentincome. However, several size categories of income are defined in the law, and workers are required to select one of these categories when calculating their contributions. (In 1978, for example, the law defined 16 categories of income, ranging from LE 12 to LE 200 p.m. The top category of income is now LE 600 P.m.)
9.13 Benefits are directly proportionalto covered earnings, giving the self-employeda powerful incentive to under-reportearnings early in their careers and over-report them just before retirement. To protect the system against this kind of practice, the law restricts workers' rights to change their contributioncategory from one year to the next. Workers are permitted to raise their self-declaredearnings by only one category per year, and they are not allowed to raise their earnings category after age 55. (The normal retirement age for the self-employedis 65.)
Eligibility for Benefits
9.14 A worker (or his survivors) becomes eligible to receive old- age, disability and death benefits under Law 79 only after he has made social insurance contributionsfor a minimum period. The minimum contributionperiod for disability and death benefits is modest. Workers or their survivors become eligible for these benefits after just - 91 -
three consecutivemonths, or a total of six intermittentmonths of covered employment.
9.15 A worker can begin collecting old-age pensions at age 60 if he has made contributionsfor at least 10 years.I A currently employed 60-year-oldworker who has not fulfilled this contributionrequirement receives special employment protection under the social insurance law. He cannot be dismissed by his employer until the contribution requirement is fulfilled or the employer has paid enough extra social insurance contributionsto pay off the full contributionrequire-ment. An actuarially reduced old-age pension is available to workers younger than age 60 who leave covered employment if they have made insurance contributions for at least 20 years.
9.16 As noted earlier, separate administrativeagencies are responsible for providing pensions to civil servants, on the one hand, and to other formal-sectorwage and salary employees, on the other. Article 39 of Law 79 makes pension coverage fully portable between the two agencies. The agency that covers a worker at the terminationof his employment is responsiblefor administeringhis pension. However, both agencies must contribute to the pension in proportion to the worker's years of contributionsto the two funds.
9.17 Workers who leave an insurance-coveredjob without becoming eligible for old-age pensions are eligible for lump-sum compensation if they die, or are disabled, or when they reach the age of 60. The compensationis intended to partially reimburse ineligibleworkers for their social insurance contributions. The compensation is calculated as 15 percent of the wo:ker's annual wage in his last two years of covered employment multiplied by the number of years of contributionsto the social insurance program.2 Under certain circumstancesa worker who leaves the covered sector but finds new work in the uncovered sector can make voluntary contributionsto the social insurance fund based upon his uncovered earnings. Periods of uncovered employment during which the worker makes voluntary contributionsare then taken into account in determiningwhether the worker meets the minimum contribution requirement for old-age, disability and death benefits.
1/ There is no minimum service requirementfor pensions based on a worker's variable wages. If a worker meets the requirementsto receive a basic pension, he is automaticallyeligible for a pension based on his variable wages, assuming he has made contributionson variable wages.
2/ Workers who leave covered employment without attaining the minimum qualificationrequirements and without attaining age 60 do not receive any compensationuntil they reach age 60. The compensation is raised by 6 percent for each year between the year in which the worker leaves covered employment and the year in which he attains age 60. - 92 -
9.18 Self-employedworkers who are covered by Law 108 are eligible for old-age, disability and death benefits, as well as lump-sum compensations,under conditions similar to those applicable to employees in the formal sector. However, the minimum contributionperiod for old- age benefits is somewhat longer (15 rather than 10 years), and the normal retirementage is 5 years higher (65 rather than 60).
9.19 In addition to monthly old-age, disability or death benefits, workers covered by Law 79 receive job-exit indemnities (or end-of-serviceindemnization) soon after they enter retiremen;,become disabled or die. Essentially a form of forced savings, the indemnity is equal to one-half month's pay for the worker's first five years of covered employment and one month's pay for each year of covered employment after the first five. A worker with 20 years of covered employment, for example, would receive a job exit indemnity of 17.5 months' pay upon reaching the retirementage of 60. The job-exit indemnity is calculatedus!ng a worker's basic wage. No indemnity is payable on the variable wage. 3
9.20 Workers insured under Law 79 receive two other important types of insurance. Work injury insurance offers employees good protection against earnings losses due to injury on the job or occupational illness; Sickness insuranceprovides income and medical- care protection in the event of illness or injury that is not job- related. Retired and disabled pensioners and the survivors of deceased workers can also receive sickness medical insurance upon the payment of a premium equal to 1 percent of their pensions.
9.21 In theory, Law 79 also provides unemployment insurance to covered workers. The program replaces up to 60 percent of earnings lost as a result of involuntaryunemployment. Unemploymentbenefits can last for a period of 16-28 weeks.4 In practice, unemploymentbenefits are rarely paid. Egyptian labor law makes it difficult,as well as costly, for employers to dismiss regular employees. As a result, few workers become jobless under circumstancesthat would permit them to draw unemploymentbenefits. The unemploymentinsurance tax, therefore, appears to be a source of revenue for the social insurance authorities, but not a source of financial liability.
.i./ In addition, under Article 73 of Egyptian Labor Law 137 (1981), employers are obligated to pay death benefits equal to two to three months' wages to the survivors of active workers. i/ Workers who have paid social insurance contributionsfor at least 6 months, but less than 24 months, are eligible to receive 16 weeks of unemploymentbenefits. Workers who have made contributions for 25 months or more are eligible to receive 28 weeks of benefits. - 93 - BenefitFormulas 9.22 In exchangefor theirheavy contributions,most workers coveredby Law 79 receivesocial insurance protection, which, at least nominally,replaces a sizablepercentage of earningslost becauseof retirement,disability, unemployment, work injury,general illness or death. For example,a workerretiring at the normalretirement age (60) after 30 years of creditableservice is eligibleto receivea pension that replacestwo thirdsof his coveredwage. Pensionsunder Laws 79 and 47 are limitedto LE 500 p.m. (80 percentof the maximumcovered wage),but this limit is rarelyattained in the case of new pensioners becauseof the formulaused to calculateinitial pensions. 9.23 ReferenceWage. The annualpension calculated under Laws 79 and 47 consistsof two parts. The first is determinedby a worker's basic coveredwage and the second,by his variablewage. The basic pensionamount is calculatedas a percentageof the worker'saverage basic-wageduring his last two years of creditableemployment. This averagebasic wage, which we shall designatethe basic referencewage, is multipliedby the worker'syears of creditableservice and then dividedby 45 in order to derivethe basic pensionamount. 5
9.24 The secondpart of the annualpension -- the part based on the variable wage -- is calculated using the average variable earnings recordedduring a worker'sentire career. To adjustpartially for the effectsof inflation,the nominalaverage wage is increasedby 2 percent for each year in which the workermade socialinsurance contributions on his variablewages. This variablereference wage is multipliedby the worker'syears of contributionson variablewages and then dividedby 45 in order to derivethe variablepension amount. 9.25 The pensionfor self-employedworkers covered by Law 108 appearsto be calculatedusing the worker'sself-reported earnings over his entirecovered career. The referencewage is multipliedby the worker'syears of contributionsand then dividedby 45 to determinethe self-employmentpension.
9.26 Treatmentof Inflation. The Egyptianpension system's built-inprotection against the effectsof inflationis quite erratic. One measureof the basic generosityof a pensionscheme is the real value of the pensiondivided by the real value of earningsduring a worker'sfinal year(s) of employment.This ratio,known as the real replacementrate, is calculatedafter adjustingboth the pensionand wages by an appropriateprice index. The formulasthat determine
~/ il'sabilityand death pensionsare based on the basic wage during the last year (ratherthan the last two years)of covered employment. In calculatingthe replacementrate for disability and death benefits,three years are added to the worker'sactual term of coveredemployment. Moreover, the minimumdisability aild death benefitis 50 percentof the referencebase wage. - 94 -
Egy'tian pensions under Laws 79 and 47 are not sensibly adjusted to reflect inflation prior to retirement. They do not maintain real initial replacement rates when inflation is high, as it has been in Egypt for more than a decade.
9.27 With low wage and price inflation (roughly 3.75 percent p.a.), the formulas fcr the basic and variable pension provide annual pensions that offer generous and very similar wage replacement rates.8 A worker retiring at age 60 after just 18 years of creditable service would receive a basic pension of about 40 percent of his average real basic wage and a variable pension equal to 40 percent of his real average variable wage. After 36 years of creditable service, the worker's two pensions would replace about 78 percent of his basic and variable wages. These replacementrates are quite liberal. Full-career workers in advanced industrializedcountries who earn average wages and retire at the normal retirement age can expect to receive a public retirement pension that replaces only about 40-60 percent of their average wage while at work.
9.28 This comparison is a bit misleading,however. As already noted, the actual generosity of a pension formula depends critically on its treatment of wage and price inflation. The treatment of pre- retirement wage inflation is crucial in determining the value of a worker's initial pension. The treatmentof post-retirementprice inflation is critical in determiningwhether a pension retains its value over time. We examine these two factors in turn.
9.29 Inflation Prior to Retirement. The indexing formula used to calculate the initial basic pension is crude, but tolerably effective, for civil servants covered by Law 79. It does not work as well for employees of public and private enterprises. The reference basic wage excludes earnings received more than two years before a worker applies for social insurance benefits; only the last two years, wages are included in the reference period. The inflation that occurred before this two-year reference period is thus irrelevant in determining the initial basic pension amount. Recent inflation in Egypt has hovered around 20 percent p.a. according to official estimates. With 20 percent j/ At lower rates of inflation, the replacement rate for the variable wage is higher than that for the basic wage. The 2 percent p.a. automatic adjustment used in calculatingthe variable wage base actually overcompensatesworkers for wage and price changes when the inflation rate is below 3.75 percent p.a. (To understand why, note that workers would receive the 2 percent p.a. adjustment even if prices were stable.) At inflation rates above 4 percent p.a., the formulas used to calculate both basic and variable pensions make inadequate provision for inflation. The formula for the variable pension is even less adequate than the one for the basic pension, however. When inflation exceeds 4 percent p.a., workers thus receive better replacementrates on their basic wage than on their variable wage. - 95 -
annual wage and price inflation,the Egyptian definition of the reference basic wage base yields an average wage that is about 92 percent of the value of the worker's real basic wage during his last two years of employment. At higher rates of inflation, the real reference wage is, of course, lower.
9.30 The effects of inflation on the initial real replacement rate are complicatedby two other features of the formula. In the case of workers in public and private enterprises,there is an upper limit on the reference wage that can be used to calculate the basic pension. (This provision does not apply to retired civil servants.) According to Article 14 (paragraph4) of Law 79, the basic reference wage can:iot exceed 140 percent of the average wage during the five years prior to the two-year reference period. When nominal wages rise faster than 14- 15 percent p.a., the referencewage will be determinedby the five-year average wage rather than the two-year average wage, which further depresses the real replacement rate.
9.31 However, the effect of this provision is partially offset by another feature of the law, which helps workers with lengthy careers in covered employment. According to Article 10 (paragraph1) of the main social insurance law, workers who have made contributionsfor at least 20 years are guaranteed a minimum pension of at least 50 percent of the reference basic wage. The maximum pension is 80 percent of the basic reference wage, or 100 percent of the reference wage in the case of workers who would otherwise qualify for very low pensions.
9.32 The combined effects of these complicated provisions are shown in Figures IX.l and IX.l. Figure IX.1 shows old-age replacement rates for retired civil servants under various assumptions about the rate of inflation. Each line in the figure traces out the real replacement rate at successiveyears in a worker's career under a specific assumption about the rate of inflation.7 The top line, for example, shows how the replacementrate rises with the duration of a worker's covered career when there is no wage inflation. The jump in the replacement rate at year 20 is the result of the 50 percent minimum pension for workers with 20-year careers in covered employment. The replacement rate stops rising after 36 years of covered service because of the 80 percent replacementrate maximum.8 The lower lines in Figure
1/ To make the calculationssimple, we assume that the worker's real wage during his final few years on the job is constant. The replacement rate is then calculatedas 100 times the nominal benefit during the first year of retirement divided by the nominal wage during the worker's last year on the job. It is assumed that the worker retires at the normal retirem ' age (60) and that his benefit is greater than the minimum pension.
L/ Workers are partially compensated for social insurance contributionsafter their replacementrate reaches the 80 percent maximum. They receive lump-sum compensationsfor their excess - 96 - IX.1 show replacementrates under successivelyhigher rates of inflation. 9.33 FigureIX.2 shows real replacementrates for workerswho retireafter a careeriL public-sectoror privateenterprises. Note that at low rates of inflation,the benefitformula provides the same pensionas the one availableto retiredcivil servants. At higherrates of inflation,the benefitsavailable to noncivilservants are significantlybelow those providedto civil servants. The reasonfor the differenceis the substitutionof a 5-yearreference wage for the 2- year referencewage when inflationexceeds 14 percentp.a. Since the two classesof pensioners(and their employers)have paid the same rate of contributionduring their working careers, the discrepancyin replacementrates seems particularlyunfair. 9.34 The variablepension is even more poorlycalibrated to inflationthan the basic pension. Its real value declinesrapidly as the durationof a worker'scareer and the rate of inflationrise. For example,at a 20 percentrate of annualinflation, the real reference wage for the variablepension is equal to just 44 percentof the worker'sactual real wage after 18 years of socialinsurar.ce contributions.After 36 years of contributions,the variablewage base is equal to only 29 percentof the worker'sreal finalvariable wage. At higher rates of inflation,the wage base erodeseven faster. 9.35 FigureIX.3 shows the real replacementrate of variable wages availableto new pensionersunder alternativeassumptions about the inflationrate. When the rate of inflationis 3.75 percentp.a., the replacementrate rises until a workerhas served36 years in covered employment,at which point the replacementrate reachesits legal maximumof 80 percentof the referencewage. If inflationruns around 10 percentp.a., the maximumreal replacementrate is only half as high. Oddly,when there is no inflation,the real replacementrate can easily exceed100 percentfor workerswith long careersin coveredemployment. The reasonis that the indexingformula for initialvariable pensions overcompensatesworkers for price changeswhen inflationis below 3.75 percentp.a. The practicalconsequence of the indexingformula is that workerswith long careersin coveredemployment cannot depend on their variablepensions to replacea dependablepercentage of their previous variablewages. 9.36 A growingpercentage of Egyptianwages is receivedin the form of variablewages. Becauseinitial variable pensions are more poorly indexedfor inflation,this trend impliesthat real replacement rates will eventuallydecline if inflationremains high. Variablewages are risingrelative to basic wages for two main reasons. First,the part of the monthlyearnings that is taxed as basic wages is limitedto LE 250. Any excessis treatedas part of the variablewage. As price and wage levelsrise, a growingproportion of all basic wages will
contributionsat the time their regularpension begins. - 97 -
exceed LE 250 p.m. Second, in recent laws authorizingwage increases for Egyptian civil servants and employees in state-owned firms, the Government has specificallymandated that the salary increases are not to be classified as an increase in the basic wage. To the extent that social insurance contributionsare made on these salary increases, the increasesmust be classified as part of the variable wage.
9.37 Inflation after Retirement. In contrast to the inconsistent and complex treatment of inflation in calculating the initial pension, the Egyptian method of handling inflation for pensions already in force is quite transparent. The basic law on social insurance contains no provision obligating the insuranceauthorities to adjust benefits periodically to reflect inflation. Instead, the Egyptian legislature, at the recommendationof the Minister of Social Insurance or the President, makes occasional ad hoc adjustments in basic pensions already in force. Thus, the most importantcomponent of benefits -- the basic pension -- is partly protected against the effects of inflation. According to the GAST, pensions based on variable wages have not, however, been adjusted for inflation.
9.38 Since January 1987, the Government has raised basic pensions on five separate occasions by a cumulative total of 110 percent. During the same interval, the official price index rose by 119 percent, only slightly more than the rate of ad hoc pension increases. Before 1987, the Government did not raise basic pensions as regularly, and, as a consequence,pensioners suffered larger losses in real purchasing power (Table AIX.2, Appendix). The failure of the social insurance law to index benefits to inflationplaces strong political pressure on the Government to periodicallyadjust benefits during spells of rapid inflation. In recent years, the President and the legislaturehave kept basic pension levels roughly current with inflation, though there is no assurance that this ad hoc indexation will continue. Variable pensions appear to be completely unindexed.
9.39 Summary. The ad hoc adjustmentsrade to a worker's basic pension after he retires do not offset the adverse effects of inflation in the determinationof his initial pension. His initial real replacement rate is reduced as a result of price inflation, and the ad hoc adjustments,at best, serve to maintain the replacement rate at its initial value. The pension formulas fail to provide an initial combined pension for newly retired workers that is a predictablepercentage of past real earnings. At high inflation rates, the formula may provide much lower replacementrates than intended to workers with many years of covered employment. In addition, no matter how high the initial variable pension, its value can be rapidly eroded as the result of rapid inflation after a worker's retirement. On the other hand, if high inflation ended in Egypt, in a fully mature social insurance system, pension levels could become unsustainablyhigh. - 98 -
F:igutL:I Egypt: Effectsof Inflationand CareerLength on Basic PensionReplacement Rate Civil Servants 90
80
70
R 60
i § No InflatUon 50 8E3 toz iuri. 20% Infl. E 40 . 30% Innr. a X( 50% Innr. a
to 10
10 15 20 25 30 35 40
Year. of Baclal Insurance Contrlbutions - 99 -
Eigure IX.2 Egypt: Effects of Inflation and Career Length on Basic Pension Replacement Rate NoncMiServants 90
80
70
R 60 Zvi
A 0 w No Inflation 50 -[ 10P%1 inn.
20% [nfl. n ------_ t 40 S 30%rYYYYvYy>yyyyvvYyYs Infl.
R -X 50%xInri.
6 a 1
10
10 15 20 25 30 35 ' 0 Years of Social Insurance ContribuUona - 100 -
Fgure IX.3 Egypt: Effects of Inflationand CareerLength on VariablePension Replacement Rate 160
140
120
R v 100 * No Inflation * t-X 3.75% Intl.
m80 0 tn -8- 20%1i enfl. R 30% [nfL I -0 50% [nfn.
40
20
2 6 10 14 182226303438 Years of S.otal Inluwae Contributlon - 101 -
Actual Benefit Levels
9 40 In spite of high inflationand the defects of Egyptian pension formulas in taking inflation into account, the social insurance programs operated under Law 79 appear to provide monthly benefits that represent a high percentage of typical monthly wages. Table AIX.3, Appendix, shows average pensions and average covered wages under some of the main programs. The top panel shows the number of pensioners, average monthly pensions, and average monthly earnings in the social insurance programs for civil servants that are managed by the NOIP. Monthly earnings include both basic and variable wages. The middle and bottom panels display similar informationfor the old-age ar.ddisability insurance programs for formal-sectoremployees operated by the GASI. Note that the average covered wage among civil servants is about 50 percent above wages paid to employees in public-sectorand private firms.
9.41 The fifth column in the panel shows the computed replacement rate in the programs. Replacement rates are uniformly high. The average pension represents at least 90 percent of the average covered wage, and in some cases it is as high as 131 percent of the average wage. Surprisingly,replacement rates are somewhat lower among civil servants than they are among other formal-sectoremployees, possibly because the lower-paidworkforce outside the civil service benefits from provisions in the law guaranteeingminimum pensions.
9.42 Wage and Pension Distributions. Table AIX.4, Appendix, shows the actual distributionof monthly pensions under programs administeredby the GASI. Even though the minimum pension plays some role in determiningbenefit amounts, it is striking how few pensioners actually receive the legal minimum pension. Only 6 percent receive minimum pensions, and fewer than half receive benefits within 50 percent of the legal minimum. The bottom panel in the table shows that 81 percent of pensioners receive monthly pensions equal to at least LE 50.
9.43 For purposes of comparison,Table AIX.5, Appendix, shows the distributionof basic monthly wages. In June 1990, slightly more than half of covered workers earned a basic wage no higher than LE 35 p.m. The total covered wage of these workers is unknown, although the administrativerecords of the GASI suggest that basic wages represent a little less than half of the total covered wages paid to insured workers. A comparison of the distributionof monthly pensions with the distributionof covered basic wages suggests that replacement rates are quite high (Tab.es AIX.4 and AIX.5, Appendix). For low- and moderate-wageworkers, the SIS appears to replace an extremely high percentage of covered wages. High-wage workers probably receive less favorable replacementrates, because an unknown percentage of their earnings exceeds the taxable maximum amount of covered monthly wages.
9.44 Benefit Trends. Although replacement rates were comparativelyhigh in the mid-1980s, they have climbed over time (Table AIX.3, Appendix). The jump in replacement rates in 1987/88 is due to ad - 102 -
hoc pension increases,which became effective in the,.year. Pensions evidently rose faster than average covered wages. One reason for this discrepancy is the treatment of basic and variable wages. as wage rates and pension levels are adjusted for inflation. When pensions are adjusted, only the basic pension is raised; the variable pension remains unchanged. However, since the great majority of existing pensions are primarily determined by the basic pension, a proportional increase in the basic pension results in an almost equivalent adjustment in total pensions in force.
9.45 By contrast, the Government has not raised wages in an equivalent way. When wage adjustmentsare made for civil servants and employees of public-sectorenterprises, the entire increase is treated as an adjustment in the variable wage. Moreover. the increase is calculated as a percentage of each worker's basic wage. Since the basic wage has not been adjusted for inflation in recent years, the pension adjustment is calculated on a steadily shrinking percentage of the worker's total wages.9
9.46 Wlhencurrent workers eventually retire, their pensions will not represent such a high percentage of their final wages unless current pension formulas are changed. For the reasons mentioned previously, workers with long careers should expect that only a small percentage of their variable wages will be replaced by the variable pension. Since variable wages comprise a steeply rising fraction of all wages, overall replacement rates must eventually decline.
9.47 Redistributionunder Social Insurance. We lack good financial informationabout the insurance funds maintained under Laws 108 (for the self-employed),50 (for Egyptians working abroad) and 112 (for agriculturaland domestic workers). For that reason it is hard to draw reliable conclusions about the extent of redistributiontaking place within and between these funds.
9.48 It seems likely, however, that workers insured under Law 112, who are among the poorest in Egypt, receive small net transfers from the state. Contributionsfrom covered workers are extrewely low and virtually independentof their earnings. While the flat-rate monthly pensions are also low, annual pension outlays are higher than i2/ For example, Law 13 (1991) states that civil servants and public-sectorenterprise workers shall be granted a wage increase equal to 15 percent of their basic wage, effective June 1, 1991. However, no part of the increase is to be regarded as forming part of the basic wage of the worker. Because the previous four annual wage increases had been celculated with the same proviso, the 15 percent pay increase was, in fact, substantially less than 15 percent for senior Egyptian workers. By contrast, the 15 percent basic pension increase that went into effect on the same day probably resulted in a total pension increase of close to 15 percent for most Egyptian pensioners. - 103 -
annual contributions,suggesting that covered workers can expect to receive higher benefits than the discounted value of their contributions.
9.49 The situation of self-employedworkers covered by Law 108 is less clear. Their pensions are proportional to their years of covered service and their final covered earnings. Hence, pensions are more or less proportionalto contributions,implying that very little income redistributiontakes place among the workers covered by Law 108. Without detailed actuarial informationabout contributionsand mortality rates, however, it is impossible to determine whether self-employed workers, as a class, receive net transfers from the state. That is, we cannot determine whether a typical worker covered by Law 108 should expect to receive higher or lower net benefits under the system than his discounted contributionsto the insurance fund.
9.50 The redistributioneffects of pensions under Laws 79 and 47 for formal-sectoremployees are a little clearer. First, civil servants appear to receive much higher net transfers under the system than other formal-sectoremployees. Their pension formula provides a more favorable treatment of inflation,and the balance sheet of the civil service insurance system suggests that their contributionsto the program represent a smaller proportion of their actual earnings.
9.51 Second, there is clear evidence that the system is relatively more generous to existing pensioners and to workers who will retire in the near future than it is to workers who will retire in the more distant future. Current retirees appear to receive pensions that are higher, on average, than the covered wages received by current workers. The variable pension formula provides a very inadequate treatment of inflation,both before and after a worker's retirement. Consequently, future pensions will be much lower relative to future wages; replacementrates will decline unless the indexing formula changes. In comparison to current pensioners, future pensioners will have contributed to the insurancefund at a high contributionrate for a much larger proportion of their careers. This will also reduce the rate of return they can expect on their contributions.
