Access to Finance and Economic Growth in Egypt

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“ his publication provides a comprehensive and informative analysis of a key policy issue facing Egypt Access to Finance and Economic Growth in Egypt Tand other developing countries-how to enhance appropriate access to finance in support of sustained Middle East and North African Region high economic growth and improved income distribution. The detailed and elegant evaluations of the key segments of the financial sector are supplemented by a holistic discussion that draws out the main interactions, including the linkages to institutional reforms. The timely publication will be interest to a large number of policy makers, academics, development practitioners and financial market participants.” Dr. Mohamed A. El-Erian, President and CEO of the Harvard Management Company, member of the faculty of the Harvard Business School, and Deputy Treasurer of Harvard University Access to Finance

“ roadening the reach of the financial sector is the key to invigorating both economy and society. If Bmore small businesses can get access to the credit and other financial services they need to turn initiative into employment and profitability, and if low income households can gain the economic security and Economic Growth offered by an account at an intermediary, economic growth and social welfare will both be enhanced. This report takes a close look at the Egyptian financial system to see how outreach and access can be improved. It is firmly based on recently collected statistics and it provides a comprehensive analysis with in Egypt recommendations. Recent government initiatives have already begun to transform the Egyptian financial system. Access to Finance and Growth in Egypt points the way to future success in lifting the system to the next level.” Dr. Patrick Honohan, Senior Advisor, World Bank; and Professor of International Financial Economics and Development, Trinity College Dublin A Study Led By SAHAR NASR

“ inancial exclusion is likely to act as a “brake” on development as it retards economic growth and Fincreases poverty and inequality. However, the access dimension of financial development has often been overlooked, mostly because of serious data gaps on who has access to which financial services. Hence, empirical evidence that links broader access to financial services to outcomes has been very limited, providing at best tentative guidance for public policy initiatives in this area. However, without inclusive financial systems, poor individuals and small enterprises need to rely on their personal wealth or internal resources to invest in their education, become entrepreneurs or take advantage of promising growth opportunities. Financial market imperfections—such s information and transactions costs—are likely to be especially binding on the talented poor and the micro and small enterprises, who lack collateral and credit histories.” Asli Demirguc-Kunt, Senior Research Manager, Finance and Private Sector Development, By Led Study A Development Research Group (DECRG), World Bank

“ or Egypt, access to ﬁnance can radically transform peoples’ lives, promote entrepreneurship, Fhelp bridge the urban-rural income divide, alleviate poverty and improve individuals’ lifetime economic and social prospects by integrating them into the market economy. In short, improved access to ﬁnance can be an engine of growth and structural transformation, if supported by other policies that

reduce barriers to competition, lower the cost of doing business and create incentives for moving out of NASR SAHAR the ‘informal sector’. For Egypt, where fewer than seven percent of households have a bank account, investments and policies that create and improve access to finance and its infrastructure, can break down economic and social barriers to economic growth and development. This well-researched report is an excellent guide and provides a practical tool-kit for economic and financial policy makers, banks and financial institutions seeking to improve Egypt’s financial infrastructure and access to finance.” Dr. Nasser Saidi, Chief Economist Dubai International Financial Centre (DIFC) Introduction i

Access to Finance and Economic Growth in Egypt ii Access to Finance and Economic Growth in Egypt Introduction iii

Middle East and North African Region

Access to Finance and Economic Growth in Egypt

A Study Led By SAHAR NASR iv Access to Finance and Economic Growth in Egypt Introduction v

Contents

Abbreviations and Acronyms viii Foreword ix Preface xi Acknowledgments xiii Executive Summary xvii I. Introduction 1 II. Sources for Financial Services: The Banking Sector 23 A. Access to Bank Financial Services 23 B. Factors behind Weaknesses in Supply of Banking Services 28 C. Access to Microﬁnancial Services 45 III. Sources for Financial Services: Non-bank Financial Services 55 A. Capital Markets 55 B. Insurance and Contractual Savings 61 C. Mortgage Finance 68 D. Financial Leasing 73 E. Factoring 76 IV. Institutional Environment 81 A. Legal Framework 81 B. Information Infrastructure–Credit Registry, Credit Bureau and Other Sources 86 C. Financial Reporting Environment 89 D. Financial Infrastructure 91 V.Expanding Access to Finance 95 A. Enhancing the Role of the Banking Sector in Financial Intermediation 95 B. Expanding the Postal System and Microﬁnance Institutions 101 C. Promoting Capital Markets in the Access Agenda 105 D. Contractual Savings Industry Potentials for Growth 107 E. Developing the Mortgage Finance Market 113 F. Increasing the Financial Leasing Industry’s Contributions to Access 115 G. Developing the Factoring Industry 116 H. Improving the Institutional Environment 117 Annexes 130 Annex 1: Indicators For Assessing The Soundness And Performance 130 Of The Banking System Annex 2: Indicators For Assessing The Capital Market 135 Annex 3: Indicators For Assessing The Insurance And Contractual Savings Sector 136 Bibliography 137 vi Access to Finance and Economic Growth Contentsin Egypt