9.52 Third, the current pension formula provides a very modest amount of redistributionamong workers who retire at the same age but who earned different average wages during their careers. Low-wage earners receive comparativelymore generous benefits under the system because of the existence of the minimum pension. However, the pension minimum appears to be small compared with the average pension. This implies that the redistributioncaused by the minimum must be relatively minor. Most pensions are proportionalto a worker's years of contributions and to his final aferage wage and, hence, to his contributions to the insurance fund. By implication,the degree of redistributionbetween well-paid and poorly paid workers is small.
9.53 Finally, the current eligibility requirementsmake pensions available to many workers who have not reached the normal retirement age - 104 -
(60). Because the financial adjustment for early retirement is small, workers are handsomely rewarded if they begin to collect pensions before age 60. Early retirement reduces the number of years in which workers make contributions,raises the number of years in which workers receive pensions, and results in only a small sacrifice in the amount of the monthly pension. The system, thus, generously redistributesin favor of early retirees.
Financial Condition
9.54 Viewed narrowly, the social insuranceprograms that cover public and private employees in the formal sector are more than adequately funded. The contributionrates are high, current benefit payouts are relatively low, and the operating surplus is a large percentage of the social insurance authority'sbudget.
9.55 Viewed more broadly, however, the surpluses of the system are illusory. They are invested in the NIB where they have historically been credited with a nominal rate of interest that is far below the rate of inflation. If the reserves of the system have to be redeemed in the future in order to cover the pension obligations of current workers, they could be found to have little value.
9.56 ORerating Suroluses. Social insurancecontributions from Egyptian workers and employers are fa. higher than needed to pay for current benefits. In 1989/90, for example, combined worker and employer contributionsto the GASI exceeded benefit payments and administrative outlays by LE 510 million, or nearly 40 percent. The high contribution rates in the Egyptian system are justified by the view that annual contributionsshould be large enough to pay for the currently accruing future liabilitiesof the system, rather than the current benefit costs. In theory, the future liabilitiesare capitalized,and the reserves of the system should be sufficient to pay off these liabilities.
9.57 Article 8 of Law 79 (1975) requires the two social insurance authorities to prepare actuarial studies of the insurance funds every five years. These studies are prepared under the assumption that the reserves of the system ought to be adequate to pay all future liabilities that are legally chargeable to the funds. If the reserves are found to be insufficient,Article 8 requires the Treasury to make good the difference.
9.58 Not all benefit payments made by the two authorities are legally chargeable to the social insurance funds. The funds are not charged for pension increases that occurred as a result of ad hoc benefit increases authorized by the Egyptian legislature. These ad hoc increases are chargeable to the general Treasury although they are, of course, included in the regular social insurance payments sent out to pensioners. In addition, the Treasury is obligated to pay for the past liberalizationof some benefits, for which no reserve existed at the time the liberalizationsoccurred. Because of the overlapping - 105 -
responsibilitiesof the social insuranceauthorities and the Treasury, the balance sheets of the authoritiesare quite complicated.
9.59 General Authority Balance Sheet. Table AIX.6, Appendix, shows a simplified GASI balance sheet during the years from 1980/81 through 1990/91, with the final year representingthe Authority's estimate of its most recent operating results. The balance sheet was described to the mission as displaying consolidatedresults under several laws -- Laws 79 and 47 (for public enterprises and private sector employees),108 (for the self-employed),50 (for Egyptians working abroad) and 112 (for agriculturaland domestic laborers). However, the social insuranceprograms created under Laws 79 and 47 are several times larger than all of the other programs combined. Thus, as a practical matter, the balance sheet shown in Table AIX.6 principally covers operations for wage and salary workers in public-sectorand private enterprises.
9.60 Total benefit payments have risen steeply over the past decade, but contributionsfrom employers and workers rose as well. Until last year, social insurance tax payments from employers were usually large enough to pay for benefit outlays. Contributions from workers were much larger than needed to finance administrativeand other costs. The program enjoyed growing operating surplusesuntil 1987/88, when the surplus began to shrink, both absolutely and as a ,iercentageof social insurance tax contributions. An analysis of other information about the system suggests that one source of the declining surplus is the fact that average pensions grew faster than average wages. Nonetheless, the total GASI surplus, including transfers from the Treasury and interest credited on the reserve, has continued to climb.
9.61 If the surplus of contributionsover benefits and administrativeoutlays had been invested in projects earning a normal rate of return, the social insurance program would receive an enormous additional surplus from earnings on its capital reserve. However, the reserve is invested in the NIB, where it historicallyhas been credited with a very low rate of interest. Between 1980/81 and 1986/87, the GASI was credited with an interest rate that averaged about 5 percent p.a. During the three years after 1987, the interest rate was raised to about 6 percent p.a.10 Over the same decade, the official consumer price index rose about 18 percent p.a.
9.62 Inflationhas substantiallyeroded the purchasing power of the reserve. If GASI reserves had earned a zero real retur..on its trust fund rather than a negative real return, the asset holdings in the
.1Q/ It is not certain that the interest rate in 1990/91 was actually raised to 13.3 percent p.a., as shown in Table AIX.4. This' represents an estimate by the GASI rather than an official notificationby the NIB. Significantly,the reserves held by the NOIP for civil servants' pensions were credited with an interest rate of on-ly6.6 percent p.a. in 1990/91. - 106 - reservewould have been worth more than twiceas much at the end of 1990/91(LE 44 billionrather than LE 21 billion). Even lf the GASI had receivedno transfersfrom the Treasuryduring the 1980s,the reserve would stillhave held nearly50 percentmore assetsat the end of 1990/91(LF, 30 billionversus LE 21 billion). This difference representsmore than six years'benefit payments. It is clear that the socialinsurance funds provide a substantialnet subsidyto the NIB and the state.
9.63 In 1989/90the reserveearned a returnof just 6.2 percent p.a. Sincethe officialconsumer price index rose more than 21 percent p.a. duringthat fiscalyear, the real valueof the initialreserve fell nearly 15 percent,or over LE 2 billion. Real lossesthis largecannot be coveredindefinitely by operatingsurpluses of the system. The real reserveof the GASI was lowerat the end of the 1989/90fiscal year than it was at the beginning.
9.64 The drop in the real value of the reserveoccurred in spite of transfersfrom the Treasuryamounting to LE 623 million. The purpose of thesetransfers is to compensatethe GASI for the cost of past ad hoc pensionincreases that were authorizedby the Government.The GASI is left with a peculiarbalance sheet. It receivestransfers from the Treasuryto cover the cost of past pensionincreases necessitated by high inflation.However, it is creditedwith such a low interestrate on its reservethat inflationerodes the value of the reserveby far more than the Treasurytransfers. The socialinsurance programs are thus helping to finance other government spending -- in particular, the capitalspending of the NIB. This methodof obtaininginvestment funds for the NIB raisesimportant equity issues because the tax that pays for socialinsurance workers is assessedsolely on laborearnings below LE 625 p.m. Labor earningsin excessof that amount,as well as all earningsfrom capital,are exemptfrom socialinsurance taxes.
9.65 NationalOrganization for Insuranceand Pensions. The balancesheet of the civil servants'social insurance funds is similar to that of the GASI. Benefitp3yments have climbedrapidly in recent years,but contributionshave grown fast,too. Includingthe interest earningson lts trustfund reserve,the NOIP runs a substantialsurplus each year. The totalsurplus in 1989/90amounted to more than 240 percentof totalbenefit outlays. On paper,the reserveis largeenough to pay benefitsfor the next 16 years.
9.66 One importantdifference between the two socialinsurance organizationsis that the civilservants' insurance and pensionfund has an operatingdeficit rather than a surplus. Accordingto information suppliedby the NOIP,benefit payments and administrativeexpenses now exceedworker and employercontributions by a smallmargin. The overall surplusof the fund is explainedby high interestearnings and substantialtransfers from the Treasury(interest income is high, not becausethe reserveearns a good return,but becausethe size of the fund is huge). - 107 -
9.67 It is surprising that benefits and administrativecosts cannot be covered by worker and employer contributions. The combined contributionrate for civil servants and their employers is approximately32-33 percent of covered earnings according to the social insurance law. But the balance sheet of the program implies that combined contributionsrepresent just 17 percent of covered earnings. This is slightly less than the amount needed to pay for benefits, which represent about 13 percent of covered earnings. The shortfall in contributions is a mystery.
9.68 The civil servants' pension reserve fund, like that of the GASI, is credited with a very low rate of interest. The average rate of return on the NOIP reserve has edged up to about 6.6 percent p.a. in 1990/91, but it remains very low in relation to inflation. Nonetheless, the reserve is so large that interest earnings on the fund now exceed benefit payments.
Analysis of Short- and Long-Term Costs
9.69 The short- and long-run position of a social insurance program is most easily analyzed by focusing on the operating surplus of the system. The operating surplus differs from the total surplus in that it ignores income arising from both interest payments on the system's reserve and special transfers from the state treasury.
9.70 The operating surplus of a SIS is determined by the difference between the cost rate and the income rate of the program. The income rate is simply the combined contributionrate of employers and workers out of covered wages. In the case of formal-sector employees covered by the GASI, this contributionrate represents about 35 percent of covered wages. For civil servants, the legal contribution rate is a bit lower -- about 32-33 percent -- but actual social insurance contribi-ionsrepresent only about 17 percent of covered wages.
9.71 The cost rate of the program is the combined benefit and administrativeoutlays of the program measured as a percentage of the covered wage base. The cost rate can be further separated into its basic determinants. Ignoring administrativecosts, which tend to be small, the numerator of the cost rate is the average pension payment times the number of pensioners currently receiving benefits. The denominator is the covered wage base, which is simply the average covered wage multiplied by the number of covered workers. In other words, the cost rate is equal to the dependency ratio (the ratio of beneficiaries to covered workers) times the replacement rate (the ratio of average benefit payment to average covered wage).
9.72 DeRendencv Ratio. The dependency ratio in Egyptian social insurance programs is low. For example, in the main program managed by the GASI, the ratio of old-age, disability and death pensioners to covered workers was just 12 percent in 1989/90. However, the dependency - 108 -
ratio in this programhas climbedrapidly in the past few years. In 1987/88,the dependencyrttio was just 10.2 percent. 9.73 The ratiorose becausethe programscovering formal-sector employeesare not fullymature. In a maturingsocial insurance system, the numberof new pensionersclimbs both becausethe numberof people reachingpension age is climbingand becausethe percentageof newly retiredworkers who have becomeinsured under the systemis growing. In a fullymature system, the percentageof retiredworkers who are covered cannotrise very much.
9.74 The immaturityof the Egyptiansystem is reflectedin statisticson the numberof pensionersand coveredworkers. The number of workerscontributing to socialinsurance programs in the formal sectorrose 3 percentp.a. after 1986/87. This is closeto the rate of laborforce growth. By contrast,the numberof pensionersrose nearly9 percentp.a. The rate of growthin coveredworkers and pensioners shouldeventually tend to converge.11The civil servants'social insuranceprograms have a higherdependency ratio than the formal-sector programs,but the dependencyratio is not climbingas fast,presumably becausethe civilservice plans are closerto full maturity. Active civilservants and civil servicepensioners are both growingat about4- 5 percentp.a.
9.75 Outlook. In an earlierdiscussion we mentionedrecent trends in the replacement ,ate (Table AIX.3, Appendix). The average replacement rate jumped in 1987 and, since that year, has remained relatively stable. The combirstionof a quickly growing dependency ratio and a jump in the average replacementrate has meant that the cost rate of the main formal-sectorsocial insurance program has climbed quickly in recent years, growing from about 11 percent in 1986/87 to 16 percent in 1989/90. The more stable dependencyratio in the civil service social insurance program has meant that its cost rate has grown more slowly over the same period, climbing from 16 percent to 18 percent. Becausethe missionwas not providedwith reliableforecasts of coveredwages, futurepensions, or the likelynumber of new pensioners,it is difficultto estimatehow incomeor cost rateswill develop in the near future.
fl./ This is true in a steadily rising population. However, many countries eventuallyenter a demographic transition in which birth rates fall and populationgrowth dramaticallyslows. About two decades after this occurs, the labor force also dramaticallyslows, even though the number of new pensioners continues to climb at the old rate. Therefore, the dependency rate can soar. At the moment, this change in population dynamicsdoes not seriouslythreaten Egyptian social insurance becausethe birth rate and laborforce growth continue to be high. - 109 -
9.76 A projection of the long-term balance sheet of the system is even more hazardous. Many of the elements that will determine future pensions and covered wages are discretionary. When Egyptian prices and wages change, it is left to the President and legislature to determine whether the covered wage base will be adjusted or basic pensions will be raised. The current social insurance law contains no provisions automaticallyadjusting the system in view of changing average prices and wages.
9.77, A couple of safe predictions can be made. In an environment of even moderate wage and price inflation, variable wages will become an incz3asinglyimportant part of the social insurance tax base. (Variablewages already account for more than half of covered wages.) The combined tax rate on variable wages is somewhat lower than the rate applied to basic wages, which will tend to reduce the social insurance income rate slightly. In the long run, however, the cost rate will fall even more. The indexing provisions that determine variable pensions are so disadvantageousto workers that real replacement rates must eventually fall. The current generation of pensioners primarily receives basic pensions, so their replacement rates are not much affected by the nonindexationof variable pensions. However, the protected position of current pensioners is not guaranteed to workers who will retire in the future. Unless present law is changed, future replacement rates must fall.
9.78 It is likely that the dependency ratio will rise, partly or fully offsetting the effects of a falling replacement rate. The SIS for formal-sectoremployees is not yet fully mature, so a growing percentage of workers will reach the retirement age fully eligible for benefits. The dependency ratio can be held down in the intermediate-and longer- run only if a growing percentage of the Egyptian work force becomes insured under Laws 79 and 47. This will tend to swell the number of covered workers while having little immediate impact on the number of retired or disabled workers who are insured under these laws.
9.79 An alternativeway to view the financial prospects of Egyptian social insurance is to use the intergenerationalaccounting framework suggested by Lawrence Kotlikoff.12 Kotlikoff is the foremost exponent of the view that a government'sfiscal policy should be described in terms of its effects on the lifetime budget constraints of successive generations. Using this framework, analysts calculate the impact of a particular public policy by computing the policy's effect on the potential consumptionof each generation. Effects on the value of what each generation can consume are discounted to the present and sutmmedover all current and future gensrations. Under this perspective, iZ/ See Lawrence J. Kotlikoff, "The Deficit is Not a Well-Defined Measure of Fiscal Policy," Science, vol. 241, August 12, 1988, pp. 791-95; and Kotlikoff, GenerationalAccounting -- Knowing Who Pays, and When. for What We Spend, (New York: The Free Press, 1992). - 110 -
the large annual operating surpluses in the main Egyptian social insurance program are not necessarily fiscally contractionary. If the discountedvalue of promised pension benefits is larger than scheduled future tax payments, the social insurance program is fiscally exDansiona#y,regardless of the size of the operating surplus in the current period.
9.80 The budget of a program normally measures receipts and outlays one year at a time. For example, Table AIX.6, in the Appendix, shows a simplified GASI balance sheet year-by-yearfor a period of 11 years. This conventionalpresentation divides up program receipts and outlays into a number of different categories. But it does not organize the results in a way that compares the long-run effects of the system on different generations. Generationalaccounts look forward over a period of many years. They classify taxes paid and transfers received according to the generationthat pays or receives the money. For completeness, this kind of classificationmust also identify the source of funds from "Transfersfrom the Treasury." If these transfers are entirely financed out of current general government revenues, then the source of the funds is the current generationof general taxpayers. If the Treasury transfers are financed through the issuance of government debt, the burden is entirely or partially shifted to future generations.
9.81 More important,however, is the allocationof social insurance taxes and promised benefits. For an existing generation, generationalaccounts estimate the taxes and transfer:year-by-year over the generation'sremaining lifetime. The accounts summarize the accounts for a generation in terms of a single number -- the present value of its entire annual series of average future payments and receipts. For future generations,generational accounts estimate the net payments based on the assumption that social security claims will have to be paid either by people who are now alive or by future generations. In this alternative accounting framework,analysts calculate how much future generationswill have to pay to the government, above the amount they will receive in transfers, if promised social insurancebenefits are not reduced from their projected path and if people now alive do not pay more than currently projected.
9.82 Generationalaccounts can be used to make a number of illuminatingcalculations. By computing the "net transfer" or "net tax liability" of the generationjust entering the labor force -- i.e., the generation aged 15-20 -- we can immediately determine whether the Egyptian social insurance tax and benefit formulas are bequeathing enormous liabilities to young workers. By performing a sl.ilar calculation for the generationjust born (aged 0-5), we can determine whether that liability is growing over time.13 Second, generational
1,/ Generatior.alaccounts do not necessarily reveal which generation accumulated the large liabilities. This determinationwould require analysis of past tax payments and transfer receipts among all current and previous generations. - 111 -
accounts can be used to analyze the effects of actual or proposed reforms in social insurance. This kind of analysis ls often much more revealing than a year-by-yeartabulation of the effects of the reform on the operating surpluses of the system. Finally, generationalaccounting makes clear the existence and magnitude of intergenerationalsubsidies that are an inherent part of social insurance. The framework clarifies the scope of redistributionwithin the existing system and in proposed reforms to it.
9.83 At the moment, it is impossibleto make the calculations necessary to create generationalaccounts for the Egyptian social insurance system. Informationabout current and future wages, social insurance taxes, and current and future benefits is too fragmentary to compute the net social insuranceliability or transfer of individual generations. We can speculate,however, on what generationalaccounts would look like. Young workers face enormous tax burdens over the course of their careers. They and their employers will pay taxes amounting to 32-40 percent of wages over the remainder of their careers, assuming that current law is left unchanged. In exchange, young workers are promised benefits that will be substantiallylower, as a percentage of average wages, than the benefits received by current pensioners. Under the assumptions that inflation continues to range between 10-25 percent a year and variable wages continue to climb in relation to basic wages, the benefit replacementrate should fall in the future. Older workers, in contrast, can expect to receive large positive transfers under the current system. Their social insurance tax payments will cease in the near future, and their relatively generous pensions will soon begin.
9.84 More interesting,however, is an analysis of the effects of possible reforms in the social insurance system. If the indexationof variable pensions were improved, for example, the net transfer to young workers could climb dramaticallywhile the net transfer to older workers would be left virtually unaffected. These kinds of calculationscan help clarify the trade-offsauthorities must face when improving or revising the system.
9.85 Outlook for Coverage. The fraction of Egyptian workers covered by Laws 79 and 47 obviously depends on future rates of growth in the formal and informal sectors. We usually expect that the relative size of the formal (i.e., social-insurance-covered)sector will grow as economic developmentproceeds. This might not happen in Egypt if there is significant economic liberalizationin the next few years.
9.86 One reason for the current size of the formal sector is the large economic role played by the state. Nearly two thirds of all workers covered by Laws 79 and 47 work directly for the state or for state-owned enterprises. It is easy to compel government employers to pay confiscatorysocial insurance taxes and to withhold taxes from the wages of their employees. If fewer economic activitieswere directly owned and managed by the Government, it might be much harder to persuade employers and workers to pay social insurance taxes, especiallywhen the - 112 - tax representsover 30 percentof the compensationpaid to average-wage workers. It is doubtfulthat the value of socialinsurance protection is worth this amountto the averageEgyptian worker. Hence,if the role of the state in the economyis reduced,the share of the workforcein uncoveredprivate employment might easilyrise as privateemployers and workersseek to evade socialinsurance taxes. III. PrinciRalProblems in the System 9.87 Basic and VariableWages. The distinctionmade In the main socialinsurance law betweenbasic and variablewages might be a useful one, but it adds to the complexityof the system. This has some administrativecosts -- for example, in collecting tax payments and calculatingpensions due. It also obscuresthe insuranceprotection availableto a typicalworker. Under certaincircumstances, both the basic and variablepension can providevery good incomc. protectionto insuredworkers. Under other conditions(notably, high inflation),the extentof protectionis difficultto understandand variessignificantly between the two kinds of pensions. The variable pensiondoes not providegood incomeprotection when inflationis high throughouta worker'scareer. 9.88 Inflation.Up until the present,Egyptian workers and pensionershave been offeredsome protectionagainst the effactsof inflationbecause of ad hoc pensionadjustments that are routinely enactedby the legislature.While this systemoffers the country flexibilityin respondingto changingeconomic and demographic conditions,it imposesan unnecessaryhardship on currentworkers. The adjustmentsfor inflationin the calculationof initialpensions, especiallyvariable pensions, are inadequate.Active workers cannot dependon their pensionsto replacea predictablepercentage of their lost earningsshould they retire,become disabled or die. 9.89 Early Pensions. The normalretirement age in Egypt is relativelylow (60). This may be appropriatein a societywhere life expectancyis comparativelyshort, but recenttrends in mortality suggestthat averagelife spans are rising. The retirementage might some day have to be raisedto reflectthis demographicreality. Otherwise,workers will spend a relativelylarge share of their potentialworking careers in retirement,forcing contribution rates to be high or futurereplacement rates to be lowered. This problemis compoundedin Egyptbecause of the country'sgenerous provision of early retirementbenefits. Workerswith at least 20 years of covered employmentcan apparentlyclaim benefitsat any age, and their benefits are reducedonly modestlyif they claim a pensionbefore age 60.14 l&/ The pensionis not reducedat all for claimantsage 55 or older. It is reducedonly 5 percentfor peopleretiring between 50 and 54; 10 percentfor peopleretiring between 45 and 49; and 15 percentfor peopleretiring before age 45. These adjustments are far too small to be actuariallyfair. If the real pension - 113 -
This seems unfair to workers who claim benefits at the normal retirement age, and it would become more costly if more workers begin to retire before age 60. However the Government claims to have restricted access to early retirement.
9.90 Low Return on Social Insurance Reserves. Two features stand out when consideringthe main social insurance programs: the high contributionrate on covered wages and the low rate of interest earned on reserves. Since the Egyptian program is nominally a capitalized system, the two features are directly related. Contributionrates must be high in a capitalized system if the expected rate of return on assets is low. Workers attempting to save for a meaningful pension must set aside a high fraction of current wages if the return on their savings is negative. Negative real returns have been the norm in Egyptian social insurance programs for at least two decades.
9.91 The large negative return on the social insurance system's assets probably does not reflect the real returns on its investments. Projects financed by the NIB conceivably earn positive real returns. However, the true returns are not reflected in the balance sheet of the social insurance funds. In truth, the investments in the NIB represent disguised transfers to the projects it financed. If the funds were optimally allocated across investmentprojects, the transfers could arguably be defended as forced saving for economic development. However, there is no guarantee that the funds have been prudently allocated. Projects that receive the heavily subsidized loans have not had to meet a market test showing that their expected rate of real return is at least equal to the social opportunity cost of capital.
9.92 The low interest rate on the social insurance reserve creates two economic problems. As just noted, the negative return in effect permits the NIB to advance funds to many projects that would not satisfy normal economic criteria, resulting in a substantial misallocationof scarce investment funds. In addition, the low rate obliges the social insurance authoritiesto impose high, and possibly distortionary,tax rates on covered workers. Not only do these rates affect the effort and hours of covered workers, they also push employment into the uncovered sector as workers and their employers seek to avoid paying the high social insurance taxes.
9.93 Inadeguate Informationfor Sound Program Management. The discussion in this chapter has shown the inadequaciesof the Egyptian social insurancedata base for program planning and system reform. In order to make plausible projections of future program operations, it is necessary to develop an informationbase that can show probable tax revenues and benefit outlays under alternativeassumptions about wage
remains level throughout retirement,under this formula, a person claiming benefits at age 45 or 50 would receive far more lifetime benefits than someone delaying retirement until the normal retirement age. - 114 -
growth, changes in the population structure, and developmentsin social insurance coverage. This will require that Egyptian social insurance authorities develop reliable data bases that include the follewing minimum information: (a) demographicprojections of the age, gender, and dependency composition of the Egyptian population; (b) similar projections of the social-insurance-coveredpopulation; (c) alternative projections of the average real and nominal wage in covered employment; (d) reliable distributionaldata on the wages of covered workers, the covered-employmenttenures of workers approachingretirement age, and -- if possible -- the correlationbetween career wages and tenure; (e) mortality rates, survivorshiprates, disability rates, and retirement rates in the social-insurance-coveredpopulation, by age, gender, and average career wage, tabulated separately for pensioners and active workers; and (f) informationabout the size distributionof social insurance pensions, for each category of pension (retiree, death, disability,and so on).
9.94 The informationjust described can and should be developed using available administrativeinformation from the social insurance system itself and from external sources, such as recent Census surveys. It can be used to develop sound actuarial estimates of the current and future financial status of the system. At a minimum, the information should be included in a simulationmodel that predicts tax revenues and benefit outlays over the next 10-40 years. It would be even better if the projection period were extended beyond 40 years. A desirable long- term goal should be the development of intergenerationalaccounts, which would be particularlyuseful for analyzing possible reforms in the social insurance system. In the short run, however, it is essential to develop reliable estimates of the performance of the system over the next 10-15 years. Without this kind of information,it is difficult to predict the consequencesof social insurancereform for the Egyptian government budget. The Government has recognized the need for improving the database and has taken initial action in this regard.
IV. Possible Reform
9.95 BasicZVariableWage Distinction. The problems created by the unnecessary distinctionbetween basic and variable wages can be remedied in one of two ways. The distinctioncould simply be eliminated. All wages would then be classified as part of the basic wage, and all pensions calculated under the basic pension formula. (For reasons described earlier, the basic pension formula makes a much more defensible adjustment for wage inflation than does the variable pension formula.)
9.96 Alternatively,the social insurance authoritiescould exploit the distinctionbetween the two types of wages in order to change the nature of insuranceprotection offered to covered workers. The basic pension could continue to be calculated under the current formula and serve the essential income maintenance role of protecting the basic incomes of low- and average-wageworkers. The variable pension could be converted into a fair, but compulsory, employee saving - 115 -
plan. Variable wage insurance contributionscould be calculated as they are under current law. Instead of being placed among the reserves managed by the social insurance authorities,they could, however, be invested in one or more private or semi-privatefunds. (See Chapter XI for a comprehensiveproposal for reform.)
9.97 The second type of reform would require that the earnings limits defining basic and variable wages be periodically adjusted to reflect wage inflation. Otherwise, the basic pension would cover an ever-shrinkingpercentage of the earnings of low- and average-wage workers. If the basic pension is to serve its fundamental goal of income maintenance,benefit levels for new pensioners cannot be allowed to decline indefinitelyin the futuire. Moreover, the basic wage base must be allowed to rise over time if tax contributionson basic wages are to remain high enough to pay for future pen3ions.
9.98 Improved Inflation Adjustment. The current variable pension is calculated using a very defective reference wage. The reference wage is supposed to reflect a worker's earnings over his entire career, but a very poor adjustment factor is used to reflect past inflation. A simpler formula for the referencewage would exclude earnings in the distant past (say, more than five years ago) when calculatingaverage wages. An even better formula would include all earnings from a worker's career, but it would separately index each year's earnings using a simple price or wage index. The reference wage would then measure the worker's average career earnings measured in price levels that are appropriate in the year the pension is calculated (the reference basic wage would also be improved if it were calculated using a similar formula).
9.99 Lower ContributionRates. The high contributionrate under Laws 79 and 47 could be substantiallyreduced in either of two ways. First, the operating surpluses of the system could be invested in a form that earns at least a normal real rate of return. The substantial capital income of the reserve could then replace part of the high contributionrate that is currently imposed. Alternatively,the system could move toward a pay-as-you-gofinancing basis. According to GASI balance sheets, this could reduce the combined employer-employee contribution rate by more than a quarter (to 25-29 percent rather than 35-40 percent).
9.100 Early Retirement Provisions. Workers without disabilities who retire before the normal retirement age should be prevented from drawing overgenerouspensions. Using recent actuarial estimates of the cost of offering pensions before age 60, the social insurance authorities should calculate a fair adjustment factor for early retirement pensions. The fair adjustment factor should be applied in computing early retirement pensions in the future. Alternatively,early retirement pensions could be eliminated altogether. Few countries offer social insurance old-age pensions before age 60. - 116 -
Government Reform Program
9.101 The Government intends to undertake a program for reforming the social insurance system by December 1993, supported by the SAMP. Implementationof these reforms will begin by July 1994 and will continue through to July 1995.
9.102 As part of this program, the Government -willestablish a team to consider the following: (a) the structure and scope of the social insurance and pension system, Including the level of benefits, the normal retirement atgeand the level and period of contributions;(b) the benefit formula with,particular emphasis on asse-sing the impact of inflation; (c) the impact and actuarial fairness of early retirement and anticipated pensions; and (d) the implicationsof raising to market levels the rate of interest paid by the National Investment Bank and the scope and speed of "farming out" the investment of social insurance reserves to private fund management companies. It will also examine the operation and impact of the unemploymentinsurance scheme.
9.103 The Ministry of Social Affairs, in addition to nominating the team of local experts for this task, has also unoertaken to collect all the necessary data for the actuarial assessmentsand the detailed calculationsof the implicationsof alternativeoptions.
9.104 On the basis of the results of the above, the Government will introduce a reform of the social insurance and pension system, that would continue to be based on fully funded principles and would include a detailed program of implementatlon. Implementationof the agreed program would be expected to begin by July 1994 and to be continued through to July 1995, with completion scheduled for a time to be determined.
V. The National Investment Bank
9.105 On paper, the NIB is the largest financial institutionin Egypt, with a total baIance sheet of LE 35 billion in June 1990 against LE 23 billion for the largest commercialbank. The NIB owes its size to its neea monopolizationof the resources of the social and private insurance funds. Resources from these funds amounted in 1990 to over LE 24 billion, or nearly 70 percent of total assets. The NIB also receives postal savings deposits from the Post Office and raises additional funds through investmentcertificates (sold on its behalf at branches of the National Bank of Egypt (NBE); through a limited quantity of development bonds; and through various governmentalsources of funding.
9.106 In practice, the NIB is far from beinq a firancial ingtitution. It is a unit of the Ministry of Planning and is, effectively,an accounting agency responsiblefor disbursing funds for the implementationof the Gcvernment'sinvestment program. Funds are disbursed to various public sector entities, such as central and local - 117 -
administrations,universities, hospitals and other service authorities; public monopolies (the PetroleumAuthority, the Suez Canal Authority); public utilities; and PEs. The NIB monitors the progress of investment projects and may recommend suspension of payments if projects are mismanaged,but its role in assessing the creditworthinessand economic rationale of different projects appears to be limited.
9.107 Despite its limited role as a financial institution,the NIB has an important impact on the functioningof the financial system. The nominal rate of return that the NIB pays to the social insurance funds has historicallyfluctuated around 6 percent p.a., although a jump to 14 percent p.a. appears to have occurred in 1990/91. These were highly negative rates of return on social insurance reserves.
9.108 Reflecting the long-termnature of its resources, long-term loans representedover 80 percent of total NIB assets in 1990. This was up from 68 percent in 1986, in part due to the continuing increase in the relative importanceof social insurancebalances as a source of funding. On the other hand, short-term loan participation decreased during the same period (Table IX.3). Other savings funds include the resources raised from the issue of investment certificatesand the mobilization of post office savings deposits, white long-term debt includes the issues of developmentbonds and loans from governmental units. The latter mostly cover the provision of so-called soft loans, mainly to regional authorities for the constructionof low cost housing.
9.109 NIB lending is divided among five recipient groups. The central government accounted for 28 percent of total loans in 1986, but its share declined to 22 percent in 1990. Lending to local government, including loans to governoratesfor the constructionof low-cost housing, absorbed 1.3percent of all loans; while loans to service authorities,which mainly include hospitals, schools, universities, etc., represented an additional 16 percent. Economic authorities,which cover the public monopolies and utilities, PEs and holding companies, accounted, respectively,for 27 percent and 23 percent of total NIB loans. However, loans to PEs increased from 18 to 23 percent between 1986 and 1990 (Table IX.4).
9.110 At present, most NIB loans carry interest rates that are below market level. The NIB is the principal source of investment credit for PEs. The interest rate on its long-term loans was long set at 9 percent p.a. The rate was increased by a half nercentage point in 1989, when long-term rates to industry from commercial banks amounted to 15-17 percent p.a. In real terms, interest rates ;,avebeen consistently negative.
9.111 As argued above, the NIB has, in the past, played a very limited role in project assessment and credit appraisal. This is evident from its very low overhead costs that amounted to less than LE 5 million in 1990. This was less than 0.015 percent of average total assets in 1990. The limited financial intermediationrole of the NIB is also confirmed by its very low level of capital, reserves and - 118 - provisions. These amounted to less than LE 600 million in 1990, or 1.4 percent of total assets. An independentinvestment bank should have funds of well over 10 percent of total assets.
Table IX.9
Egypt: Naturit, Structure of NIB Assets & Liabilities (percent of total)
1986 1987 1988 1989 1990 Assets Liquid Assets 9.4 7.8 6.1 5.6 5.4 ST Loans 15.5 11.9 8.6 5.9 3.8 LT loans 68.4 73.3 77.9 80.2 82.3 Soft Loans 5.9 6.1 6.2 7.0 7.4 Cther Assets 0.8 0.9 1.2 1.3 1.1
Total 100.0 100.0 100.0 100.0 100.0
Liabilities ST Debt 3.6 1.8 2.7 2.1 1.9 Social Insurance 59.4 63.7 65.1 67.6 68.6 Other Savings Funds 16.2 16.6 17.2 17.3 17.8 LT Debt 20.2 17.4 14.4 12.1 10.3 Provisions & Capital 0.7 0.6 0.6 0.9 1.4
Total 100.0 100.0 100.0 100.0 100.0
Source: Tables AIX.9 and AIX.10.
Table IX,4
EgvRt: NIB Loans Analysis
1986 1987 1988 1989 1990
Central Government 27.9 25.7 23.6 23.9 21.7 Local Government 13.4 13.5 12.7 12.9 12.8 Service Authorities 13.8 14.9 15.9 16.1 16.4 Economic Authorities 27.2 27.8 28.2 26.0 26.6 Public Enterprises 17.6 18.2 19.6 21.1 22.6
Total 100.0 100.0 100.0 100.0 100.0
Source: Table AIX.l1. - 119 -
TabLZIX.
E*ypt: NIB OLerating Ratios (percent of average total assets)
1986 1987 1988 1989 1990
Revenues 7.26 7.29 7.61 7.90 8.78 Financing Costs 7.41 7.45 7.50 7.51 7.84 Gross Operating Income-0.15 -0.16 0.11 0.39 0.94 Operating Expensee 0.01 0.01 0.01 0.02 0.01 Provisions 0.00 0.00 0.11 0.36 0.68 Total Costs 0.01 0.01 0.12 0.37 0.70 Profit -0.16 -0.17 -0.01 0.02 0.24
Source: Table AIX.13.
9.112 The Government has decided that social insurance funds should no longer be used to provide subsidized finance to PEs, although NIB has been allowed, on a temporarybasis, to continue lending to them but through funds raised on the capital markets. (These reforms are being supported by SAL I.) The question remains as to how efficient the NIB will be in mobilizing long-term resources on the capital markets and in allocating them to PEs on a nonsubsidizedbasis? Nevertheless,this was an important decision in redefining the future role of NIB. It is consistent with the government program for reforming the PE sector on the basis of market principles.
VI. The Future of the NIB
9.113 The NIB must now reconsider its future since the Government of Egypt has begun relying on market forces to direct resources in the economy. This section examines whether a rationale for government interventionin credit markets remains under these circumstances,and, if so, what role the NIB could play.
The General Case for Credit Market Intervention15
9.114 It is well known that the allocation of resources is improved through government interventionwhen there are externalitiesor when markets are incomplete or fail. Externalitiesare generally not found in the credit market but the credit market could fail under some circumstances. Such credit market failure arises from adverse selection and moral hazard when informationis costly. Markets are often
.L2/ The analysis in this section is taken from S. Ramachandranand A. Musalem "Mexico - The Future of Development Banks," Country Department II, Latin America and the Caribbean Region, World Bank, mimeo, September, 1991. - 120 -
incomplete in that several types of risks cannot be borne by others more willing or able to bear them. The absence of term credit may be an example of the inability to trade interest rate risk but, even so, interventionwould not be justified when government policies are responsible for the market's incompleteness(e.g., laws that prohibit particular contracts or policies that create economic uncertainty). It is better to correct such inappropriatepolicies than to try to compensate with additional intervention. Credit interventionto redistributeincomui is rarely appropriate. The poor deserve transfers, not credit, and tying subsidies to credit makes it difficult to target the poor and invites wasteful rent-seekingby the less poor, but creditworthv,borrowers; it also destroys the intermediary'sfinancial discipline.
9.115 While interventionin credit markets designed to correct some credit imperfectionis warranted, interveningin credit markets to overcome problems in other markets is generally unwarranted. There could be exceptions of course but, invariably,direct interventionin the market where the problem arises is.more effective and administrativelyless costly. Possible exceptions are infrastructure, the social sectors and low income-housing.
9.116 There is ample justificationfor the Government to provide for public goods such as infrastructure(roads, drainage, etc.), or for general education and health due to externalities. Such projects are best handled at the lowest practicable level of government but local governmentsdo not often have the means to pay for them. The central government could fund such projects through transfersbut it may sometimesprefer to lend the funds. Such loans could be either made directly or through entities like developmentbanks and at interest rates lower than commercial lending rates. So long as the rates are at least equal to the marginal costs of eentral government borrowings, transparencyis ensured. While such lending could be considered credit market interventions,they would have no adverse effects.
9.117 Government involvementin low-income housing is both for income redistributionand to relieve urban squalor. Relieving the congestion and the health hazards of slums is probably the more defensible reason for government intervention. It is desirable that a single institution implement a well-designedgovernment program for low- income housing. Such a program should rely on lump-sum transfers from the budget to low-income earners to help them with housing affordability,but financing should be provided at market terms.
9.118 The Form of Intervention. Having established that the Government should intervene in the credit market, the manner in which to intervene is the next issue. A developmentbank is costly to set up and run because it is difficult for a government to evaluate how well it does, and bureaucracies tend to take on a life of their own. Clearly, temporary interventionsdo not require developmentbanks; even permanent interventionsmay be undertaken in other, more efficient ways. - 121 -
9.119 Developmentbanks are certainly not set up for profit but the absence of a profit motive eliminates a convenient yardstick with which to measure the efficiency of the institution. A developmentbank (like other PEs) could lose money but then claim that they did well and demand additional funds because profits were never their motive to begin with. Furthermore,development banks, in particular, could defer revealing the full extent of their problems for years (even decades) by rolling over nonperforming loans, then borrowing cheaply from the Government or with government guarantees. This could continue even after the full extent of the problems became known because the borrowers are "in need" and "deserve" to have their unpaid loans forgiven. Finally, banking supervisorsare rarely sufficientlystern with a government bank.
9.120 Developmentbanks do not have as great an incentive to collect on loans but this function can be delegated to commercial entities when developmentbanks act only as "second-tier"lenders. This would also reduce developmentbanks' retail branches and staffing needs but it would nevertheless require staff to have an intimate knowledge of the final borrowers' requirements. There would inevitably be some duplication in functions but how much is best would depend on whether there are economies of scope and efficiency gains derived from specialization. Ultimately, whether the Government should intervene through a self-containedbank or through a second-tierentity is a public secto. administrativeefficiency issue.
9.121 It is, however, incorrect to think that the establishment of a "second-tier"development bank complementsprivate commercial banks. While commercial bank lending is not displaced when loans are subsequentlyrediscounted at a (second-tier)development bank, it does displace commercialdeposit gathering. While it is true that such funds appear to augment the resources of the commercialbank, the Government obtains these funds by borrowing. Private sector savings, therefore, get funnelled through the government rather than through commercial banks alone. After all, if the Government had not borrowed (or if the development banks had not borrowed directly in the market with the Government's implicit guarantee), the non-bank public would have bought other financial assets instead of government paper. This crowds out16 private sector resource mobilizationand causes excessive -- and needless -- government interventionin the financial system.
9.122 This crowding out of private sector intermediationis reflected in the gross size of developmentbanks. If such displacement is to be avoided, developmentbank assets must shrink, even though they operate as second-tier institutions. Of course, if it could be shown that the private sector may not allocate efficiently,then government
IW This crowding out of intermediationis to be distinguishedfrom the more serious "crowding out of private sector resources,' which results from government nontransfer expenditures. - 122 -
interventionwould be warranted even though there would be some crowding out.
9.123 Development banks should complement and not compete with private commercial financial intermediaries. The international experience with developmentbanking overwhelminglyfavors the private sector as the best lenders even to low-income producers.17 The very existence of developmentbanks tends to dampen commercial banks' enthusiasm for nontraditionalclients.
A Bank for Public Works and the Social Sectors
9.124 Considering the framework outlined above on government interventionin the credit market, the recent developments in Egypt financial markets described in this report and the suggested proposal for reforming the social insurance and pension systems (Chapter XI), the discussion should now focus on what role the NIB could have in the future. Unlike the previous sections, this discussion is more speculative. Opinions would differ within Egypt -- and doubtless even within the NIB -- on how this institutioncould evolve and the pace at which it should do so. There is, however, a convergenceof opinion on the purpose, namely that the financial system should be sound, efficient and cater to the real needs of the economy.
9.125 The scenario laid out below is one view of how the future could evolve. It is not to be construed as the Bank's blueprint; rather, it should be considered the basis for additional discussions and changes. Many suggestions involve a matter of judgement, and the Government and the NIB themselves are very knowledgeable about the problems and what could be done about them. Changes cannot occur overnight, and there must obviously be a short, well-defined transition. The transition should not, however, be never-ending.
9.126 The proposed reform of the SIS system will have considerableimplications for the future role of the NIB. If pension funds are allowed to evolve into modern-styleinstitutional investors, their reserves will be placed in marketable securities (governmentand corporate bonds as well as corporate equities) earning market rates of return. The NIB would then have to fund investment projects through transfers from the Treasury which should be the only issuer of government bonds paying market interest rates. Hence, the automatic NIB access to social and private insurance funds would be severed. In this context, the authoritiescould consider discontinuingNIB's role as a goverDnmentaccounting and disbursing agency for the financing and l/ The World Bank Economic Review, Vol. 4: no. 3 (September)1990 has a collection of articles on the subject, especially "Introduction:Imperfect Informationand Rural Credit Markets -- Puzzles and Policy Perspectives,"by Kharla Hoff and Joseph Stiglitz; and "Peer Monitoring and Credit Markets," by Joseph Stiglitz. - 123 -
monitoring of investmentprojects in the public sector. This activity could be transferred to the MOF.
9.127 If the NIB is forced to pay market rates on its liabilities,it would have to raise its lending rates or it would suffer interest losses that would need to be covered by transfers from the budget. Moreover, the use of market interest rates, as well as the removal of subsidies from PEs, might lower the collectabilityof some of the loans to PEs. Any loan losses would also need to be covered by the budget. However, these budget transfers would reflect a recognitionof losses caused by past policies. Their level would depend on a detailed forward-lookingassessment of the prospects of PEs and on the success of the privatizationprogram that is currently under implementation.
9.128 Furthermore,large enterprises in both the private and public sectors, including, in particular, the public utilities and public monopolies such as the Petroleum Authority and the Suez Canal Authority, should be encouraged to raise long-term funds on the capital markets by issuing corporate bonds as well as equity instruments.
9.129 Considerationis currentlybeing given to the scope for converting the NIB into a fully fledged development and/or investment bank. Since the regulatory frameworkprovides ample scope for the establishmentof privately owned investmentbanks, allowing the NIB to evolve into a public sector investmentbank would run counter to the current policy of promoting a market-orientedapproach to the financing of investments. As discussed above, the performance of public sector investment and developmentbanks has, in most countries, been rather poor. The requirementsfor a successful public sector investment bank in a competitive and ever-changingfinancial market would be daunting even for a well-establishedpublic institution,let alone for an institution like the NIB that has traditionallyoperated as an accounting agency and has acquired little expertise in selecting and assessing investmentprojects.
9.130 On the other hand, municipalitiesand social sector institutions(public or private) in Egypt may not borrow directly and so require central government assistance in funding and project appraisal. This will be of particular importance once the current decentralization efforts materialize. Therefore, a specializedinstitution would be needed to lend and provide technicalassistance to municipalitiesand social sector institutions.
9.131 SummaXy. The need exists for a developmentbank under the aegis of the financial authoritiesand subject to the supervisionof the CBE. This developmentbank would function as an apex (second tier) institution to promote and develop public infrastructureand social projects. Consideration should also be given to making it responsible to implement the Government'slow-income housing program. This institutionwould have the responsibilityfor the economic, financial .and environmental analysis of projects and would only lend for viable projects implementedby institutionallyand financiallysound - 124 -
implementingagencies. This bank's minimum lending rate should be higher than its marginal cost of funds to cover its intermediationcosts and risks. The participatingfinancial intermediarieswould be free to determine the onlending rates. Subsidies, if any, should be targated through lump-sum trAnsfers to beneficiaries (as against below market onlending interest rates) and reflected in the budget of the central government.
9.132 If these reforms are implemented,then the Housing Development Bank (HDB)18 would become a specialized financial institutionunder the supervisionof the CBE, offering mortgage instrumentsat its marginal cost of funds, and relying on deposits and funds from the apex institution. Other banks would also offer housing finance and the HDB could ultimately be privatized.
9.133 The authoritieswill have to think through a radically changed role for NIB bearing in mind the need for a rationale for government interventionin financialmarkets. The function of acting as a government accounting and disbursing agency for the financing and monitoring of the government investmentprogram could be transferred to MOF. Moreover, its lending activities to PEs, and to the economic authorities,should be phased out. Finally, its lending to the service authorities and governorateswould be transferredto the newly created developmentbank.
9.134 As an apex institution,the main role of the new development bank would be to: (i) promote and develop public infrastructureand social projects; (ii) monitor the performance of executing agencies (e.g., water utilities, hospitals, educational establishments,municipalities) and their continued eligibility for project financin:;;(iii) mobilize resources domesticallyand internationallyto finance local governments,water utilities, health, education, municipalitiesand low-incomehousing projects; (iv) review sample subloans; (v) monitor and report the end-uses and repaymenttsof funds; (vi) handle procurementand disbursementsfrom multilateral lenders; and (vii) provide technical assistance. An apex institution is often an efficient way of reaching a large number of diverse end- borrowers and of promoting rolicy reform. Moreover, loans to local governments could be tied to technical assistance in project analysis and resource mobilizationtargets. Finally, to the extent possible,
jfi/ HDB is 30 percent owned by the Ministry of Housing and Public Utilities (MHPU), six public sector banks, one private bank and the Misr Development and Housing Co. HDB lends to individuals, companies and cooperativesfor housing and is also involved in house construction. It takes deposits and borrows from the CBE (about LE 400 million p.a.) at market rates of 15-21 percent p.a. and onlends at 6 percent p.a., with the difference coming from the budget (LE 94 million, or US$30 million equivalent in FY91). This policy needs to be reviewed in line with the proposals suggested in the text. - 125 -
this developmentbank should operate as a second-tier Institutionand should serve as a catalyst for attracting the participation of private sector financial intermediariesin financingprojects.
9.135 Ultimately, a detailed analysis is necessary before any hard decisions on the fate of the NIB are made. The financial sector reforms suggested throughout this report will necessitate a fundamental assessment of the need and further role of the NIB in the sector. Although such an assessment is beyond the scope of this study, it needs to be carried out on an urgent basis. The information gathered about the NIB for the financial sector reform report suggests that a two part study of the NIB should be conducted. The first part should analyze the need and justificationfor the NIB to continue its present functions taking into account any instancesof market failures and poverty alleviation (e.g., infrastructure,municipal, aocial services, low- income housing) and felt need for apex lending arrangementsto compensate for market failures. If, after the first part has been completed, a determinationis made that there is a need for the NIB to continue and restructure its operations,the second part of the study should prepare a blueprint for restructuring. In particular, the second part should focus on issues such as: (i) the financial viability of the 'nstitutionand its autonomy in terms of its resources and operating costs; (ii) assumption of responsibilityfor the present assets (loans/investments)of NIB; and (iii) how the institutionshould complement rather than compete with commercial banks and other financial intermediaries. CHAPER X PRIVATEPENSION ELASM
I. Introduction 10.1 Privatepension plans includeboth occupationalpeniion plans and personalpension plans. Occupationalpension plans are organizedeither on a multi-employer,industry-wide basis or on a single employerbasis. Personalpension plans are traditionallyorganized on a personalbasis for self-employedpersons and employeesnot coveredby occupationalpension plans, but incrwasinglythey are being used for all kinds of workers. 10.2 Occupationalpension funds exist in many developedcountries eitheras an alternativeto the socialinsurance system or as a source of supplementarybenefits. In most countries,the first occupational pensionplans were set up to cover civil servantsand military personnel,mostly on an unfundedbasis, but the conceptwas later extendedto the privateseeitor, especially among the larger corporations. 10.3 Industry-wide schemes covering employees working in banking, insurance,and other sectorsare in widespreaduse in several continentalEuropean countries. In contrast,company-based schemes are predominantin Anglo-Americancountries such as the United States,the UnitedKingdom, Canada and Australia,although multi-employer schemes may cover blue collarworkers in variousindustrial sectors, such as miningand construction,where there is a high mobilityof labor. 10.4 Littleinformation on the existenceof occupationalpension funds in developingcountries is readilyavailable. As in earlier periodsin cdevelopedcountries, those that exist mostlycover civil servants,military personnel and privilegedemployees of large public sectorcorporations and financialinstitutions. Company-based schemes are more likelyto be found in countriesthat are formerBritish coloniesand also in countrieswhere multinationalcorporations have a strongpresence. However,in countrieswith well-developednational providentfunds, company-based schemes are unlikelyto be large. In Malaysiawhere the EmployeesProvident Fund (EPF)has a wide coverage, company-basedpension funds representedin 1987 only a small fractionof the resourcesaccumulated by the EPF. In Chile a systemof compulsory personalpension plans has been in operationsince 1981. 10.5 Companypension funds have grown at very high rates in some developedcountries over the past forty years or so. Several explanationshave been put forwardto accountfor this growth. Historically,pension plans representeda formalizationof discretionary paymentsmade by employersto retiringemployees in recognitionof their long and faithfulservice. Over time,company pensions came to b; seen as deferredcompensation that providedincentives for greaterloyalty and increasedproductivity. They were also seen as a means for ensuring a satisfactorylevel of incomefor retiredworkers. The growthof - 128 -
company pension funds was also stimulated by two other factors. During times of restrictivepolicies on wage and salary increases, improved pension benefits were an effective means for raising total labor compensation,while the more favorable treatment of saving through pension plans provided a strong and persistent incentive to save through qualified pension schemes.
II. Pensions and Priyate Annuity Markets
10.6 The growth of company pension funds is also often related to the imperfectionsof private annuity markets. Historically, savers have been reluctant to buy annuities for two reasons. First, the annuity market suffers from adverse selection: people with short life expectanciesare less likely to buy annuities than people with long life expectancies. Because of this, insurance companies are forced to base their annuity prices on the mortality risks of people buying annuities: this results in higher annuities costs than if prices are based on the mortality tables of the whole population. These prices are considered by some commentatorsto be "actuariallyunfair," 1 although it can be argued that the higher costs reflect a necessary segmentationof the market. In life insurance, market segmentationby risk characteristic is accepted as rational and desirablebehavior on the part of insurers; it is difficult to see why in life annuities the same approach should be seen as involving "actuariallyunfair" prices.
10.7 A second, and a more important, reason for the underdevelopmentof the private annuity market may be that people are generally reluctant to part with a substantialsum of money and run the risk of leaving no money to their heirs if they should die shortly after setting up an annuity contract. The bequest motive is generally considered to be an important determinantof household saving. Insurance companies have developed contracts that refund a substantial part of the capital in case of early death. Economists have tended to treat annuities as assets that leave no bequeathablewealth, 2 but this is not in conformitywith prevailingbusiness practice.
10.8 A third reason for the underdevelopmentof private annuity markets may be the very growth of social insuranceand private pension
1/ For a discussion of these points, see Friedman, Benjamin and Mark Warshawsky: "Annuity Prices and Saving Behavior in the United StatAs" in Bodie Zvi, John B. Shoven and David A. Wise (ed), Pensions in the U.S. Economy. The University of Chicago Press, Chicago, 1988; and Friedman, Benjamin and Mark Warshawsky: "The Cost of Annuities: Implicationsfor Saving Behavior and Bequests," The Ouarterlv Journal of Economics, February 1990.
~/ See the editors' introductionin Bodie Zvi, John B. Shoven and David A. Wise (ed), Pensions in the U.S. Economy, The University of Chicago Press, Chicago, 1988, and the two papers mentioned in the preceding footnote. - 129 -
funds, which may have deprived the annuity markets of a substantial segment of potential customers. A feature of both social insurance and private pension schemes is that they are mandatory programs that save on marketing and other production costs (such as medical screening)and overcome the problems caused by adverse selection. They may, therefore, be more efficient means of providing for retirement incoa and insuring against excessive longevity than individualannuities, but this is no different from arguing that mandatory group life insurance is a more economicaland efficient means of providing against the risk of premature death than individuallife policies.
10.9 The growth of pension funds is often attributed to their preferred tax status. In most developed countries,pension funds enjoy the advantage of tax deferral on both contributionsand investment income, a treatment that is not generally available on other forms of saving. This is because company and employee contributionsare tax deductible, and no tax is levied on their investmentincome and capital gains; however, pensions are subject to tax like other income.3 Tax deferral is a considerableadvantage in a country with a highly progressive income tax. In addition, the comparative tax advantage of saving through pension plans and other forms of contractual savings becomes very significant in countries where investment income and capital gains in financial assets, such as bank deposits, mutual fund shares or direct holdings of securities,are subject to tax, sometimes at high marginal rates. In these cases, the tax treatment of pension plans representsa move towards a consumptiontax base, which avoids the taxation of saving. Personal pension plans may receive an additional stimulus frorathe opportunitiesfor tax arbitrage in countries where interest paymepts on personal loans are tax deductible (Chapter V and Annex V.1).
10.10 The preferentialtreatment of contractual savings also affects the compositionof financial assets in favor of long-term savings held with institutionalinvestors. In countries that suffer from a shortage of formal term finance, the promotion of contractual savings through a preferentialtax treatment would be a desirable objective of financialpolicy. The continuingprovision of tax incentivesto contractual savings could result, however, in an excessive concentrationof financial savings in the hands of institutional investorswith potentiallyundesirable implicationsfor the functioning of capital markets and for the market for corporate contrnl.4 Thus, in the longer run, it would be advisable,and more equitable to remove the preferential tax treatment of contractualsavings by ext- ..ningthe
2/ As discussed in Chapter V, the tax treatment of pension funds is different in Egypt.
_/ These may include overprovisionof equity finance, inadequate monitoring of large corporationsand undue emphasis on short-term results, although existing evidence on the occurrence of these practices is inconclusive. - 130 -
principle of tax deferral to all types of savings.5 An alternative approach is to place limits on the amounts of contractual savings that benefit from tax deferral.
10.11 Pension funds, like life insurance companies, have long-term liabilities,and their reserves are ideally suited for investment in long-term assets. Because their pension liabilitiesare often open- ended in real terms, pension fund managers have a strong preference for investing in real assets, such as corporate equities and real estate, or in indexed bonds.
III. Tyves of Private Pension Plans
10.12 As discussed in Chapter VIII, there are basically two types of pension plans: DB and DC plans. These have different operating characteristicsand different advantages and disadvantages. In DB plans, employers promise their employees a pension equal to a certain percentage of pensionable salary for every year of service.6 Employers and employees (if the pension plan is contributory)make contributions to the plan. Employer contributionsdepend on the investment performance of the fund, but employee contributionsare a percentage of salary that is either constant or varies with age and length of service.
10.13 In DC plans, the level of pensions depends on the contributionsmade by employers and/or employees and the investment performance of the fund. DC plans do not carry an implicit insurance that retirement income will be a certain proportion of pensionable salary. Their members are exposed to the investment risk of fund assets and especially the impact of unexpected inflation. However, they are free from the restrictiveconditions that affect DB plans.
10.14 The main advantage of DB plans is that sponsoring employers assume the investment risk of pension plans and, thus, provide a sort of insurance that retirement income will be a certain fraction of pensionable salary.7 With few exceptions,mainly for civil servants and other public sector employees, this insurance is limited to the nominal value of pensions at the time of retirement,although sponsoring companies often adjust pensions on an ad hoc basis to take account of
5/ This would amount to a generalizationof a consumption tax system. It should, however, be noted that although consumption tax systems can be as progressiveas income tax systems, they require higher tax rates to generate the same amount of revenue. i/ Some defined benefit plans, especially those negotiated with trade unions and covering blue collar workers, may fix a pension in nominal terms irrespectiveof salary levels.
2/ For a discussion of these issues, see Bodie, Zvi: "Pensions as Retirement Income Insurance,"Journal of Economic Literature, March 1990. - 131 -
inflation. DB plans are subject to vesting and portability4 restrictions,which penalize early leavers and discourage labor mobility. They also lack transparencywhile the value of retirement income insurance depends on the solvency and integrity of the sponsoring employer.
10.15 DC plans are simpler to operate than DB ones. They usually confer immediatevesting and are not subject to portability restrictions. As a result, they have no adverse impact on labor mobility. They are also not affected by the solvency and integrity of the sponsoring employer. However, DC plans depend on the solvency and integrity of the financial institutionsadministering and managing the funds, while the investment risk is assumed by participating employees. A sound regulatory framework is, therefore,necessary to safeguard the interests of savers and to stimulate competition and efficiency. In addition, in countrieswith high and volatile inflation, DC plans must have access to indexed instruments to increase their ability to hedge against the inflation risk.
10.16 The impact of pension plans on labor mobility is a somewhat controversialissue. Pension benefits that are subject to vesting and portability restrictionsreward long tenure and are often seen as an effective mechanism for encouragingthe undertaking of job-specific training by both employers and employees. Where job-specifictraining is important, compensationschemes that discourage high labor mobility may contribute to higher labor productivity. It is not, however, clear that pension plans are the best tools for rewarding long tenure, especially as pension payments are made when workers are in retirement and have no means of ensuring that they represent an adequate compensationfor long tenure. If long tenure is important, it would be best to encourage it by adequate differentiationin wage and salary payments and by the use of appropriate labor contracts such as fixed- (or minimum-) term contracts.
10.17 Occupationalpension funds may be self-administered, especially if they are based on DB plans and are operated by large companies. DC plans and plans of smaller companies tend to be insured
1/ Vesting refers to the acquisitionof pension (and other benefit) rights by employees. The main distinction is between immediate vesting, when pension rights are vested on joining a pension scheme, and deferred vesting, when accrued pension rights are vested after reaching a stipulated minimum service and age. There is also a distinctionbetween full vesting, when accrued pension rights are vested in their entirety, and graded vesting, when accrued pension rights are vested on a sliding scale as more vesting requirementsare met. Portability refers to the ability to transfer accrued and vested pension rights to other pension schemes. For a fuller discussion of these issues see McGill, Dan: Fundamentalsof Private Pensions,Richard D. Irwin, Inc, 1984. - 132 -
and administeredby life insurancecompanies or other types of financial institutions.
10.18 Personal pension plans always operate as fully funded DC plans, but occupationalpension schemes can operate either as fully funded DC plans or as DB plans, which may be fully funded, partially funded or totally unfunded.9
10.19 Personal pension plans share the advantages and d'sadvantagesof company-basedDC plans although they tend to be more transparent and provide greater choice to employees in selecting the managers of their pension bavings. In recent years, many countries, including, in particular, the United Kingdom and Chile, have promoted personal pension plans. The main motivation for this has been the need to contain the growing burden of aging populations on social insurance systems, resolve the vesting and portabilityproblems of company-based pension schemei and establish a more transparentsystem of incentives in the labor market.
IV. Pension Funds (PFs) and the Developmentof Capital Markets
10.20 One of the main problems faced by developing countries in promoting a large and efficient capital market is the absence of institutionalinvestors. At the same time, the lack of a capital market inhibits the appearance of institutionalinvestors, such as insurance companies, pension funds and investment funds. This situation can be remedied by creating a private pension fund system based on capitalizationor savings, while removing regulatory impedimentsto the development of the securities market (Chapter XII).
10.21 The main objective of a pension fund system is to pay adequate pensions to those people who have lost their earning capacity. The most common system finances current pensions with current contributions,the PAYG method. Under this system, there obviously isn't an important accumulationof resources, and the aim of creating a capitalizationfund is not achieved.
10.22 Another possible system is a capitalized pension scheme that accumulates resources through the state, with pensions paid by the state. In this case, the state accumulatesand makes investments directly and, therefore, does not contribute to the developmentof the private capital market. This type of system is intimately related to and coherent with central planning, but it is not supportive of a market economy.
2/ Occasionally,defined benefit plans may also be over-funded. This could happen if investmentreturns on pension assets are very high, and sponsoring companies are restrictedby pension regulations from withdrawing the resulting surplus. - 133 -
10.23 The third type of pension system contributes to the development of a capital market; it can be achieved by creating privately managed pension funds (PFs), which are subject to strict laws and state regulation. These PFs accumulate and invest resources through regulated operations in the capital market, creating demand for financial instruments. Before they receive clearance to be purchased by the PF, these instrumentsmust be analyzed and classifiedby independent agents according to their risk level.
10.24 Once a PF system is operational,it acts as a booster for the market economy, providing resources, creating professionalmarkets and providing incentives for other investors. Another benefit obtained from the creation of the PF is the possibility of transferringcompanies into private hands, as the PF and life insurance companies are potential buyers for these companies. Institutionalinvestors with solid resources provide assurance that privatized companies will continue to operate without any difficulties.
10.25 A PF system requires detailed regulatory legislation,the creation of a specializedsupervision organism and a financial instrument classificationmechanism. These matters are discussed next, and a detailed example of a regulatorymodel is presented in Annex X.1.
V. Regulatory Framework
10.26 An effective regulatory and supervisoryframework for pension plans is important for three main reasons: to safeguard the solvency of the institutionsthat are entrusted with the management of the funds; to ensure the delivery of the benefits promised to plan members; and to specify the tax treatment of pension plans. Supervision of pension plans is required to verify compliance with the regulatory framework and to ensure the solvency of fiduciary institutions.
10.27 The regulation of pension plans is faced with broadly similar problems to those confronting the regulation of life insurance. DC plans (both company-basedand personal pension plans) involve less complex contracts than the various types of life insurance policies. There is, therefore, less reason for government to intervene in order to sta,idardizecontracts and facilitate market comparisons. Because of the problem of adverse selection, the sale of annuities after retirement may present difficulties. However, adverse selection can be overcome by making the purchase of annuitiescompulsory at the time of joining a plan rather than allowing it to be optional at the time of retirement.
10.28 In the case of DC plans, regulationsare mainly concerned with safeguardingthe solvency of the financial institutionsmanaging the funds and ensuring the delivery of future benefits. This requires minimum regulations on the capitalizationand solvency of financial institutions,and on the prudent investmentof accumulatedreserves, similar to those applicable to insurance companies. - 134 -
10.29 The regulation of company-basedDB plans is more complex. In addition to safeguardingthe safety of pension funds, which requires a separation of pension reserves fi)m the ordinary assets of the sponsoring company, there are the questions of vesting and the portability of pension rights. It is also necessary to ensure that the sponsoring company will deliver the promised benefits and will not renege on its promises.
10.30 Restrictionson vesting and portability are often used by companies to encourage employee loyalty and to enable a company to benefit from any training given to its employees. Regulatory standards for vesting may be required in order to limit excessive barriers on labor mobility and to restrain the incentive for abuse that sponsoring employers may have in firing employees just before they acquire vesting rights for their accrued benefits. Regulatory standards are also required to assure equitable treatment of all employees under a plan, but this is a wider issue that applies to all aspects of the operations of pension plans.
10.31 Minimum regulationsregarding portability rights are justified by the need to minimize the potential losses of early leavers and, thus, limit the adverse impact of company-basedpension plans on labor mobility. For example, companies may be required to calculate the present value of vested benefics of leaving employees and transfer this amount to the pension fund of a new employer or to a personal pension plan. Since company pension schemes have different rates of benefit accrual and different funding assumptions,which complicate the calculationof the value of vested benefits, transferringemployees are likely to lose something on the value of their benefits, due to the conservativeassumptions used by the actuaries of different schemes. Therefore, the portabilityof pension rights would protect them from a complete loss of benefits or the freezing of benefits until retirement age.
10.32 Regulations on firms' contributionsand withdrawals to/from pensions funds are also an issue. For example, Mexico does not allow firms to continue to make contributionsinto their pension plans when assets exceed liabilities. A similar restrictionprevails in Japan. In the United States, contributionscan continue as long as assets are not more than 150 percent of liabilities. Full funding limits clearly restrict the tax deductions firms can receive from additional contributionsand, thus, protect the federal treasury from "unneeded tax expenditures." However, these restrictionsalso mean that fewer funds will be accumulated in the pension funds, and this increases the risks that funds will be underfunded at sometime in the future.
10.33 Several countries specify conditions for the withdrawal of pension funds. In Mexico, firms are authorized to withdraw from the plan any amounts in excess of their obligations,though they must pay any correspondingtax. However, this authorizationdoes not apply if a pension plan is part of a collective agreement. Also, in the case of plan terminations,if the pension plan is part of a collective - 135 -
agreement, it has first priority in court on the assets of the firm in the case of bankruptcy. In Japan, excess pension funds must be withdrawn at each actuarial review of the plan, which must occur at least every five years. In the United States, firms can not withdraw funds without terminating the plan.
10.34 Investment rules are also required to ensure that pension reserves are segregated from the other funds of the sponsoring company and are invested prudently. The latter implies a limit on the amount of pension reserves that can be invested in the securities and property of the sponsoring employer and diversificationrequirements similar to those applicable on the technical reserves of insurance companies.
10.35 Ensuring that sponsoring companies will not renege on their pension plan obligations requires an effective system of supervision to make sure that pension plans are properly funded. In addition, minimum regulations are required with regard to plan provisions for the allocation of available pension reserves when plans are terminated. Pension plans may need to be terminated for valid business reasons, such as bankruptcy, insolvency, financial inability to continue contributions to the plan and change of ownership, but employers should be prevented from engaging in opportunisticbehavior at the expense of their employees.
10.36 In most countries, the income tax law plays a key part in laying down general guidelines for the design and operation of pension plans, such as the permissible level of benefits and the allocation of pension assets. However, income tax laws are mainly concerned with preventing the abuse of tax advantages by prohibiting discriminationin favor of managers and other high-level employees and by controlling against excessive and unjustified tax deductions. Additional legislation,dealing specificallywith pension plans, is required to ensure the actuarial soundness of pension plans and to protect the pension rights of participatingemployees.
10.37 In many developing countries the only regulation affecting pension plans is the requirementthat a fund be registered with the tax authorities in order to deduct contributionsand exempt investment income from income tax. In some cases, registrationentails some prudential regulationson the investment activities of the fund, such as a requirement to hold a certain portion of assets in government securities or to invest only in trustee securities. In general, however, little effective regulation and supervision is undertaken, and this may also explain the paucity of statisticalinformation on the operations of occupationalpension funds.
VI. Status of PFs in Egvyt
10.38 In addition to the social insurance scheme regulated by Law 79, discussed in Chapter IX, there are two pension schemes in Egypt: Private ComplementaryPension Funds (PCPFs), and Private Alternative Pension Funds (PAPFs). The contributionsto PCPFs are in addition to, - 136 -
or complementaryto, those demcnded by the state for social insurance; in contrast, PAPFs totally replace the state social insurance.
Private ComplementaryPension Funds (PCPFs)
10.39 Legal Definitions and Regulatory Framework. PCPFs are regulated by Law 54 of 1975 and its ExecutiveRegulation (Decree 78 of 1977). These funds are under the supervisionof EISA, which depends on the MOE. PCPFs are formed without initial capital, by people grouped in a union, organization,profession, company, etc., to provide its members with work disability and other retirementbenefits in the form of pensions or lump-sum compensationpayments.
10.40 PCPFs consist of members' contributions,plus earnings obtained from investments. Said contributionsconsist of month';- payments made by members on their income, as well as by employers on the basis of agreements written into the bylaws of each PCPF. The funds are managed by a board of directors, elected directly by the fund general assembly. The PCPF must be registeredwith EISA before it starts operating; it must submit to that authority a contributionsand benefits plan, as well as a list of bylaws. The benefits are defined in the bylaws; therefore, the contributionsmust be calculated in such a way as to cover said benefits; this is, as discussed above, a DB plan. DB plans require permanent actuarial control over the system. Law 54 stipulates that at least every five years each PCPF must present a financial statement made by an actuary registered with EISA; also, EISA may, if it considers it necessary, ask an external actuary to review this statement.
10.41 Technical Reforms of Actuarlal Oversight. Actuarial adjustment is extremely important to PCPF management. Certain changes need to be made to ensure that Law 54 stipulationsare carried out. General and uniform regulations should be provided by EISA so that all actuaries proceed from the same pre-establishedbasis -- e.g., the interest rate used to calculate reserves, the criteria for calculating inflationaryeffect and life expectancy tables (life expectancy in different industries and occupationsdiffer). If EISA does not have its own actuaries, or does not wish to have them for the time being, an actuary designated by EISA could provide an independentassessment, in addition to the one performed by the PCPF. Without such an analysis, it may be difficult for EISA to determine if the PCPF report is correct. Nevertheless, EISA should have, in the short term, its own team of actuaries and the equipment needed to perform this important task; as economic deregulation takes place and labor becomes increasinglymobile, EISA will need more permanent control over the level of reserves.
10.42 Investments. PCPF investmentsare regulated by Decree 78; therefore, investment updates do not require modifying Law 54. - 137 -
10.43 Instrument Dlversiflcatlon. The following are the investmentsauthorized as a percentage of the fund: (i) at least 25 percent in state-guaranteedsecurities; (ii) no more than 15 percent in a checking account in a bank in Egypt; and (iii) no more than 65 percent in:
* real estate in Egypt; * up to 50 percent In securlties bought and sold in the securlties exchange; * time deposits in a bank in Egypt; * loans to members according to bylaws; and * other fixed-incomeinstruments approved by EISA.
10.44 The fund must send EISA a certificate from the bank and from the institutionswhere investment documents are held in custody; the fund must list these investmentsand agree not to withdraw any monies except with EISA approval. In addition, it must send EISA documents proving that real estate purchases were convenient anadfree of encum- brances. Likewise, the fund cannot sell any property without the approval of EISA.
10.45 Hinimum Required Investment. If minimum required investment amounts are enforced, as is the case with the 25 percent that is to be invested in state-guaranteedinstruments, fund administratorscease to be responsible for the yield of said investmentsand, therefore, for the fund's yield. This policy may herald the beginning of a forced channeling of funds towards the state, which is not consistent with the fund's objectives: profitabilityand security. It is preferable, from a security point of view, to replace this requirementwith measures to ensure solvency monitoring and prudent regulationsconcerning investment diversification,and to leave the full responsibilityfor investment decisions to fund administrators.
10.46 Reforming DiversificatlonStandards. With regard to the 65 percent ceiling on other investments,it is preferable to break down this percentage into types of instruments in order to force greater diversification. For example, in real estate, a maximum of 30 to 40 percent would be more appropriate;in the case of securities, it is necessary to distinguishbetween bonds and shares and to have a maximum for each kind, e.g., 35 percent in bonds and 30 percent in shares. In addition, it would be more appropriateto limit investments in time deposits and other instrumentsapproved by EISA to 50 and 30 percent, respectively. Regarding investmentsin "loans to partners," allowing a limit of up to 65 percent is excessive as, generally speaking, these loans are made at interest rates below market levels, compromisinga basic objective of the pension fund. In general, these loans are not used by all members in the same proportion and favor those closer to the administration. Perhaps it is better not to have this alternative or to reduce it to proportions that cannot compromise the fund's objectives, that is to no more than 5 percent, with the stipulation that said loans shall always be made at market interest rates. - 138
10.47 Issuers Diverslfication. The concept of diversification according to the issuer of instrumentdoes not exist. It would be prudent to introduce this concept as having a percentage of the fund in securities from one issuer is not the same, in terms of risk, as having it in securities from 10 or more issuers. The model in Annex X.1 provides an example of diversification.
10.48 Another concept that should be considered is that of "related issuers," i.e., issuers related to the fund administration. Investment instruments from related issuers pose potential conflicts of interest, which may prove harmful to the fund. These investments, therefore, must be reduced drastically,either to zero or to an insignificantpercentage, depending on the closeness of the relationship.
10.49 Ex-ante Authorlzation for Transactions. The obligation to obtain ex-ante authorizationbefore selling instrumentsor real estate renders the adequate handling of investmentportfolios in an active financial market totally inoperative. The competition and effort of portfolio administratorsis aimed precisely at maintaining the best possible portfolio, according to the variables of the period; these change from day to day, necessitatingmarginal modificationsto the portfolio every day, which cannot be done if ex-ante authorization is required. This security regulationmust be changed. However, its removal should depend on establishingan effective regulatory and supervisorymechanism, includingproper valuation methods and reporting procedures. This would allow EISA to call attention to any irregularities,without interfering in the efficienthandling of the funds.
10.50 Valuation of Financial Instruments. Another concept that must be introduced into the law concerns fund appraisals. It is preferable that appraisals of financial instrumentsbe done at market prices with the covenant that these prices be limited to specific markets and specific days. In a DB system, thia is not as important as in a DC system, but, in any case, it is economicallymore precise to give values at market prices than at historical or accrued prices.
10.51 Financial Monitoring. Once a year, the PCPF assembly must approve the fund's financial statement, which must be audited by a registered auditor. A copy of the balance sheet, as well as of the profit and loss accounts and other data, must be sent to EISA every year. Also, EISA establishes certain books that must be kept by the fund to provide details on fund members; directors; lists of investments,and any changes that have taken place; income and subscriptions;claims and expenses; and loans to members. Finally, an actuary must revise the fund's financialposition at least every five years. EISA can, if it considers it convenient, ask for this revision to be made before the five years have passed. EISA may also ask for a second revision if it considers that the first was not correct. It does not seem efficient to separate financial control from actuarial control; - 139 -
it also might be better to require both controls on a yearly basis. As discussed above, EISA should develop its own actuarial capacity and maintain an ongoing monitoring of the reserves. Fed with monthly reports on losses and payments made by the fund and on new subscriptions,as well as daily reports on financial instruments transactions,EISA would be better able to monitor purchase and sale prices, and to monitor the financial conditions of the PCPF. EISA should be empowered to request additional informationabout a fund, as vell as to revise the correspondingdocumentation in the PCPF offices, whenever necessary and not just once a year.
10.52 Transaction Controls. As noted above, financial controls that hinder a fund's administration,such as the need to receive prior authorizationto sell, must be abolished. Controls that increase the prompt flow of informationto EISA about transactionsmade with a fund's resources should, on the other hand, be increased. Ensuring that transactionprices correspond to market prices is particularly important. For this purpose, EISA must receive daily computer tapes from the securities exchanges,where most of the transactionstake place, including a listing of the instrumentstransacted each day and their prices, which must be compared with each fund's transactionsfor the same day. Thus, transactionsmade at irregular prices can be detected and investigated. This may be more feasible to perform in a small system, but rather costly in a large, fully mature private pension scheme. In the latter case, although informationrequirements should be maintained, transactionsmay be monitored at random and less frequently.
10.53 Formal Markets. Another concept that needs to be introduced in Egypt is the transparencyof lnstrument transactions. It is desirable to restrict transactionsto those formal or public markets where many buyers and sellers are present simultaneously;this ensures that transactionsare common knowledge, includingwho buys and who sells. However, this is difficult to implement in transactions Lnvolving real estate, for example.
10.54 DeveloRmentof PCPFs in Egypt. PCPFs, already developed in Egypt, are currently in a period of sustained growth. To date, there are close to 383 PCPFs in operation handling funds that, as of June 1989, represented LE 1,239 million (close to US$375 million), or about one percent of GDP. This developmentcan be explained by: (L) the insufflciencyof state social insurance for workers with higher qualifications,professionals and technicians,who, together with their employers, have decided to create their own PCPF; and (ii) the tax advantages and possibilitiesof creating capital for private developmentsrepresented by these funds. - 140 - Table X.1 Eernt: PCPF Investment Diersif'ication (in percent) Real estate 1.0 Securities 52.0 Loans to members 2.0 Time deposits 27.0 Other investments 6.0 Checkingaccounts 3.0 Variousdebtors 8.8 Other assets 0.2 100.0
10.55 PCPF growthbetween 1988 and 1989 was 9 percentin real terms. PCPF nominalyields, measured over the total funds as of June 1988 (LE 993 million),were LE 131 million,or 13 percent(Tables AX.1 and AX.2, Appendix). This figurereflects a negativereal profitability of -1.5 percent. A more detailedanalysis could determineif this resultwas due to accountingprocedures (ways of appraisingassets) or else to problemsderived from the capitalmarket. Anotherproblem that becomesevident when observingthe investmentportfolio is the concentrationof investmentsln only two groups (TableX.1): securities and time deposits. (It would be desirableto disaggregateinvestments in securitiesby its components,i.e., bonds, equity). In a mature system,the olulybank balancesof a fund would be thoseneeded for short-termliquidity and the paymentof pensions. These funds shouldbe allocatingacross investment projects not payingthe banks to do it for them. The low volume of investments in real estate is especially notoriousand must be the consequenceof rent controlsand regulations in this sector;these shouldbe phasedout if new investmentsare to be channeledinto buildingsand houses. The issuanceof instrumentsthat providehedging against the risk of inflationand the devaluationof the Egyptianpound (e.g.,instruments with variableinterest rates, indexed to the CPI and denominatedin foreigncurrencies) should also be permitted. Aside from providingsecurity for fixed incomeinvestments in the medium-and long-term,this would enablefunds to lower their risk level.
10.56 Benefits. The numberof coveredworkers of these private funds is over 2 mlllionpeople. Benefitsvary considerablyfrom one fund to another,as do the contributionsrequired (Table AX.3, Appendix). Most funds pay lump sums at the end of a person'sactive workinglife; this representsfrom 0.5 to 4 monthsp.a. of contributions,using as a base the salaryof the last month of work. Only a few fundspay monthlypensions, due in part to the complexityof this process. The main reasonthe fundspay in lump-sumdistribution is becauseof the financialrepression that inducesretirees to quickly diversifyinto real assets. Nevertheless,a problemarises for the - 141 -
worker who receives a lump sum, which is usually on the order of 8 to 10 years worth of salary. Because there is no efficient life insurance company market where a life-long annuity may be purchased, these funds will probably be inadequatelyinvested. This is a limitation of the PCPF that needs to be addressed.
10.57 Required Contribution. The contributionsrequired vary considerablyamong PCPFs. Some funds charge on the complete wage, others on whatever amount surpasses the LE 625 maximum state social insurance contribution,or something in between. In general, these contributions,added to those of social insurance constitute an amount that is very high -- one that does not provide an Incentivefor companies to hire workers. The implication is that fewer pensions are offered as part of compensationto workers. The system must be simplified to reduce the total cost of the social insurance system.
10.58 Portability. There are no rules that regulate what happens if a member withdraws from a PCPF without having lost his work capacity, i.e., if he changes employers. These workers usually receive lump-sum payments, in direct proportion to their contribution;sometimes they are allowed to continue making contributionsfrom their new workplace. It is important to regulate portability and vesting, particularly if labor mobility increasesunder a dynamic market economy.
Private Alternative Pension Funds (PAPFs)
10.59 These funds were a second attempt to compensate for the inadequacy of state pensions. Nevertheless,due to problems in the law that governed the system, the PAPF did not grown as fast as the PCPF. The legal framework under which PAPFs operated was Law 64 of 1980 and its Executive Regulation (Decree 52 of 1985). Government regulations regarding these plans have changed recently resulting in new plans being no longer available, though existing plans continue to be operational.
10.60 PAPFs receive contributionsfrom members, employers and the state social insurance systems for those members who changed from the state system to a PAPF. The funds belong to the members and are managed by a self-appointedboard of directors. The sponsoring company where the members work also participateson the board of directors and names the chairman of the fund.
10.61 Registration. The PAPF had to be registered under the Ministry of Insurance, which also controls PAPF performance. To register, the PAPF had to: (i) submit its bylaws and financial and actuary projections (approvedby a registered actuary); (ii) have over 1,000 members; and (iii) have paid-up capital of over LE 10 million (around US$3 million).
10.62 There are a total of eight PAPFs operating with reserve funds totaling LE 116 million and US$15 million, which amounts to about US$50 million in total, or about 0.15 percent of GDP. Reserves in US dollars are due to the fact that there are some PAPFs whose members - 142 -
receive their income in dollars and are authorized to form their reserves in that currency. Seven out of the eight PAPFs are linked to banks. The total number of members is 4,085, a lower figure than required by law. (There should be at least 8,000 members or 1,000 per PAPF).
10.63 Financial-Monitoring. PAPFs are subject to financial controls similar to those of PCPFs. Therefore, the same recommendations provided under the analysis of the regulations governing the PCPF hold for the PAPF, despite the fact that new plans are no longer available, as significant reserves are still being managed on behalf of beneficiaries. In sum, ex_antg authorizationto move the resources from the funds must be replaced by ex post financial monitoring, including of transactionprices, compliance with diversificationrules, reserves volumes and the harmonizationof criteria used by actuaries (e.g., discount rates, life expectancies).
10.64 A better solution would be to unite the control over both types of pension funds under a single authority, so as not to duplicate functions. In our opinion, this unification could be done under EISA, which controls insurance companies as well as PCPFs. To accomplish these reforms would require strengtheningand modernizing the correspondingdivision in the Ministry of Insurance.
10.65 Investments. The following are the PAPF investment diversificationrules:
* at least 50 percent in the NIB; * 10 percent, as a maximum, in debentures with fixed interest; * 10 percent, as a maximum, in shares of Egyptian companies; * 10 pe'.cent,as a maximum, in demand deposits of public sector banks; * 10 percent, as a maximum, in real estate in Egypt, in houses to be built or owned by members of the fund; * no limit on notes with government warranty; and * no limit on time deposits in public sector banks.
10.66 The PAPF must not withdraw funds from checking accounts; if it does, it must reimburse these accounts immediately. This is expressly stipulated in Art. 27 of Law 64. The idea seems to be that PAPFs are to operate only with new contributions. Nevertheless, in practice, these regulationsonly apply when the authorities do not trust the management of a PAPF. The problem, then, is knowing which parts of the law must be strictly obeyed.
10.67 Investments in the NIB yield considerablylower rates than market rates. Moreover about 50 percent of the reserves for most years suffer a depreciation in real terms because the real interest rate is usually negative. To be able to recover what is currently needed as reserves, PAPFs are forced to raise their contributionrates, which are very high. This practice of forcing PAPFs to deposit part of their funds in the NIB should be eliminated; if the NIB wants to attract these - 143 -
deposits, it should do so by competing in the market. Note, however, that 100 percent of the main social insurance reserves must be invested in the NIB. Thus, PAPFs enjoy a considerableadvantage.
10.68 Moreover, there should be no minimum limits on the obligation to invest in any type of instrument,especially to receive rates below market levels. The following limitationsare unsatisfactory:
(M) In the case of nonpublic financial instruments,a maximum of only 20 percent can be invested: 10 percent in shares and 10 percent in debentures. These figures should be increased to 30 percent in each case;
(ii) The 10 percent limit in real estate is also low and should be raised to 30 percent, leaving the decision about whether it is convenient or not to invest to the administrators. Also, it seems impracticalto demand that the purpose of investing in real estate is to lease property or to sell it to a member of the fund; this has an adverse effect on the object of investment,which is to guarantee future benefits owed. Table X.2 indicates that PAPFs currently invest an insignificantshare of their portfolio in real estate; and
(iii) There should be a limit to the amount that can be invested in government guarantee notes, as well as in time deposits in order to preserve diversification. Also, the bias in favor of deposits in public sector banks should be eliminated.
10.69 Other types of instrumentsshould be eligible for investment as well, such as commercial paper, mortgage bonds issued by banks and shares of investment funds. Ir.addition, a limit should be established with regard to the issuing party, similar to the PCPF limit (for a complete model see Annex X.1).
10.70 In spite of the fact that tne law requires a 50 percent investment in the NIB, the relevant figures in Table X.2 add up to only 39.9 percent of the PAPF funds in Egyptian pounds and a much smaller percentage of total PAPF assets. This plus the fact that the minimum number of members required to form a PAPF is also violated (see above), suggests weakness in enforcing regulations. - 144 -
Table Z.1
Ewytt: iAPF InvestmentDiversificationlc December 31, 1990
Funds in Egyptian Pounds: LE 97,237,955 Percentae
a) NIB investment certificates 5.5 b) NIB deposits 34.4 c) Time deposits 58.5 d) Shares and bonds in public companies 1.3 e) Real estate 0,3 100.0
Funda in US Dollars:"1 US$15,874,009
a) Time deposits 85.2 b) Shares and bonds in private companies 14.2 c) Developmentbonds 0 6 100. O
10.71 The profitabilityof these funds during 1990 was 11 percent on investmentsdenominated in Egyptian pounds (about LE 11 million) and 7 percent on investmentsdenominated in US dollars (about US$1.1 million). The real return from investment in Egyptian pounds was about negative 5 percent; this demonstratesthe need to modify investment policies as suggested.
10.72 Benefits and Reauired Contributions. The average amount paid by an employer is 39.4 percent of the basic or fixed salary, and 26.5 percent of the variable salary.12 The employee pays an average of 10.2 percent of both amounts. Between both, the average is 49.7 percent of the basic and 36.6 percent of the variable salary. These figures are very high, largely because of inadequateyields due to investment regulationsand market distortions (Table AX.4, Appendix).
V/ These figures correspond to the investment fund: nevertheless according to the official informationgiven by the Ministry of Insurance, the reserve fund is different from the investment fund; its resources are: LE 116 million and US$15 million.
I/ These funds correspond to companies that pay their employees in foreign currency and are authorized to keep the fund in that same currency. In this case, the requirement to invest in the NIB is not applicable.
12/ This basic salary is not the same as under Law 79; the amount is very much higher and depends on the company. - 145 -
10.73 With regard to benefits, these also vary according to each PAPF but are usually quite generous according to international standards. One of the requisites for PAPF approval is that the benefits provided are better than thov provided by the state in those areas where a PAPF would replace the state. The PAPF can substitute all benefits provided by the state, or only some. (Contributionsmust be paid to PAPFs in those areas in which they replace the state and to the state in those areas still controlledby the state).
10.74 Old age Penslons. An old-age pension is usually equal to 3 percent of the amount resulting from multiplying the last monthly salary by the number of years of contributionspaid. Therefore, with 33 years of service, a pension equivalent to 100 percent of the last wage is obtained. Pensions have a maximaumlimit in those cases in which the wages over which contributionswere paid also had maximum limits (LE 3,000 and LE 2,400 p.m. are two examples of top dutiable wages). When wages over whicb contributionsare paid do not have a maximum limit, neither do pensions; they are established at 80 or 90 percent of the last wage.
10.75 Other benefits include: (i) :urvivorshipand death pensions on the order of 75 percent to 80 )ercent of the last monthly wage quoted; (ii) lump sums, in the event that the years of paid contributionsfor an old age pension total over 100 percent; and (iii) severance payments, in case of discharge before complying with pension requirements. In some cases, health benefits are also included, covering all medical treatment expenses for the beneficiary and his family dependents,as well as compensationif the beneficiary cannot work.
10.76 Portability. Law 64 regulates the situations in which a person emigrates from the state system to a PAPF, and vice-versa, but not a change from one PAPF to another. Regulating these transfers becomes more imperative as the labor market becomes increasinglymobile.
VII. General Rules to Pension Fund Investment
10.77 Certain concepts underlie the control, transparencyand efficient operation of a pension system based on PFs. These concepts are applicable to funded systems, either DC or DB, as they refer to regulations that guarantee the security of the capital accumulatedby a PF.
10.78 Risk ClassificatiQn(RC). Each financial instrument purchased by a PF should have previously been analyzed by institutions spicializingin RC and, consequently,zhould have received a cl.assificationbased on the issuing party's solvency, instruments' warranties and other characteristics. PF investment rules should c)nsider the RC, within h.eauthorized margins, and give better margins t'ithose with the best classificationand none to those not meeting a cirtain standard. - 146 -
10.79 Nevertheless,few developing countries to date have institutionsthat classify instruments,namely, private evaluators with good reputations. It is essential to create these institutionsto give the capital market transparencyand security. Without risk classification,many investors do not know about the real backing situation of the instrumentsthat circulate and, therefore, abstain from participating in the market, limiting their investmentsto foreign currency or titles with state warranties.
10.80 It is, however, difficult to find trustworthyclassifying companies. Therefore, a risk classifying institution,or a Risk ClassificationCommission (RCC) with members from both the public and private sectors, needs to be created. Annex X.1 provides an example of such an institution,its functions and operating methods.
10.81 Physical Custody of Financial Instruments. Titles representingPF investmentsshould remain under the custody of an institution that guarantees their security; PF administratorsmust be allowed to dispose of only a percentage of these titles at any given moment to make the transactionsthey consider necessary. This custody should be entrusted, ideally, to a specializedorganism with modern electronic methods that make it unnecessary to physically transfer titlea when making transactions. For the time being, this functicn could be entrusted to some state or private sector institution,which guarantees security and efficiency.
10.82 Investment DiversificatlonRules. The purpose of investment diversificationrules is to avoid concentratinginvestments in any type of title and on any issuing party.13 Although the diversificationof issuing parties is not stipulated in the regulations concerning the PCPF or the PAPF, it should have the following objectives:
(i) under no circumstancesshould the percentage of exposure of a PF to a particular issuer be higher than 5 to 10 percent of the PF portfolio;
(ii) a PF should not acquire a share of the issuing company that gives it a controlling interest because, if this is allowed, other objectives may appear attractive to the PF administrators,different to and opposing the only valid objective, that is, to obtain a reasonable profitability and security from investments. The control of other companies through a PF must be avoided;
.L A model of diversificationaccording to instrumentsand issuing companies can be seen in Annex IX.l. - 147 -
(iii) PFs should not be the only investors in certain groupi of issuing companies, such as banks and bond-issuing companies. Doing so would create political pitfalls for PFs that could be avoided by the inclusion of other investors; and
(iv) transactionswith entities related to PF administratorsshould be carefully regulated and should have special controls. As a matter of fact, there is a potential conflict of interest between the PF and its administratorsif transactionsbetween then are permitted.
10.83 InstrumentTransaction lues. It is necessary to regulate the way PF transactionsare made. If this is not done, there is opportunity for fraud; for example, instrumentscould be sold by PFs at below-market prices and bought at above-marketprices. Therefore, with the exception of transactionsin real estate and similar assets, all other transactionsmust be made in secondary and primary markets that are subject to regulationsand supervision,including the participation of the supervisory institutionfor the PFs. A well-regulatedstock exchange is necessary to avoid direct instrument transactions,except primary issues or such non-negotiabletitles, such as time deposits in financial institutions.
10.84 Ins%rumentTransactlons Control and Supervision. Direct control over PF transactionsis needed because even small differences in each transaction,considering the huge volumes purchased by PFs, can generate important losses. The impact of these small differences in the total yield is almost imperceptibleand would not be detected in yearly audits. The way to implement control is through computer programs that compare transactionsfor each instrumentmade by the PF with the average market value of said instrumenton the same day. This is not difficult and only requires that each PF submit a daily report of transactionsto the controlling organism and that stock exchanges do likewise.
10.85 Valuation of Instruments. Each type of financial instrument that PFs keep in their portfolios must be valued daily at market prices. This is especially relevant in the case of the defined contributionPF, in these funds the benefits received by a person depend on the value or the accumulated fund, and, therefore, the fund's value must be measured as precisely as possible. Also, in tho case of the defined benefit PF, it is preferable that the value attributed to the fund at any given moment correspondto the market value, and not to any ad hoc valuation method. Valuation rules that consider the type of instrument, transactionvolumes, relevant interest rates, last prices. etc., are needed, as well as a financial model and computer programs to monitor asset valuation on a daily basis. However, real estate and similar assets should be evaluatee on a periodic basis, perhaps more frequently than once a year. - 148 -
10.86 Indexation of Instruments. It is important to be able to issue documents indexed according to Egyptian inflation, as well as to the dollar. Salaries in Egypt are paid in Egyptian pounds and, therefore,pensions are too. There is an element of financial incongruencein the case of some programs of the DB type. Although pensions are paid in Egyptian pounds, some funds are indsxed to the US dollar. The real exchange rate to the dollar varies; therefore, indexing to the dollar is not equivalent to indexing to the domestic price level. To further deal with risks and uncertainty, the issuance of long-term maturity instruments indexed to the CPI and to foreign currencies,as well as instrumentswith variable interest rates, should also be allowed.
10.87 Rate of Return of Instruments. Special care must be taken when dealing with the rate of return of PFs, as a small difference in yearly rates over 3C or more years has important consequenceson accumulated resources and, therefore, on the level of benefits paid in the DC programs. In the DB program, the effect of lower expected returns can be felt in the contributionrate required to accumulate the capital needed to pay the DB. This is the case with the PCPF and, particularly,the PAPF, where regulationson investmentsrequire that 50 percent of investmentsbe made in the NIB, which pays a fraction of market interest rates. It becomes very difficult, even with the high contributionsrequired today, to provide the promised benefits. Contributions4.8 times higher would be required at an annual interest rate of 10 percent than at one of 18 percent.14 Considering that this is approximatelythe relationshipbetween the interest rate paid by the NIB and the market rate for 50 percent of PAPF funds, and supposing that the other 50 percent is at normal rates of return, then the required increase in contributionrates would be 2.9 times; this would raise a normally reouired rate of 17 percent to levels of approximately50 percent.1 5 One can see thon, the enormous cost of the prevailing in- vestment policy.
>t/ The accumulatedreserves (AR) at the end of 30 years, investing every year an amount S x tZ, where S is the salary, t% the percentage contributionrate, and i the annual interest rate, is: AR - S z t%[(l+i) 3 0 - l/i. If i - 18%, then AR, - 791 X S x tX; but if I - 10%, AR3 - 164 x S z tX. Then AR2/ARz - 4.8. If the AR req.o'resa contributionrate tX at i - 18%, at I - 10%, the raiutced contributionrate would be 4.8 t%. l28/ If only one half of the AR is capitalizedat i - 18% and the other half is capitalizedat i - 10%, the required contribution rate tl would be 2.9 t% (1/2 S x 4.8 t% + 1/2S x t% - S x 2.9 tX, that is t'X - 2.9 j%). - 149 -
VIII. Regulatory Reform
10.88 Because of their small size and supplementarynature, occupationalpension schemes, which are mostly based on defined benefit plans, appear to have a relatively small impact on economic efficiency and labor mobility. People working in privileged sectors, such as banks and public enterprises,appear to enjoy generous pension benefits, but, as pensions are only part of total compensation,it is not easy to say, without a detailed study of the labor market, whether these benefits are justified or not.
10.89 In promoting the development of pension plans, the Egyptian authorities can take various measures to stimulate the development of both occupationalpension schemes and personal pension plans. As discussed in greater detail in the next chapter, a system of compulsory contributionsto personal pension plans16 could form a major source of retirement income for Egyptian workers over and above the minimum pension paid by social insurance institutions. Such a system could coexist both with a social insurance system, providing basic benefits, and with voluntary, company-basedpensior plans operated by a number of large companies and offering additional benefits.
10.90 Although the case for company-basedplans would be weakened by the introductionof a compulsory system of personal pension plans, there might still be some companies that would like to encourage employee loyalty and reduce labor turnover by offering supplementary plans. The present rules and regulations governing pension plans have many gaps. A major overhaul of pension regulationswould be required to introduce a more comprehensiveand integrated system of rules and regulations that would foster the developmentof a sound and efficient pension industry. A detailed model for the regulation of a compulsory system of personal pension plans is presented in Annex X.1. The main areas that require action to reform the regulatory framework are discussed below.
10.91 Plan Formation. The introductionof a compulsory system of personal pension plans would help to remove distortions in labor markets. Any supplementarycompany schemes should be based on voluntary agreements between employers and their work force, subject to approval and registrationwith the appropriate regulatory agency.
10.92 Administration. Personal pension plans should be administeredby financial inteimediaries,while PCPFs could continue to be administeredby financial intermediariesas under current regulations. To foster competition among plan administrators,a uniform set of regulations should apply to all types of administrators(i.e.,
16/ These pension plans would be managed by trust departments of banks, insurance companies, brokerage houses and, perhaps also, speci&lizedpension plan administrators. - 150 -
banks, insurance companies and brokers). The case for auithorizing specializedplan administratorsshould also be considered.
10.93 Plan administratorsshould be required to maintain adequate capital for their operations, segregate their pension plan operations from the5r ottieractivities and comply with all the rules and regulations issued by the competent regulatory agency. The regulations should also allow sponsoring firms and participating individualsto transfer their administrationcontracts to other plan administrators.
10.94 Benefits. Personal pension plans (and any company-based, supplementary,DC schemes) should be based on contributionsranging between a compulsory minimum rate of 10 percent and a maximum rate of 15 percent of pay. Pension benefits would then depend on the performance of plans.
10.95 For company-based,DB plans, the determinationof supplementarybenefits should be left to voluntary negotiationbetween sponsoring firms and their employees. However, the tax concessionson the creation of pension funds should be dependent on the equitable treatment of employees and on adequate funding.
10.96 Vesting. In the DC personal pension plans (as well as in DC company schemes), there should be immediate and full vesting. In deflned benefit schemes, however, immediate, full vesting is difficult to justify as it is likely to be too expensive and disruptive for sponsoring firms. Deferred and graded vesting should be allowed, but subject to a requirement that pension rights be fully vested within 10 years of service.
10.97 Portability. In personal pension plans, the portability of accumulatedpension reserves between different plan administrators should be free, subject perhaps to a fee for covering the administrative expenses of closing and opening accounts. The actual transfer of funds may also be subject to a minimum notice of a few months.
10.98 In funded, company-based,DC schemes, the portability of accrued and vested pension rights to approved, funded schemes operated by other comparies should be allowed after a minimum period of service. For DB plans, the terms and conditions of the transfer should be set by the respective actuaries on the basis of reasonable and generally acceptable actuarial assumptions.
10.99 Terms of Payment. In all types of plans, pensions should be payable on reaching the normal retirement age specified in each plan. Lower pensions may be payable to employees reaching a specified early retirement age. Pensions should be payable in the form of annuities, but with an option to convert a fraction of the discounted value of pension benefits to a lump-sum payment. - 151 -
10.100 Indexa,oJM. Plan administratorsand sponsoring companies, in the case of DS, company-basedschemes, should be required to offer indexed pensiors.
10.101 Transparency. All types of pension plans should be required to issue an annual statement to participating employees with details of their accrued and projected pension benef'ts, including details of any supplementarybenefits such as life and health insurance. In the case of personal pension and other DC plans, such statements should also indicate the rate of return achieved on invested assets and the cost of administrationof the funds.
10.102 Funding. Personal pension plans and other DC schemes are, by definition, fully funded. DB plans should be required to maintain adequate funding levels with some flexibilityprovided on the rate of annual contributionsto fund uncovered accrued liabilitiesand on reversals of contributionsif plans become overfunded.
10.103 Investment Rules. Investment rules similar to those recommended for life insurancebusiness should be promulgated (see previous section). These should specify maximum limits of asset holdings by major groups of assets and by individual issuers of securities. Pension plans should be allowed to invest a proportion of their assets in approved foreign securities and should be required to invest in indexed instrumentsand other assets that are protected from unexpected inflationaryshocks. Limits should also be set on investmentsin related concerns (includinglimits on investments in the assets of sponsoring companies, in the case of company-basedplans).
10.104 Plan Termination. The terminationof personal pension plans does not arise. Plans would continue to accrue investment income until retirement, even if no further contributionswere made. Plan terminationsof company-basedschemes, like plan formations, should require the approval of the regulatory agency. Sponsoring companies should be required to respect the vested pension rights of its employees and of those already pensioned. In addition, sponsoring companies should be subject to a tax clawback on any funds withdrawn from the plan.
10.105 Regulatory and SupervisoryAgency. A single regulatory agency, EISA, should be empoweredwith overall responsibilityfor issuing secondary regulations,as necessary; for authorizing the formation, amendment and terminationof company-basedpension plans; for authorizing the establishmentof specializedplan administrators;and for supervising all plan administratorsto ensure compliance with all existing rules and regulations. ILlsurancecompanies that are already authorized should not be required to seek separate authorizationto engage in pension business.
10.106 All plan administratorsshould be required to submit regular reports to the regulatory agency on the financial standing and performance of the plans under their administration. The regulatory - 152 -
agency should conduct on-site inspection at regular intervals to verify the correctness of the financial informationcontained in the regular reports of plan administrators.
10.107 SUDerVisionand Control. PFs must be supervised rigorously in all normative aspects required by law, and, for that purpose, the controlling institutionshould:
(i) have the hig!oesttechnical and professional cadre, including at least 5 graduates in business or economics, 5 financial analysts, 2 systems analysts capable of develop- ing and adapting computer programs, 3 programmers and a variable number of auditors, depending on the number of PFs to be controlled ;ao less than 1 auditor for every 10 PFs);
(ii) have a head officer appointedby, and directly reporting to, the President of the Republic, the Prime Minister, or Congress who would remain in 'is post for a previously determined period of time; to remove him from his post before that time would require the agreement of Congress;
(iii) forbid officials to work for a controlled institution for a period of five years after they leave the institution;
(iv) offer wages comparable to those of the entities under control, so as to have equally qualified personnel;
(v) be empowered to act promptly and without bureaucratic obstructions. The director should give orders and assume responsibilitywithout consulting councils or committees;
(vi) be empowered to liquidate a PF in special cases, as well as to apply fines to administrators;
(vii) be able to control the primary and secondarymarkets with regard to PF transactions,notwithstanding the powers of other controlling organs; and
(viii) respond to appeals to courts against fines and sanctions imposed by it.
10.108 InformationDisclosure. In addition to the disclosure of different pension plans, includingadministrators' commissions, informationon the financial standing and the performance of individual administratorsneeds to be made public. Currently, there is no informacionof this kind available. The market would benefit from timely and fully disclosed financial information. The public identific"tionof troubled administratorswould bring pressure from the rest of the financial community to bear on them. This step would also prevent pressure from being exerted on a regulator to delay early action. This depends on the willingness of the authorities for such - 153 -
disclosure as no legal restrictionsexist at present against disclosure. In addition, thc financial statements 2 administratorsshould be audited by sxternal, independontaudizors, according to instructions issued by EISA.
10.109 Tax Treatment. The consumptiontax principle should be fully applied to all types of contractual savings (ChapterV and Annex V.1). This would imply either the full deductibilityof contributions and other additions to contractual savlngu and the exemption from tax of investment returns, while taxing pensions as any other source of income, or, alternatively,not allowing the deduction of contributionswhile granting tax .,xemptionstatus to investment returns and pension benefits. To encourage the eatablishmentof supplementary funded occupational. pension schemes, consideration could be given to imposing a special tax on government bonds but rebating such a tax to pension plans.
10.110 TiMing. The reforms advocated above should be undertaken as soon as possible to create a regulatory framework conducive to the rapid development of pension plans and to the promotion of contractual savings. A system of compulsory contributions to personal pension p-%ns, combined with a system of compulsory group life insurance, holds high promise for the generation of substantial long-term financial savings in a relatively short period of time.
Government Reform Program
10.111 In line with the proposed reforms outlined above, the Government has undertaken to review the regulations of the private complementary pension funds to improve investment rules, to introduce portability of pensions, and to strengthen solvency monitoring along international prudential standards. It will also introduce enabling legislationand executive regulations for the creation of voluntary defined contribution complementary private pension funds to operate alongside the existing defined benefit ones. These reforms will be supported by the SAMP. The review of regulations and preparation of enabling legislation will be completed by December 1993 and implementation will begin by July 1994. CHAPTERXI
A PRQPOSALFOR REFORMINGTHE EGYPTIANSOCIAL INSURANCE
ANDP1RIVATEPENSION SYSTEMS
I. Overvie
11.1 As discussed in the previous chapters, contractual savings economics involves a wide array of issues, including the tax treatment of insurance and pension plans, the regulation and supervisionof CSIs and the effects on public finance, labor markets and income distribution. Only a comprehensiveprogram of reform that takes into considerationall of these related factors would provide a significant and unambiguous contributionto the development of the Egyptian economy. In contrast, a narrowly focused approach -- simply introducing a forced saving scheme -- might worsen conditions in labor and financial markets. The proposal presented here aims at a comprehensive,rather than a narrow, reform.
11.2 This chapter describes an integrated set of proposals to reform the social insurance system and private pensions in Egypt. The reforms primarily involve wage and salary workers in the formal sector. The aocial insurance programs that protect these workers are the most significant in the country. Workers in other sectors, where information about labor incomes is less relia-le, would continue to receive social insurance under separate systems.
11.3 The main goals of reform are to:
(i) improve the efficiency and equity of the overall pension system;
(ii) provide covered workers with old-age, disability, and survivors' pensions that are adequate relative to their previous earnings;
(iii) minimize poverty among those retired and disabled workers who have spent full careers in covered employment;
(iv) assure tbe solvency and long-term credibility of the public insurancesystem;
(v) increase the transparencyof the benefit formula, improve the indexation of public social insurance benefits and strengthen the perceived link between contributionsand benefits;
(vi) minimize labor market distortions;
(vii) reduce administrativecomplexity; - 156 -
(viii) minimize the extent of transfersbetween the insurance system and the Egyptian Treasury (the public social insurance system should be self-sustainingand independentof state subsidies);
(ix) assure the adequacy of reserves in a privately managed supplementarypension scheme; and
(x) contribute to the developmentof private capital and financial markets in Egypt.
In addition, the developmentof CSIs may reduce the economy's vulnerability to financial crises by creating a stable demand for long-term public debt. This may encourage capital inflows, reduce real interest rates and increase the efficiency with which domestic savings are allocated and mobilized.
11.4 An important philosophy underlying the reform is that the Government should not use more than one or two specific policies to redistributeincome. Introducingredistribution into each and every government program is a prescriptionfor cumbersome, inefficientand overly complex programs. Also, encouragingexcessive labor movement from the formal to the informal sector and deterring mobility within the formal sector should be avoided.
11.5 Another philosophy underlying the reform is that a publicly managed social insurance system must play a central role in assuring adequate retirement incomes for low- and average-wageworkers. Because this function involves redistributionbetween poorly paid and well-paid workers, a compulsory public role is essential. Moreover, a purely private contributorysystem could not guarantee adequate retirement incomes to low-wage workers because of the uncertaintyof long-run real returns in private capital markets. At the same time, a supplementary private pension system could provide an ideal vehicle for providing adequate retirement incomes to highly compensatedemployees. Finally, a prudently supervised private pension system could contribute to the developmentof modern capital markets in Egypt.
11.6 Many countries have implementedplans with objectives similar to those stated above, though the methodologieshave differed from country to country. The changes that Egypt could adopt range from revising its current social insurance system, without altering its defined betiefitcharacter, to graduallyphasing out the system and replacing it with fully funded, DC schemes. Naturally, the specific economic and legal choices will be made by the Egyptian Government itself.
II. Outline of Basic System
11.7 For wage and salary workers in the formal sector, the current Egyptian pension system is comprised of three principal elements: (a) basic public insurance scheme that insures workers' - 157 - earnings up to a moderate level (LE 250 p.m.); (b) supplementarypublic scheme that offers extremely inadequate insurance on wages above LE 250 p.m.; and (c) purely voluntary private scheme that provides supplemental prot,ction to a minority of mostly well-compensatedworkers. A very small number of workers are enrolled in private schemes that fully or partially replace the first two (public)elements in this overall system.
11.8 The reformed system would include three pillars to assure adequate retirement incomes: (a) a basic, fully-fundedDB public scheme thav insures workers' earnings up to a moderate (but presently undetermined) level; (b) a new funded compulsory private system that insures workers' wages above this moderate level through DC private pensions; and (c) a purely voluntary private scheme that could supplement the pensions and insurance provided under the first two compulsory programs. The systems under (b) and (c), although privately managed, would be publicly supervised. The small number of formal- sector workers, who are presently insured under alternative (replacement)private schemes, would be forced to enroll in the compulsory public and private insurance systems.1 The present supplementarypublic system, which insures workers' variable wages, would be phased out altogether. We do not propose including self- employed workers or Egyptians working abroad in the reformed public system at the current time. These workers are already covered by other public programs and should probably continue to be covered under those programs until reliable methods can be devised to measure their annual earnings.2 However, we would encourage the Egyptian authorities to provide the opportunity for self-employedworkers and Egyptians working abroad to participate in the private schemes.
11.9 One other change in the current social insurance system is also recommended. The end-of-service indemnities should be funded outside the public social insurance system. Since these indemnities are strictly proportional to workers' wages and creditable years of service, they involve no significantredistribution between workers. There is, thus, no strong argument for government involvementin funding the
1J The funds accumulatedby this system would be redistributed to the public social insurance system to cover the corresponding liabilities under the social insurance benefit formula, and the remaining assets would be placed in the compulsory private pension scheme. yJ If annual earnings cannot be accuratelymeasured, it is not feasible to include independent or foreign workers in the reformed basic pension program. The reformed program involves some redistribution in favor of full-career workers with low lifetime earnings. If self-employedworkers can hide an importantfraction of their annual earnings, they can receive improper windfall benefits under the basic public scheme. For that reason, they should be excluded from the plan. - 158 -
indemnities. They could be financed as part of the private pension scheme or, alternatively,as a separate liability of all employers in the formal sector. In either case, the liabilities should be funded as they accrue, and employers should set aside real reserves to pay for the liabilities,possibly in funds managed by the same private organizations that administer the private pension plans.
11.10 Under the reformed system, the public social insurance system would continue to be responsible for assuring minimum retirement incomes, but the new private compulsory pension scheme would assume responsibilityfor providing adequate retirement incomes to well-paid and highly compensatedworkers. As under the current basic system, the public system would offer defined-benefitpensions under a formula that contains a relatively generous minimum pension for workers who have spent a full career in covered employment and who retire at the normal retirement age.
11.11 The compulsory private plan would supplement the publicly provided pensions with payments from a defined-contributionpension plan. That is, a fixed percentage of wages would be placed in individual saving accounts where they would earn market-determined returns. The individual accounts could be managed as part of sirgle- employer pension funds or as part of larger, multi-employerfunds. The funds would be managed outside the present public social insurance system, although they would be subject to strict regulation and public supervision to guarantee their safety. Workers, or their beneficiaries,would receive their contributionsplus all accumulated returns upon retirement,disability or death. The payment could be received in the form of an annuity or as part of a package that includes a lump-sum distribution,as well as an annuity.
11.12 Both the basic public pension, as well as the compulsory private pension, should be portable across employers in the formal sector. Vesting in the public social insurancepension would require contributionsover a minimum number of years, while vesting in the defined-contributionprivate pension plar.would be immediate. Workers who leave covered employment in the formal sector should be prevented from withdrawing their contributionsfrom the public and private plans until they attain the normal retirement age or become disabled. The purpose of pension contributionsis to insure workers against the loss of earnings due to old age, disability or death. Hence, contributions into the funds should continue to accumulate until one of these events occurs.
III. Advantages of the Reformed System
11.13 The proposed reform offers several advantages over the current Egyptian system. First, the new system is much more transparent than the existing system. It is clearly the responsibilityof :he public system to provide minimum retirement incomes, as it is -he responsibilityof the private scheme to provide earnings-related pensions to highly compensatedworkers. Second, the link between - 159 -
contributionsand eventual benefits is also much clearer. Benefits under the reformed pension formula would directly depend on average covered wages and years of covered service. The connectionbetween contributionsand benefits under the supplementaryprivate pension is very straightforward. By strengtheningthe link between contributions and benefits, the proposed scheme improves economic efficiency. If a worker perceives that benefits are unrelated to contributions,the contributionis equivalentto a pure tax on labor earnings, driving a distortionarywedge between the output of workers and the marginal reward to working. This distortioncan be especiallyburdensome in a labor market with a large informal sector, wbere the tax can be avoided. If the tax can be avoided in an uncovered sector, workers are provided with a strong incentive to find employment in that sector, and employers are provided with an equally strong inducementto create employment opportunitiesthere. The DC program provides a clear link between contributionsand benefits, increasingthe likelihoodthat workers will perceive the contributionas part of deferred compensationrather than as a tax. Thus, the reform raises the attractivenessof employment in the formal, social-insurance-coveredsector.
11.14 A third advantage of the reform is that it is administrativelyeasier to manage. The public pension is simpler to administer for two reasons. Pensions would be calculated on the basis of wages up to a specified maximum. The distinctionbetween basic and variable wages would be eliminated. If transfers between the public pension system and the Egyptian Treasury are halted, the financial position of the social insurance system would also be far easier to understand and manage, and would be put on a sounder basis if the reserves were to earn market rates of interest.
11.15 Fourth, the private funding of erd-of-serviceliabilities and the development of a large private pension system can contribute to the maturation of an efficient private capital market. The reserves of the present social insurance system are largely invested in the NIB, where a few public officials aze responsible for allocating investment funds across projects. The projects in which they have invested have historicallyyielded negative returrs to the social insuran_e funds, implying that many of the projects would not pass a market test. In the reformed system, a much higher percentage of pension reserves would be held in or managed by private insurance funds. Managers of these funds would be forced to seek out investmentopportunities with good returns. If they failed to find good investmentopportunities, covered workers would seek to aove their accounts to pension funds where returns were higher.
11.16 The reserves of the SIS would be invested through private insurance funds and in public debt instrumentsthat earn market rates of return. The public pension system must also hold precautionaryreser-zes in order to maintain a buffer against unexpected economic events, such as recession -- which can sharply reduce contributions -- and inflation -- which can raise the system's liabilities to current pensioners. - 160 -
These reserves must be invested in tradable and secure assets, primarily Egyptian government securities.
IV. The Reformed System
11.17 Basigc ublic System. The current public social insurance system consists of two elements, one that insures basic wages (wages below LE 250 p.m.) and a second that insures variable pensions (wages between LE 250 and LE 625 p.m.). The suggested reform package is intended to minimize transition problems from the old to the new system. The first component of the existing system, with some changes, could constitute the basic public program under a reformed system. The second component of the existing system should be abolished altogether and replaced with a compulsory private program. The present variable pension program fails to provide worker with pensions (retirement, survivors' and disability) that replace a meaningful or predictable percentage of lost earnings. For young workers who expect to work a full career in covered jobs, the system imposes high taxes for very small and uncertain future benefits. The functions of the current variable pension system should be assumed by a new private pension system. The current distinctionbetween basic and variable pensions should be eliminated. Both types of wages should be combined under a single definition. The reformed system should, instead, make a distinctionbetween the public pensionable wage -- say, wages below LE 300 p.m. -- and the private pensionable wage -- the amount of the total wage in excess of LE 300 p.m. (This benchmark wage should be indexed.) Without additional informationabout the distributionof wages in Egypt, it is impossible to make an exact determinationof the best level of the maximum public pensionablewage (see below).
11.18 Redistributionbetween highly paid and poorly paid workers must take place within the basic public social insurance system. The principal goals of the system should be to provide dependable basic pensions to all covered workers and to minimize the extent of poverty among families of retired, disabled or deceased workers who have served full careers in covered employment. A dependable pension can be offered if the basic pension formula makes explicit allowance for wage and price inflation. The promised pension should replace a predictablepercentage of a worker's average real earnings after a full career in covered employment.
11.19 The current pension formula provides a reasonable,though perhaps overgenerous,formula for computingbasic pensions when there is no inflation. The worker's replacementrate rises by slightly more than 2 percent for each year of creditable service in covered employment, with a maximum allowable replacementrate of 80 percent. This basic formula can be retained. However, the referencewage should be changed. The present reference wage is the unindexed average wage during the worker's last two years in covered employment. This should be modified in two ways. First, the reference wage should reflect the worker's real, rather than nominal, wage during the reference period. (Preferably,the indexing factor applied in adjusting past nomirnalwages - 161 -
ahould reflect the year-to-yearrise in average covered wages rather than in average prices.)
11.20 Second, the reference period should be extended to reflect more than two years' wages. The present reference perioxdis so short that workers and their employersare provided strong incentivesto defraud the social insurance system. By permitting workers nearing retirement to work extraordinarilylong hours or by granting them excessive (though brief) wage increases,employers can greatly increase the size of a worker's pension without significantlyraising the worker's lifetime contributionsto the system. This type of fraud can be minimized by lengtheningthe period used to calculate the reference wage. Ideally, the referenceperiod would eventually include all but the lowest 5 or 10 years' wagas, with fd.l iLndexationfor inflation, from the time the worker attained age 20 until he reached the normal retirement age. For a full-careerworker retiring at age 60, this would represent a period of 30 or 35 years. In the short run, this formula would not be feasible. The social insurance authoritiespossess 30 years' wage data for only a few workers. However, the new reference wage definition could be phased in over time, with the reference period being extended by one year as each new year of informationbecomes available.3
11.21 It is unclear whether the combined effect of the two proposed changes would raise or lower average pensions. The indexation of the reference wage would certainly raise initial pensions, but the extension of the reference period would eventually lead to lower pensions for workers whose real wages rise strongly over their careers. In any event, the basic pension would be a much more predictable percentage of workers' real wages than it is under the present formula.
11.22 The basic pension should also attempt to minimize poverty. This could be accomplishedby introducinga minimum basic pension, which should be available mainly to families of workers who contribute to the basic system during a substantialpart (at least two thirds) of their potential careers and who do nor begin to receive old-age benefits until the normal retirement age. In a labor market in which the entire labor force is covered by a single social insurance system, & more generous minimum pension would be possible. However, in a market with a large uncovered sector, it is impossible to guarantee generous minimum pensions to workers who have only a few years of covered employment. Workers would find it advantageousto become employed briefly in the social-insura:ace-coveredsector, in order to become eligible for the
Assume that only 10 years' reliable wage data are available. The reference wage for a particular worker could be defined as the average indexed wage during that 10-year period, excluding the 5 years with lowest wages. The following yea=, when reliable data from an additional year is ava,lable, the reference wage could be based on the average wage in the 11-year period, excluding the 5 years with the lowest wages. - 162 -
generous minimum pension. While advantageousto workers, this strategy would be extremely costly to the social Insurance fund.
11.23 A feasible minimum pension scheme might offer a minimum pension equal to 60 percent or 70 percent of the minimum monthly formal- sector wage. The full minimum pension would only be available, however, to retired or disabled workers who have worked full careers in covered employwent. An example can illustrate how this scheme might be implemented. A worker retiring at age 60 is presumed.to have a potential career beginning at age 20 and lasting 40 years. If the worker has made social insurance contributionsfor a minimum of, say, 30 years -- 75 percent f the years between age 20 and age 60 -- he is deemed a full-careerworker and is entitled to receive at least the minimum pension. If the worker made soeial insurance contributions during only 20 years, he would be eligible for a minimum pension of just two thirds (20 years/30 years) of the minimum pension available to full- career workers.4 In this way, the minimum pension scheme could guarantee decent retirement incomes to low-wage, full-careerworkers without extending a similar degree of protection to workers who have brief _areers in the social-insurancecovered sector. LTnderthis scheme, poorly paid workers would have a strong incentive to find and keep jobs in the formal sector.
11.24 In order to ensure that the basic public pension remains adequate throughout a worker's retirement,pensions must be indexed to inflation. A simple indexing scheme would adjust pensions in force to reflect the previous year's price inflation. Over time, prices usually rise more slowly than wages, implying that pensions in force would rise more slowly than the taxable wage base. The faster wages risu relative to prices, the lower the contributionrate required to support any given pension formula.5
11.25 Unfortunately,indexing pensions to prices can lead to dangerous jumps in the pension system's cost rate if real wages unexpectedlyfall. For example, if real wages fall 20 percent and pensions are indexed _o price inflation, the cost rate will jump one-
_4/ It is straightforwardto extend this scheme to cover survivors' and disability pensions. For each deceased or disabled worker, the potential duration of a full career could be calculated as the number of years between attainmentof age 20 and the age of death or disability. Workers with covered earnings in at least 75 percent of those years would be deemed full-career workers and would be entitled to full minimum pensions. Workers with earnings in fewer years would be eligible for a reduced minimum pension.
.~/ When pensions in force are indexed to price inflation,the indexing scheme protects the standard of living of retired workers, but it does not permit a retiree to share in the improvement in workers' standard of living that might occur after the retiree began to collect his pension. - 163 -
quarter. (In a DB system the jump in the cost rate must eventually resultin an equivalentincrease in the contributionrate imposedcm activeworkers.) It seems unfairto raise the tax burdenon workerswho have suffereda loss in their standardof livingin order to protectthe livingstandards of retirees. An alternativeindexing scheme would adjustpensions in forceby the rate of price inflationso long as it is no higherthan the rate of wage inflation. When price inflationexceeds wage inflation,the adjustmentin pensionsin forcewould be limitedto the changein averagewages. 6 This indexingvcheme provides reasonable protectionagainst inflation to retireeswhile, at the same time, protoctingthe solvencyof the socialinsurance system. 11.26 The basic socialinsurance system must be adjustedto reflectinflation in anotherway as well. The reformedpublic system is intendedto insurolow and moderatewages. The currentbasic pension systeminsures wages below LE 250 p.m. Wages above this le.valare noc subjectto taxation,nor are they replacedwhen a workerretires. Becausenomina'l wages are .sing,this earningslimit shouldbe adjusted each year. Otherwise,the basic pensionwould becomeincreasingly irrelevantover time. In addition,rhe contributionrate would have to climb sharply in order to pay for pensions in force, which rise at the rate of price inflation. The Governmentis introducinga schemewhereby the maximumbasic wage would graduallybe adjusteduntil it reachesLE 500 per month.
11.27 It is not clearhow fast the taxablewage limit shouldrise, however. This dep3nds,in part, on how the Egyptianauthorities wish to definea "moderate"wage. The higherthe taxablewage limit,the larger the proportionof Egyptianworkers who would receivevirtually all of their retirementincome under the publicprogram, and the smallerthe scope of the compulsoryprivate pension program. (The end-of-service indemnitywould be receivedunder a privatelyfunded scheme, however, even in the e of low-wageworkers.) On the otherhand, the higher the taxablewage base, the lower the contributionrate that would be needee,to financea publicpension scheme with a comparativelygenerous minimumpension. The need for a relativelygenerous minimum pension should decline s average wages rise. When Egyptian real wages and livingstandards improve, it, therefore,seems sensibleto gradually increasethe scope of the privatesystem and reducethe scope of publicly provided social insur&nce. 11.28 The basicpension should be a fully fundedDB scheme. The requiredcontribution rate would dependon the cost rate (the ratio of pensionpayments to total coveredwages), the level of desiredfunding and the rate of return achieved on accumulated reserves. The cost rate, in turn,would dependon two main factors:the ratio of pensionersto
61 When real wages once again begin to rise, pensionscould then be permitted to rise at the rate of wage changes for one or more years. Pensionscould be allowed to rise faster than prices until the initial real level of pensions is once again attained. - 164 -
active workers (the dependency ratio) and the ratio of average pension payments to average covered wages (the average replacement ratio). The rate of return would depend on the yields of the assets in which the reserves would be invested.
11.29 If current eligibility standards are left unchanged, a sharp rise in the depev%.encyratio is inevitableover the next three decades. Mortality rates are falling, and a rising percentage of workers are reaching retirement age with insurance coverage under the public pension system. To slow down the increase in the dependency ratio, it may be necessary to tighten current eligibilitystandards. Three features of the present system appear exceptionallygenerous.
11.30 First, the normal retirement age is only 60 for a worker who h,asmade social insurance contributionsfor at least 10 years. Given the present trend in Egyptian mortality rates, this low retirement age implies that typical workers can expect to spend a large fraction of life in retirement. While it is not necessary to raise the retirement age immediately,it mlght make sense to raise the age of eligibility for full retirement benefits gradually over a 10-year period, to 65.
11.31 Second, workers under 60 are eligible to receive extraordinarilygenerous early retirement benefits. The early retirement age should be raised, in stages, to age 60, and workers electing to receive pensions between ages 60 and 64 should receive monthly benefits that are actuariallyfair relative to the full benefit that is available at the normal retirement age.7
11.32 Third, current eligibilitystandards for survivors' and disability pensions are extremely liberal. Workers or their survivors become eligible for these pensions after just three consecutivemouths, or a total of six intermittentmonths, of covered employment. It seems reasonable to require that workers make contributionsto the social insurance system for a minimum of three or five years before they become fully eligible for these kinds of pensions. During these initial years eligibilityfor beneflts should accumulate in a graduated manner, in line with months of service. Any of the three reforms just mentioned would slow the rise in required contributionsthat could otherwise be expected over the next few decades.
11.33 To calculate the contributionrate needed to finance the proposed system, it is necessary to obtain detailed informationabout mortality rates, disability rates and retirement rates in the covered
1/ An actuarially fair early retirement benefit is one whose expected lifetime value is exactly the same as the lifetimevalue of the full retirement benefit that becomes available at the normal retirement age. Since a worker expects to receive an early retirementbenefit during more years than he can receive a normal retirement benefit, the monthly amount of the early retirementbenefit must be less than the monthly amount of a normal retirementbenefit. - 165 -
population. Such informationis not presently available to the World Bank. In addition, it may be necessary to obtain reliable estimates of the correlationbetween workers' average earnings and their tenure in covered employment and expected mortality rate. Without this kind of information,it is impossible to compute the tax rates that would be needed to finance the proposed scheme. The required rate, however, is likely to be substantiallylower than the current basic contribution rate.
11.34 The reduced level of required contributionsshould be reflected in a lower level of payroll taxes. This would improve labor market efficiency in two ways. First, the very high contributionrate drives a wedge between the compensationthat firms pay for and the compensationthat workers receive. This wedge distorts workers' and firms' choices about the optimal amount of labor that should be used in the production process. Second, the large wedge creates a strong incentive for workers to find employment,and for firms to create employment, in the untaxed, informal sector.
11.35 The scheme outlined above assumes there would be a clear demarcationbetween the wages that are insured under the basic public scheme and wages that are insured under the new private pension system. The main advantage of this system is that it is easy to understand, especially in relation to the current Egyptian social insurance system, which distinguishesbetween basic and variable wages. The pension formula of the new public system could be similar to the formula under the existing basic pLnsion system, thereby easing transition problems and reducing the need to compensate workers or pensioners for benefit loss's.
11.36 The one maJcr shortcomingof the reformed system is that the tax base for the public system would be limited to the public pensionablewage. All redistributionin the system would have to take place within this limited tax base. Workers with wages substantially above the public pensionablewage would not contribute any more toward redistributionthan workers with wages near the taxable wage limit. This seems undesirable,inasmuch as high-wage, rather than moderate- wage, workers should be expected to contribute the most toward redistribution. If the Egyptian authoritieswish to stress redistribution,this will push them toward adopting a high taxable wage limit. If private pensions are only supposed to insure wages above the taxable wage limit, a very high limit will greatly reduce the scope of the new private pension scheme. The smaller the private scheme, t&ae l3ss it will accumulate in privately managed reserves.
11.37 One way to permit greater redistribution,while at the same time increasing the scope of the new private pension schemc, is to adopt an alternativebasic pension formula and a different kind of compulsory defined-contributionformula. For example, the maximum public pensionablewage could be raised to, say, LE 400 p.m., but the public pension formula could be revi:ed to reduce the replacement rates - 166 -
available to high-wage workers.8 In order to make up for the low public pensions being offered to workers with wages near the maximum public pensionable wage, the private scheme could be made compulsory for workers with wages somewhat below the maximum public pensionablewage. For example, the compulsory contributionto the private scheme might be equal to zero percent on wages below LE 200 p.m., 7 percent on wages between LE 200 and LE 400 p.m., and 14 percent on wages above LE 400 but below LE 1200 p.m. Workers earning less than LE 200 p.m. would participate in the public social insurance svstem only; workers earning between LE 200 and LE 400 p.m. would make modest contributionsto the prifate scheme, depending primarily on public pensions; and workers with wages above LE 400 p.m. would primarily rely on private pensions for old-age, disability and survivors' insurance.
11.38 While this type of system would permit a greater amount of redistributionwithin the public social insurance system, it would be somewhat more complicated to administer and less transparent to participants,and it would present more difficult transition proUlems. Moreover, there is some question regarding how much redistributionis possible within a social insurancesystem that covers only a moderate share of the total work force. Affluent workers who are heavily taxed in order to guarantee generous pensions to retired low-wage workers might seek employment or supplementaryincome in the uncovered sector, limiting tho practical scope of redistribution.
11.39 Transition Problems. The reformed basic public pension system raises few transition questions. The proposed pension formula is more generous than the current formula in some respects and less generous in others. If pensions are actua,ly indexed as proposed, they would certainly be more secure than existing public pensions. On the other I .nd, the long-run replacementrate under the reformed system would .e lower for some classes of workers than replacementrates offered under the current system. Since many of the proposed reforms would be phased in gradually, no current pensioner or older worker would be adversely affected. Thus, it does not seem necessary to compensate pensioners or current workers for the reforms through some kind of special transitionalscheme.
11.40 Compulsorv Private Pension Scheme. The second pillar of the reformed pension system would be one in which workers with incnmes above a certain minimum would bet.uU'gnted to contribute a specified percentage of their excess earnings to a defined-contributionprivate
1/ Under the current formula, old-age pensioners receive a replacement rate that rises a bit more zhan 2 percent a year for each year of creditable employment. Under a revised formula, the replacement rate could be reduced slightly for every LE 10 increase in the reference wage. Workers with reference wages near the taxable maximum wage -- LE 400 in our example -- might receive replacement rates that are only half as high as workers with low referencewages -- say, LE 75 p.m. - 167 -
pension fund. The system would be managed by the private sector through individual pension funds and insurance companies.
11.41 The new pension funds would be open to any worker required to make mandatory contributions. Funds would compete among each other to obtain the participationof workers on the basis of lower costs and better services. The pension funds would all be privately managed, but they would be subject to careful regulation and close public supervision. Each worker would maintain an individual account with one of the funds. Contributionswould be automaticallywithheld from wages by employe-rsand placed in the individual accounts. Interest and other income would be earned on the contributionsin proportion to the earnings obtained by the entire fund. These earnings would, in turn, reflect the success of the fund managers in investing the contributions of participatingworkers. Each fund would prepare annual reports for its participatingmembers, explaining the recent investment performance of the fund and showing the value of each member's current holdings.
11.42 The compulsory contributionwoali be withheld from earnings in excess of the public pensionablewage but below some maximum contributionlimit. Initially, the maximum contributionlimit could be the same as the upper limit of the variaole wage (LE 625 p.m.). This maximumnshould be ratsea to reflect the year-to-yearrise in Egyptian salaries. If the contributionrate on the private pensionablewage9 is 10 percent and the real earnings of the fund are 5 percent p.a., a typical fund should be able to replace approximately 70 percent of average pensionablewages, in the ca3a of a worker who has steadily contribated to the fund for 37 years. Disability and survivors' pensions (term life insurance) on the private pensionable wage would have to be financed out of an additional contribution,amounting to perhaps 3 percent of the pensionablewage. Nonetheless,the required contributionrate is substantiallylower than the current contribution rate on variable wages, and the benefit is likely to be substantially more generous.
11.43 Transition Problems. Unlike the reformed public pension, the new private pension raises important transition issues. The new plan replaces the public pension on workers' variable wages. Since variable per,sionswould cease, workers would have to be compensated for their previous contributionsto the program. Variable pensions have not been available for that long, however. They were established under Law 47 in 1984. Moreover, because of high inflation and an extremely defective indexing method in the benefit formula, promised benefits under the variable pension scheme are quite low, especially in the case of young and middle-aged workers. Consequently,the liabilities of the present variable pension program are modest.
.2/ The wage on which workers are obligated to make compulsory contributions to a private pension plan. - 168 -
11.44 A simple transitionprogram should be sufficient. Workers older than age 50 or 55 could be permitted to receive the variable pensions to which their previous contributionsentitle them. These pensions could probably be financed out of the financial reserves of the current system, which ought to be large relative to the accumulated liabilities. (Variablepensions are not automaticallyindexed to inflation, and the Egyptian legislaturehas failed to adjust variable pensions to reflect changes in wages or prices). Workers under age 50 or 55 ought to have some, or all, of their previous contributionson variable wages transferredto the new prIvate accounts.
11.45 If existing reserves are too small to permit a transfer of the entire amount of previous contributions,the Egyptian Treasury could, instead, issue a recognitionbond for the remainder. This bond would be non-negotiableand would earn a rate of interest to be determined on the basis of equity, to avoid intertemporalincome aistribution. Thp upper limit on this interest rate would be the rate of interest credited on government bonds. However, this rate might prove inequitable. It is also far above the rate of return implicitly guaranteed in the current variable pension formula. (Because the indexing formula for variable pensions is so unfair to workers, the rate of return is probably substantiallynegative.) As a more equitable alternative,the recognitionbond could be credited with a 6 percent nominal return. This is the return offered to workers who withdraw from the present basic pension formula. Under that formula, workers who withdraw from the basic social insurance scheme before gaining eligibility for old-age pensions are compensatedwith a lump-sum payment equal to 15 percent of the referencewage multiplied by the number of years of contributionsto the system. This lump sum is not payable until the worker reaches age 60, becomes disabled, or dies. The amount is raised only 6 percent p.r-:.between the time the worker leaves covered employment and the time the quialifyingevent occurs.
11.46 Whatever the interest rate the Government decides upon, the recognitionbonds would mature at the time a worker retired, became disabled or died. If, alternatively,the Treasury issued a recognition bond ior the benefits that accrued under the variable pension program, the bonei would be extremely small, inasmuch as the variable pensions have very little real value.
11.47 Fiscal Implicationsof the Reforms. A more significant transition problem is the effect of the proposed reform on the Government'soverall financial position. The present system of basic and variable public pensions generates large surpluses. Worker and employer contributionsare much higher than needed to finance current benefits. The surplus is placed in the NIB, where it is invested in low-return investment projects largely chosen by the state. Under the reformed system, the basic public social insurance system would continue to be financed on a fully-fundedDB basis. At the same time, the variable public pensicn system -- which currently generates large surpluses -- would be turned over to private pension funds. - 169 -
11.48 The reformed system would contribute to long-term savings in two ways. First, the surpluses in the fully-fundedDB public scheme would be invested in short- and medium-term securities. Second, the contributionsto the compulsory private system would, for many years, yield large increases in the flow of savings to private institutions, primarily private pension funds. The private funds would channel these long-term savings into the public and private investment projects that appear to offer the best combination of safety and high yield.
11.49 However, the flow of social insurance contributions to the government sector would almost certainly slow down. One way to equitably reduce the impact of the reform on the state budget would be to eliminate income tax deductibilityon the pension contributionsof workers. Withdrawals from the pension funds after retirement would be tax free. Public finance theorists agree that it is equitable and efficient under a comprehensiveincome tax system to tax labor compensationonce. Compensationin the form of pensions could, thus, be taxed either when contributionsare made to the fund or when they are withdrawn. In either case, the worker wou'd pay a tax on the compensationjust once, and he would earn the after-tax rate of return (see Chapter V and Annex V.1). If an income tax is imposed on contributions,the state receives tax revenue sooner but may receive less revenue over a worker's lifetime.10 If income tax were collected on pension contributionsin Egypt, the extra short-term revenues would offset the financxal repression tax loss connected with the use of the social insurance surplus.
11.50 It is possible, of course, that the efficiency gains from the reformed system would eventually raise government revenues by enough to offset the losses from the lower contribution rate. By reducing the overall contributionrate for pensions and social insurance, the reform reduces the incentive of workers and firms to move to the informal sector in order to evade the tax. A higher percentage of national income would, thus, be earned in the taxed, formal sector, partly offsetting the loss of revenue from the lower contribution rate. The lower contributionrate might also spur higher work effort and output among workers and firms currently in the formal sector. Finally, the reformed system should yield a more efficient allocative mechanism for Egyptian savings. Instead of passing through the NIB, a greater percentage of savings would be channeled to irrestment projects through the competing private pension funds. If the projects yield a higher
.12/ Under a strictly proportional income tax system, the state would certainly receive less revenue because it would receive no taxes on the interest earnings of the fund. (In present value terms, however, it would receive the same revenue whether it taxed pension contributionsor withdrawals.) Under a progressivetax system, like the one in Egypt, the state might receive higher revenues if it taxed contributions. Since workers generallyreceive higher incomes than pensioners, it is reasonable to expect that they face higher marginal tax rates. - 170 -
rate of return than past projects undertaken by the NIB, national output and tax revenues should rise.
11.51 Before any reform package is adopted, tax authorities must carefully work out the detailed fiscal implicationsof the reform. At this stage of analysis, any predictions of net fiscal impact would be hazardous. Revenue should increase due to the collection of income tax on contributionsto pension plans and by a possible increase in the base due to an expansion in formal sector employment.11 Central government expenses would increase by eliminating the financial repression tax on the surplus of the SIS (about 2.9 percent of GDP, see Chapter III) but would be reduced by the elimination of future transfers to a self- financed pension system (about 0.8 percent in FY91, see Chapter IX). However, consolidatingthe accounts of the SIS, NIB and the central government may prove that the financial repression tax loss may be substantiallylower than 2.9 percent. This may be so because the SIS is overfunded (see Chapter IX), i.e., a substantialamount of its reserves may not be matched by SIS's liabilities.
11.52 Voluntary Contributionsto Pension Funds. Workers should be allowed to make limited, voluntary contributionson top of the mandatory defined contribution,with some restrictionson withdrawals (perhaps one withdrawal of voluntary contributionscould be made every three months). Income would accumulate in these funds tax free, and withdrawals would be exempt from income tax. Upon retirement, the worker would be able to combine his accumulated funds with his pension account, increasing the size of his pension. One advantage of such accounts is that they would enable low-incomeworkers to save through the financial system -- something that may now be impossiblebecause small accounts would be unprofitable for any financial institution. Also, firms could offer pension plans in excess of the mandatory, DB and DC contributionplans.
11.53 Regulatory Framework. The efficient functioningof private pension plans requires an adequate system of prudential regulation and supervision and a system of investor protection that includes appropriate accounting standards and informationdisclosure to investors. The formulation of detailed regulations requires consideration of many economic, legal and political issues. The basic principles that should guide the new regulatory framework in Egypt are spelled out in Chapter X, and the specific regulationsare presented in Annex X.1.
11/ The mission was unable to obtain the infcrmationneeded to perform this estimate. CHARTER XII
THE SECURITIES MARKET
I. Introduction
12.1 The Government has been concerned for some time about the need to reactivate the securitiesmarket. In 1991, the Government asked the World Bank for assistance in this area and the resultant reform program is described in the World Bank sector report, "Reform and Development of the Securities Market."1 Drawing on that report and incorporatingthe analysis of new measures undertaken by the Government, this chapter assesses the role of the securities market since n Lonalizationin the 1960s; identifies the priority areas where de elopment is required; and summarizes the principal components of the ne4essary reform program.
12.2 The implementationof a reform program has already begun. It includes introductionof a new Capital Market Law (CML) and substantialchanges to existing regulatory and operational practices. Successful completion of the three-year reform program is expected to result in i) a more efficient securities market capable of serving as a revitalized source of capital formationand risk management; ii) broader ownership of economic assets; and iii) new types of securities and financial services, which, overall, will contribute to the creation of a more vibrant economy.
II. Hietorical Develoomentof the Securities Market
12.3 Summary. In the late 1950s the Egyptian securities mazket was an important source of funding for business. Today it is insignificant.
12.4. The economic dominance of the public sector, which has relied on public sector financial institutionsfor its funding since the nationalizationof most businesses in the 1960s, has contributed substantiallyto the underdevelopmentof the securities market. The revitalizationof the private sector now underway will create pressure for the reemergence of an active securities market. This will arise as a result of the renewed emphasis on private-sector-ledgrowth in the Government'sERSAP and the substantial increase in the supply of corporate secur .ies expected as a result of the Government'sPE reform and privatizationprograms. More than 300 PEs are mandated for conversion into joint-stockcompanies and listing on the stock exchanges.
12.5 Structural deficienciesand operationalpractices in the securities market themselves have also been important in holding back development. These center on inadequate regulation and supervision;
.~/ World Bank, Arab Regublic of Eaypt: Reform and Development of the Securities Market, February 1992 (Number 10337-EGT). - 172 - poor accounting, auditing and financialdisclosure practices; and anomalous and inefficientlisting and trading practices. Together theme have eroded public confidence in the fairness and transparencyof the market and failed to make the market an attractive vehicle for capital raising. The securitiesmarket reform program being implementedby the Government is directed to these problems.
12.6 A third impediment has been the bias in the tax code against corporate securities which makes it difficult to allocate capital efficiently on a risk-adjustedbasis. The proposed reforms in tax policy (Chapter V) and of CSIc (ChaptersVII and XI) address this issue and should significantlyexpand financial intermediationthrough the securities market.
12.7 Prior to Nationalization. The first stock exchanges in the Middle East were established in Alexandria and Cairo in 1883. By 1900, there were some 230 joint-stockcompanies with paid-up capital of LE 29 million.2 Corporate financing and stock market activity fluctuated during the first half of thn twentieth century, largely in response to changing internationalinfluences on Egypt's cotton-dominatedeconomy. By 1958, the number of joint-stockcompanies had increased to 925. All of these companies offered shares to the public by prospectus; some 275 were listed, and most of these were actively traded.
12.8 During the period following World War II, the private sector led the diversificationof the Egyptian economy into consumer products, intermediategoods and even some consumer durables, including fertillizer,automotive and refrigeratorassemblies, plastic ,roducte. paper, glass, cement, pharmaceutical,copper and detergents. Many of these companies were financed through the stock market. Between 1952 and 1955, for example, 56 now companieswere listed on the exchange, with total paid-in capital of rE 18.4 million.4 In 1958, an additional 36 companies were floated, with total paid-in capital of LE 9.5 million.5 Market activity peaked during the 1950s: in 1955, turnover amounted to LE 115 million, equivalentto 30 percent of the market value of listed securities,with as many as 1,000 daily transactions.6
2/ K.M. Barbour, The Growth. Location & Structure of Industry in EoyRt, Praeger, New York, 1972, p. 57.
3/ Robert Mabro, The Ea'ptian Economy, 1952-1972, Oxford, 1974, pp.142-3.
4/ The Stock Exchanae Yearbook of Egypt, various annual editions, 1952-1958.
5/ "ibi.,1958.
6/ National Bank of Egypt, Report of the 56th ordinarv_General Meetina (19551, 1956; and an interviewwith Mr. Mohamed Hamed Mohamed, broker, Cairo, October, 1991. - 173 -
12.9 Nationalization. The succesoivewaves of Egyptianizatior., nationalization,sequestration and exproprlationof foreign and Egyptian-ownedproperty between 1957-1963 radically changed the structure of the economy and had a devastating effect on the securities market. The number of listed companies fell from 275 in 1958 to just 55 in 1975.7 Turnover declined from LE 66.7 million in 1958 to about LE 4 million, on average, between 1963-1974,the year in which President Sadat introduced the Open Door Policy to encourage renewed private sector business activity.
12.10 The number of active stock brokers declined, along with transaction volume. From 76 brokers, representing47 brokerage offices in Alexandria and Cairo in the late 19509, the number of brokers declined to just 15 by the late 19809 and most of these were cnly marginally profitable.
12.11 Despite the devastatingeffect on the stock market, the exchanges remained private sector institutionsand were neither nationalizedor closed, except for a two-month period following the Expropriation Law of 1961, though a government suporvisor was introduced to monitor trading activity.0 In fact, beginning in 1964, the dwindling number of brokers were actually kept going by a modest annual subsidy from the Ministry of Economy, the CBE and the four public sector banks in the form of a salary paid to the brokers as commission advances. Commissionswere earned from the negligible amount of trading carried on by the four nationalizedcommercial banks.9
12.12 There were three reasons for the declining importance of the securities market following nationalization. First, the state, not the private sector, became the leading proponent of economic development wad the leading industrial investor. The Economic Organization,established as sequestratorof nationalizedproperties; the General Organization for the Execution of the Industrial Five-Year Plan (the al-Nasr Group); and the newly created Ministries of Finance and Planning initiated the concept of state investment and five-yeareconomic planning cycles. State investmentswere financed through state-controlledresources: the budget, foreign grants and concessionalfinancing, loans from the four large public sector banks, directed investmentsby such public sector financial institutionsas the Social Insurance Organizationand pension
7/ Accurate and consistent figures are difficult to find. CMA statistics indicate that the number of listed companiee declined to a low point of only 55 in 1975.
8/ As an indication of the deterioratingbusiness prospects of th.e private sector, the ratio of market value of stocks to nominal value fell from 146 percent at the end of 1960 to 97 percent at the end of 1962. CrE, Sponomic Review, 1961 and 1962.
9/ CBE, Economic Report, 1978, vol. XVIII, No 1, pp. 1-5. - 174 -
funds, as well as by substantialpublic borrowing. Only the latter passed indirectly,and in small part, through the securitiesmarket.
12.13 Second, the level of planned industrIal investment by the state dwarfed anything the private sector had managed before and was, arguably, beyond its resource limits. The first Five-Year Plan, beginning in 1960/61, envisioned industrial investmentsof LE 439 million.1 Indicative of th.eshift away from private 6actor investment (and rapidly declining private sector confidence in the economy), net bank and non-bank credit to the private sector fell LE 11 million in 1962, while public sector credit increased by LE 76 million.11
12.14 Third, what remained of the private sector after nationalizationdid not need to mobilize resources on a scale requiring the use of the securities market nor was it interested in sharing ownership with unaffiliated individuals. The nationalizationpolicy did not extend to small businesses-- those with under fifty employees -- and these remained active in the private sector. Despite the uninviting business environment,small-scale industriesmanaged to hold their own, and even to grow, in the local and export markets during the 1960s and 1970s. However, the aggregate share of the private sector in total industrial investment continued to decline, averaging only 4 percent between 1970-74.12
12.15 With the state in control of most of the medium- and large- scale industries in the modern sector, the private sector, which had utilized the securities market, was eclipsed, and the importance of that market as a source of capital declined, from 26.8 percent of net external private sector capital raised in 1958 to less than 2 percent from 1961 on. Henceforth,the pr'vate sector relied on internally generated funds and banks, and there is no record of new corporate securities being issued during the 1964-1974 period. Stock market capitalizationas a proportion of GDP declined, from 12 percent of GDP in 1958 to only 1 percent of GDP in the 1970s and early 1980s (Table XII.1, Appendix).
Reactivationof the SecuritiesMarket
12.16 President Sadat's Open Door Policy in 1974 began to have a positive impact on stock market activity in the early 1980s. Trading volume picked up gradually (Table XII.1).
10/ CBE, Economic Re2ort, 1961, vol. 1, No 4, p. 525. Compare this to the relatively modest new issue volume on the stock market in the early 1950s of LE 6-10 million annually.
11~/ CBE, Economic Report, 1963, vol. II, No 2. p. 183.
12/ Ikram, ov.cit., pp. 246-53. - 175 -
Table XII LI
Xgo=t: Cairo and_AlexandriaStock Exohancess Turnover 198411990 (millions) Average Annual l9aF 198_Z 198 19Q I=E Chancie (F)
Quantity of Shares 7 10 7 9 14 18.9
Value of Transactions (LE) 122 186 134 229 341 29.3
CPI Inflation (%) 23.9 19.7 17.7 21.2 16.8 19.8
Source Capital Market Authority.
12.17 Listina of Foreian Currency-DenominatedShares. The resumption of activity was prompted by two developmentsthat fundamentallychanged the characterof the market. First, foreign currency-denominatedshares were introducedin 1977 to attract non- resident Egyptian capital. This has been a positive development. Although most of the capital invested has been Egyptian-owned,the issuance of foreign currency-denominatedsecurities has helped to effectively internationalizethe local securitiesmarket. In part, am a result of the depreciationof the Egyptian pound, the value of foreign currency-denominatedshares on the stock market exceeded 50 percent of total market capitalizationby 1990.
12.18 Listina of Closely Held Comoaniws. A second, far more important,yet unfavorabledevelopment has been the growing number of closely held companies (those with 15 shareholdersor less) listed on the stock exchanges. Before nationalization,all listed companies had been offered to the public by prospectus. In contrast, the reactivation of the stock exchanges in the 1980s was led by the rapid addition of closely held companies to exchange listing. About 80 percent of the 418 companies listed between 1980-1990were of this sort. Their incentive to list arises from the tax law introducedin 1981, which promoted the formation and listing of joint-stockcompanies and their securities, without concern for broad securities ownership or the number of shareholders involved. The listing of closed companies has generated a profitable level of fee income for the exchanges; about 70 percent of total exchange income, on average, in 1989 and 1990 was derived from listing fees paid by closed companies.13 Moreover, listing of closed companies has resulted in a rapid growth in the broad listing aggregates (Tables XII.2 and AXII.2).
13/ Data supplied by the Cairo Stock Exchange, October 1991. - 176 -
TableXII1.2 EVDot: Stock Exhanae Listinas and Tradino by Tyge of Comnmnyat December31. 1290
Value Nuboer Traded Number Shares Shares Number X of Number as X of of X of Traded X of Traded X of Lisatd Lst Tra Listd Trades Traes t LE TM)otal MoL Total PublIcly Issued Coapanles 155 27X 99 64X 6825 93X 112 28X 15.0 53X Closed Companies Amfl flj11 530 TS 291 Zm I]A 47X Total 573 IOOX 210 37X 7355 100% 403 100% 28.1 100%
Source: CapitalMerket Authority
12.18 Lack of Market Liouidity. Despite the large number of listed securities, the prevalence of closed companies on the exchanges is a major reason the securities market lac'-s sufficient liquidity to constitute a true market providing ease of entry and exit for investors and issuers. In any given year, only about 20 percent of listed securities trade. For many companies there is simply no marketi in many cases, listed shares haven't traded in years, some as far back as 1959.14 The result is a narrow base of tradeable securities and few daily transactions, only 20-30 on average.
12.19 The listing of closed companies constitutes an obstacle to the sustaLnable long-term growth of the market since it consumes the scarce administrative resources of the market without adding to liquidity. Market participants -- the exchanges and the active brokers -- only prosper at such a low level of business because of a schedule of fixed registration (listing) fees and commissions, which, because they are not linked to turnover, provide little incentive to modify the commission and fee structure to promote an increase in transaction volume.
12.20 Shares in closed companies are held almost exclusively by principals in a busiisess, often family members and friends. Trading tends to take place between principals, and trades are infrequent. For example, in 1990, only 27 percent of closed companies traded, and these trades constituted only 7 percent of total trades ln the year. Because the trades are between priLcipals, the average transaction is far larger than is the case with publicly issued companies. The average block of closely hold shares traded in 1990 amounted to almost 25,000 shares, with an average value of LE 549,000 per block.
14/ "Cote Officielle," the daily journal of the Cairo stock exchange, June 3, 1991. - 177 -
12.21 The securitWesof publiely issued companies are a llttle more liquid. In c=ntrast to closed companies, 64 percent of publicly held companies traded ln 1990. Generally speaklng publicly lssued shares are more wldely held, but even so about one half of such chares are owned by small groups of corporate sBonsors or "founders," in order to take advantage of the tax incentives.15 Like closely held companles, thls ownership concentrationcontributes to low aggregate turnove_.on the market and a lack of liquidlty,as founders' shares are less likely to be traded than those held by the publlc or institutional investors.
12.22 Inactlve InstitutlonalPortfio LaManacement. There are other factors that contributeto the lnactlve state of the securities market. InstLtutLonalLnvestors may be unable to sell even a small block of securiLieswithout seriously affectlng thelr realizablemarket value, they face mlnlmum investmentguidelines, a shortage of sultable alternative investments,regulatory limltations (ChaptersVII and X), and inadequate accounting,auditing and financlal disclosurepractices. In additlon, staff in the investmentdepartments of these institutions are not tralned in the fundamentaldLeciplines of the securltlesmarket (financialanalysLs, securLtLesvaluatlon, portfolio management). Even the best tralning will not overcome the general lack of reliable and timely lnformationabout public or private sector companies. These shortcomingsneed to be corrected in parallel with the introductionof measures to boost market liquLdity.
12.23 LimLted Number of Investors. Given the lack of liquLdity created by the combination of closely held companies and founders' shares, and CSI compulsory portfolio allocatlonson public sector instruments,lt is not surprisingthat there are not a large number of active shareholders. While the Cairo Stock Exchange does not release detailed data, institutionaltradlng reportedlyaccounts for about 90 percent of average daily volume, and there are a limited number of such investors. Custodial records of the four public sector banks, which handle most securLties,indicate that the number of institutLonaland individual investorsmay be about 10,000.
12.24 Comparisonwith InternationalMarkets. A co.mparisonof basic indLcatorsbetween Egypt and other developingcountrles in the IFC Emerglng Markets Factbook shows the Egyptian market to be illlquid and narrow relatlve tcoothers. 16 Table XII.3 gives data for Egypt and three comparators.
15/ Capital Market Authority data on lLitLngs, new Lssues and turnover. Data on public share offerings prepared by the CHA show that in the case of 106 "public" offerings by prospectusduring the 1982-86 period, founders'shares comprLsed over 50 percent of the total value and number of publlcly lssued shares floated.
16/ InternatlonalFinance Corporation (IFC), Emeroino Stock Markets Factbook, 1991, Washington,D.C., pp. 46-70. - 178 -
Egypt: International Stock Market Comparators - 1990 Ivp.t Jgrdan iarkey grazil k/ g2rua GDP ($MM) A/ 25,699 3,869 96,648 182,723 236,880 Market Capitalization ($MM) 1,833 2,001 19,065 16,354 110,594 Market Capital/GDP (%) 7.1 51.7 19.7 9.0 46.7 Value Traded ($MM) 237 407 5,841 5,598 I5,949 Turnover Ratio (%) 12.9 20.3 30.6 34.2 68.7 Listed Companies (1) 573 105 110 581 669 Market P/E Ratio c/ 6.4 8.2 22.5 5.3 21.5
Source: IFC, "Emerging Stock Markets Factbook, 1991." a/ For Egypt, 1989 GDP. b/ Sao Paulo market only. c/ Average of a sample of 45 listed securities.
12.25 While Egypt has more companies listed than Brazil and all but 2 of the 20 developing countries in the IFC Factbook (India with 2,435 and Korea with 669), countries with market capitalizationsimilar to Egypt, such as Colombia ($1,416million) and Nigeria ($1,372 million), have only 80 and 131 companies listed, respectively. Turkey and Jordan have achieved larger market capitalizationwith fewer companies than even the publicly offered companies in Egypt (155 companies). Jordan, a nation of only 3.5 million people with jus' over 100 listed companies, had turnover amounting to over US$400 million equivalent in 1990, more than three times the combined turnover of the Cairo and Alexandria exchanges in that year.17
12.26 The negative impact of listing many un-traded securities shows up clearly in the turnover ratio, an important comparator of relative market liquidity. Countries with a turnover ratio below 10 percent are generally considered to have relatively shallow markets; countries with turnover ratios as low as Egypt (for example, China! 6 percent; Zimbabwe: 3 percent; and Nigeria: 1 percent) are considere. illiquid and unattractive for that reason, particularlyby international investors.
12.27 While no two countries are identical,Turkey is one country in the region that offers an interestingexample of the potentially positive impact of economic liberalizationand securities market reform on the reactivationof the securitiesmarket. In the 1985/86 period, Turkey implemented a comprehensiveeconomic reform program, as well as a
.17/ Amman Financial Market, The Thirteenth Annual Report. 1990, Amman, Jordan, 1991, pp. 14-5. - 179 -
securities market reform program, with Bank and IMF support. Wlthln S years, the number of listed companies had nearly trLpledg market capitalizationhad grown by a factor of 20; and daily market turnover had grown to a level twice the total annual turnover in 1996 (Table AXII.2, Appendix).
III. Leaal and InstitutionalImpedlments and a Reform Agenda
Capital Markets Law and Executive Regulations
12.28 The Peoples Assembly passed the new CML in late June 1992. The Capital Market Authority (CHA) issued Executive Regulations (ERB) ln April 1993 which are intended to supplement the law and correct some perceivwd deficienciesin it. Taken together the law and ERB constitute a significantadvance in providing a framework for capital market development. The main features of the CML and ERs are described below and recommendationsare made regarding further development.
12.29 General Structure. The legal framework is made up of the CML, ERs and the rules of the CMA, and other related laws such as Law 161 on stock exchanges and Law 159 on joint stock companies. A notable feature of the CML is lts brevity and broad scope and some concern has been expressed in legal circles as a result. This concern has two aspects. One is that the CML always h&s precedence over the ERa and so unless the ER. unequivocallyresolve anomalies ln the law, tha anomalies will remain. The second is that the ERs and rules of the CMA are more fluid and less certain than the law and given that so much is contained in them this may lead to confusion and inefficiency. Related to this is a concern that the CMA or other agency of government may take too interventionista role in the market using the broad rule-making powers conferred under the law.
12.30 For it. part, the Government has stated that the approach taken was motivated by a desire to set a minimum framewcrk in the law and allow the greatest degree of administrativeflexibility possible in order to best serve the needs of an evolving market. It has confirmed its intention to facilitateprivate sector, market orlented development and to minimize direct government involvement in operation of the market.
12.31 InformationDisclosure. The CML and ERs introduce assential reforms in regard to initial disclosure requirements. On the other hand, the informationrequired to be disclosed must be considered the minimum standard appropriateto a developing market. If the Government wishes to gain internationalinvestor interest it will have to consider more stringent requirementsand in any case will have to modlifythe requirements as the market matures. The Government has agreed that greater detail in disclosure is desirable but has formed the judgement that a gradual implementationof disclosure requirementsis appropriate to its circumstances. - l8G -
12.32 While the CWL and ERs require listed companies to disclose price sensitive informationon a cogtlnuing basis there is no clear statement of how this is to be done. The 3overnmenthas agreed to institute an informatliondLiclosure system by December 1994. Such a system will provide a centralized means for companies to comply with the law and for the CMA to supervise compliance. It is likely that the stock exchanges will be the nodal point for the system.
12.33 Tender offers. At present the CML and ERs establish reporting requirementsfor companies engaged in takeovers. They should define more concretely parameters within which offers can be tendered and specify, in detail, requirementsassociated with the acquisition of large blocks of rhare6. The Government intends to develop regulations along these lines.
12.34 Stock ExchanWea. The criteria for authorizationof stock exchanges are stated only very generally and should be augmented by a statement of the basic rules an exchange is expected to have. Also, the CHA's power to approve stock exohange rules and changes to the rules should be made explicit. The Government is considering its approach to these topics.
12.35 Similarly, the stock exchange guarantee fund required under the ERs should be more fully defined and specified. In this regard the Government has undertaken to have an investor protection fund established by July 1994.
12.36 Licenaing of Intermediaries. All firms engaged in securities buslness are required to be licensed by the CMA but apart from incorporatlon and corporate structure no criteria are set upon which a license will be granted, restricted or withheld. The ERs specify some criteria which stock exchanges must apply in admitting members but similar provisions are more usually included in licensing criteria so that the supervisoryauthority can have direct enforcement power in this important area.
12.37 Prudential Reaulation. Minimum paid up capital requirements for intermediariesare introduced in the ERs in order to address capital adequacy concerne.18 This is an improvementon the previous situation but is just a first step. The components of a comprehensiveprudential regulation system and options for implementationare given in the 1992 World Bank report on developmentof the securitiesmarket. The CMA should begin early to build on the new capital requirementsin the ERs in order to have a comprehensive,risk-based prudential regulation scheme in operation by 1995. Such a scheme includea liquid capital requirements based on actual risk exposure and a record keeping and reporting system to facilitate supervision.
18/ Se-urities activities are divided by business type and a paid-up capital amount is specified for each derived from a rule-of-thumb assessment of the overall risk of each type. - 181 -
12.38 Mention L also made in the ERs of a guarantee fund to be established by stock exchanges and of insurance coverage to be obtained by intermediaries. The purpose and scope of both is unclear and as they appear to be directed to investor protection in the event of the financial failure of an intermediary,the policy and operationaldetail should be developed ooon by the CMA in tandem wlth the prudential regulation system.
12.39 Civil Liability and Recourse. One of the lmportantmeans of discipliningthe market and creating lr. stor confidence is to ensure that investors harmed financiallyby the actlons of an intermediarycan pursue a claim for compensation. The CML and ERs do not mike clear the circumstancesin which a civil liabilityarises and the general Egyptian law is not strong in this area. The Government should spectfy the circumstances in which a civil liabllity arises and also make clear the avenues of recourse open to investors.
Supervisory Capacity
12.40 In parallel with the legal reforms already begun, the Government has begun the lnitial phase of restructuring and upgrading the supervisory capacity of the CMA. The program is broadly in line with the recommendationsof the 1992 World Bank report on the securities market and is being supported by the UNDP.
12.4i It would be difficult to over-emphasizethe importanceof the restructuringand upgrading program. Without a very effective and professionalsupervisory agency equipped with appropriatecomputer support, much of the advances made in legal reform will amount to little.
SecuritiesMarket Operations
12.42 Stock Exchance Ownershoi. The stock exchanges in Cairo and Alexandria operate under the Stock Exchange Law 161 of 1957 and the CML. The exchanges are private sector bodies with substantial self-regulatory powers. However, the exchanges are organized under the Law of Professional Associations, which requires a certain minimum membership. Since the number of active brokers has been below the required level since the 1960s, actual ownership of the stock exchanges is in limbo. The exchanges should remain private sector organizations,and this status and the ownership of their physical property should be confirmed.
12.43 Unificationof the Market. The BRs require the Cairo and Alexandria stock exchanges to efficiently link thair trading floors in order to facilitateaccurate price discovery. As trading volume increases this will be an important issue and the successful implementationof the link should be monitored by the CNA. Also, as the CML envisages the establishmentof new stock exchanges, the CHA should develop a policy approach to linking other markets listing the same securities. - 182 -
12.44 Listina Reauirementsand Fee Structure. The two existing exchanges are viable only because listing fees are inflated artificially thrc _n the requirement that all incorporatedcompanies must be joint- stock compan.es and must apply for listing on both exchanges within three years of profitable operation. They are also encouraged by the tax benefits of listing. The new CML has continued the existing tax benefits for cloeed companies, although they serve no market developmentalpurpose. The Investment Law 230 of 1979 and the Company Law 159 of 1981, which require companies established under these codes to seek exchange listing within a fixed time period, should be amended to end the compulsory listing of companies. In addition, the tax reforms proposed in Chapter V would remove incentives for listing as part of a comprehensivereform based on tax-neutraltreatment of all financial assets. These changes would free the stock exchanges to concentrate on what should be their primary objectives: providing an efficient and fair trading forum and developing and monitoring turnover in actively traded securities.
12.45 Securities Trading. The ERs impose a general duty on stock exchanges and intermediariesto conduct trading in an orderly, transparent and fair manner. Specific positive requirementsregarding the exposure of marriage trades and the publication of trading data and negative requirementsregarding fraud and manipulationsupplement the general duty. These are important reforma which must now be followed up with close supervisionand enforcement. It is also likely that greater specificitywill be needed in the ERs or CML in order to adequately regulate these areas. For example, insider trading appears not to be adequately defined.
12.46 Clearance and Settlement. The transfer of securities ownership is an awkward manual process at present. Securitiesmove physically between custodians and must be returned to their respective corporate headquartersor authorized signatoriesto be re-registeredin the name of the new owner. This cumbersome process entails the risk of physical loss, delay and high costs. According to market participants, this process may take 45-60 days during which time securities may be held without adequate protection against physical loss and are unnegotiableby the new owner.
12.47 While such a system has been tolerated at the current low levels of trading activity, it will be inadequatewhen trading volume increases as expected. While the brokers could physically handle many times the current level of transactionswithout additional staff or equipment, the clearance and settlement procedures would soon experience a high failure rate in an environmentof increasedmarket activity.
12.48 A computerizedbook entry clearance system would be the most efficient alternativeto enhance the efficiency of securities transactions,though it would require computerizationof stock exchange and brokerage operations. It would be wise to implement phased improvementsto the manual systems in a way which would allow for easy computerizationat a later date. Or, in anticipationof substantially - 183 _
highe- future turnover, it may be advisable to assess the cost )f inatt_ling such a system now, using off-the-shelftechnology, evt6n before it is commercitllyviable. This would offer the advantage of debugging the system at a relatively low level of turnover.
12.49 Such a system could be operated by the stock exchanges or as an independentcorporation, as is the case in Europe, Canada and the United States. The latter course may be preferred as it would allow the involvementof other importantparties to the clearance and settlement process: listed companies, large investors and banks.
12.50 Custodial Services. The CML and ERs bring securities custodial services under the authority of the CMA. At present public sector banks provide custodial services for client's securities at their major branches. This service includes the timely filing of coupons for dividend and interest payments and the handling of transfer procedures. One of these banks has over 5,000 custodial accounts. Brokers have neither the facilities nor the capital to offer custody, though some d^ so on an informal basis or while waiting to gather securities to send fv.rre-registration.
12.51 The Government has begun to encourage the establishmentof a central securities depository to be operated by the private sector. Several market participantshave stated an interest, in principle, in participatingin a commerciallyviable central securities depository in order to enhance the efficiency of securitiestransactions.
Intermediaries
12.52 Incorporationand Foreian Competition. The CML has continued the provisions of the Stock Exchange Law 161 of 1957 that require all securities to be traded on a stock exchange, by an authorized stock broker. Two important changes introduced in the CML are that licensed intermediaries,including stock brokers must be incorporatedjoint stock companies or partnerships (not individuals)and non-Egyptiancitizens may now own licensed intermediaries. Incorporationshould provide greater accese to capital and, in this way, better meet prudential requirementeand allow growth in expertise and diversificationof market intermediaries. Opening the brokerage industry to internationalfirms could lead to the introductionof new Capital, expertise and investment services.
12.53 Commissions and Fees. The CML leaves open the continuation of the present fixed commission and fee structure. The CMA has expressed the view that this is necessary in the medium term to protect the domestic stockbrokingindustry. But despite legally fixed commissions of 1 percent, in total, on both sides of an equity transaction and somewhat lower rate on bonds, the income level of brokers has apparently not been sufficient to attract new participants. Only one new broker has been licensed in the past 10 years. And in practice, discount commissions are negotiated on large transactions. - 184 -
12.54 The fixed commission structure should be phased out to better reflect reality and allow greater flexibility in the priclng of brokerage services. Competition in pricing in a key element of the diversificationof seriiicesand improvementsin service qualfty. Because this is a subivantialchange from present practice, and, in order not to present an obstacle to the possible entry of new brokerage firms, this change should be phased in over a 12- to 24-month period.
12.55 Record-kegoLnaanq Clle.t Pr2tegtion. The ERe impose specif4.c record keeping practices on intermediariesand require that the a client's interests be protected and that a client's orders be efficiently executed. These are important reforme. Additional requirementsrelated to safe custody of securities and the handling of client furndsin separate accounts would greatly strengthen them.
Accounting Standards
12.56 The content, acciracy and consistencyof published financial statements are unsatisfactory,due In large part to flexible and inconsistentaccounting practices. Thc public sector follows a consistent set of accounting principles,the Uniform Code of Accounts, under the watchful supervisionof the CAO. Accounting practices in the private sector vary greatly between companies: the Company Law 159 of 1981 only requires companies to adopt "recognized"accounting standards but does not define those standards.
12.57 There are also material differencesbetween accounting practices and the presentationof financial statements in the private and public sectors, which make for inconsistencyand a lack of comparabilitybetween the accounts of private and public sector firms. These differences will become material with the listing of more than 300 government-ownedcompanies (the result of the Public Business Sector Law 203 of 1991).
12.58 There is therefore some urgency to the exercise initiated by the Egyptian Institute of Accountants and Auditors (EIAA), with the support of USAID, which is to develop and agree on a set of generally accepted accounting and auditing standards, consistent wJth internationalpractice.
12.59 The ERs require audited financial statements of public companies at the time of public offering and annually thereafter. Listed companies must report more frequently. The ERs contain pro-forma financial statements which were not available at the time of writing this report btu it is expected that they go some way to setting minimum consistent standards. More important though will be the monitoring and enforcement effort exerted by the CMA. Strict enforcement of high standards will be crucial to building the market's reputation as fair and transparent. - 185 -
Mutual Funds
12.60 Among innovationsto develop the securitiesmarket, the introductionof mutual funds and investmentmanagement companies could be one of the moct important. Their establishment is also one of the most difficult, given the recent unfortunateexperienoe with the so- called Islamic InvestmentCompanies.
12.61 The potential benefits of professional investmentmanagement and adequate risk diveroificationat relatively low transactior coats for well-managedmutual funds have made fund management one of the fastest growing segments, internationally,of the securities industry in the past decade. Carefully regulated, well-sponsoredand professionally managed, mutual funds should be attractive to resident and nonresident Egyptians and would facilitate the privatizationof the Government'e substantial shareholdingsin joint-venturecompanies as well as Pgs.
12.62 At prejent, the CML and ERs deal only partially with the regulation of mutual funds and the Government may wish to give more emphasis to this area by eatablishinga comprehensive framework for their establishmentand operation. Additionally,the viability of mutual funds may depend to a large degree on clarificationof their tax treatment as fiduciaryvehicles (Chapter V).
Supply of Corporate Debt Securities
12.63 The Government has recently removed interest rate ceilings on corporate bonds, which were an important impediment to the development of the corporate bans market. In effect the new CML provides for the General Assembly of a company issuing debt securities to set the interest rate payable without restrictionsprovided in any other law.
12.64 A measure that would promote the bond market would be the establishmentof a credit rating agency, such as Moody's or Standard and Poors, along the l.nea familiar to most developed market economies. This would provide a useful independentvaluation bench mark for individual and institutionalinvestors interested ln corporate securities, particularlycorporate debt issues.
IV. ConcludinciRemarks
12.65 The Government is to be commended for its commitment to reform of the securities market. The legal and supervisory reforms already begun represent an important advance in establishinga framework to allow for development of the market.
12.66 The groundwork laid so far needs to be augmented by substantial institutionaldevelopment and reform in the CHA and by fine- tuning of the CML and ERs. If the momentum of reform can be maintained throughout this stage of the program a great deal will have been - 186 - achieved and the expected grcwth of the uecurities market will be supported by the infrastructure essential for its success.