Tables

Table 1.1: Main Macroeconomic Indicators in Egypt (2001-2006) 7 Table 1.2: Business Environment in Egypt 9 Table 1.3: Various Sources of Finance in Egypt, MENA, and the World 15 Table 1.4: Household Use of Financial Services by Education Level in Egypt 17 Table 1.5: Use of Finance by Employment Status of Head of Household in Egypt 18 Table 2.1: Frequency Distribution of Private Sector Credit in Egypt 25 Table 2.2: Share of Savings Accounts by Size of Deposits in Banks in Egypt 27 Table 2.3: Local Currency Deposit Interest Rates in Egypt 27 Table 2.4: Number of Credit and Debit Cards Issued in Egypt during 2005 28 Table 2.5: Branching and ATM Presence, Cross-Country Comparisons 30 Table 2.6: Earnings per Employee of Banks in Egypt 37 Table 2.7: Expense Ratio of Banks in Egypt 37 Table 2.8: Main Reasons for not Lending to SMEs in Egypt 40 Table 2.9: Lending Rates for Local Currency of Banks Operating in Egypt 41 Table 3.1: Compound Annual Growth Rate by Sub-Sector in Egypt 62 Table 3.2: Statutory Investment Limits—Life Insurers in Egypt 63 Table 3.3: Assets and Investments in Egypt 63 Table 3.4: Insurance Investment Allocation in Egypt 65 Table 3.5: Private Pension Investment Allocation in Egypt 66 Table 3.6: Investment Approach of the Contractual Savings Industry 66 Table 4.1: History of Public Credit Registry Database in Egypt 86 Table 4.2: Negative Databases of CBE Credit Registry 87

Figures

Figure 1.1: Current versus Desirable Situation of Financial System 2 Figure 1.2: M2-to-GDP in Selected Countries across the World 8 Figure 1.3: Private Sector Credit-to-GDP in Selected Emerging Economies 9 Figure 1.4: Investment Climate Constraints in Egypt as Perceived by Businesses 15 Figure 1.5: Percentage of Firms Currently with a Loan from a Financial Institution in Egypt 16 Figure 1.6: Enterprises’ Access to Finance in Egypt and Selected MENA Countries 16 Figure 1.7: Households’ Share in Access to Financial Services by Educational Attainment in Egypt 18 Figure 2.1: Loans-to-Deposits Ratio in Egypt 24 Figure 2.2: Loan-to-Deposit Ratio in Egypt 24 Figure 2.3: Treasury Bills-to-Total Assets in Egypt 24 Figure 2.4: Government Sector Loans-to-Total Loans in Egypt 25 Figure 2.5: State-Owned Enterprises Loans-to-Total Loans in Egypt 25 Figure 2.6: Credit Extended to Private Sector in Egypt 26 Figure 2.7: State-Owned Banks’ Share of the Banking System Total Assets in Egypt 29 Figure 2.8: Urban and Rural Branch Density by Bank Type in Egypt 31 Figure 2.9: Equity-to-Assets Ratio of Banks in Egypt 33 Figure 2.10: Distribution of Staff in the Egyptian Banking System 38 Figure 2.11: Return on Assets of Egyptian Banks 39 Figure 2.12: Return on Equity of Egyptian Banks 39 Figure 2.13: Collateral Requirements as a Percent of Loan Values 41 Figure 2.14: Marginal Effects of Branching and Education on Access to Financial Services in Egypt 45 IntroductionContents vii

Figure 3.1: Equity Finance and Corporate Bonds as Sources of Investment Funding in Selected Emerging Economies 56 Figure 3.2: Assessment of Enforcement in Egypt’s Capital Markets 60 Figure 3.3: State-Owned Insurers’ Share of Insurance Assets in Egypt 63 Figure 3.4: Funds under Management: Egypt and OECD 65 Figure 3.5: Developments in Mortgage Loans in Egypt 71 Figure 3.6: Volume and Number of Leasing Contracts in Egypt 74 Figure 4.1: Legal Rights of Creditors in Egypt and Other Countries 82 Figure 4.2: Cost to Create Collateral in Egypt and Other Countries 83 Figure 4.3: Bankruptcy Costs and Time in Egypt, MENA Region and OECD 84 Figure 4.4: Dominance of Collateral-Based Lending in Egypt 85 Figure 5.1: Funds Build Up Under Five Percent Mandatory Pillar Option 111

Boxes

Box 1.1: Access to Finance as an Obstacle to Growth 5 Box 1.2: Rationales for the Privatization of Banks 12 Box 1.3: Egyptian Women’s Access to Finance 19 Box 2.1: Egypt Post Offices 32 Box 2.2: Status of Islamic Finance in Egypt 34 Box 2.3: Bank Performance Analysis by Size and Ownership 35 Box 2.4: Weaknesses in Corporate Governance in Egyptian State-Owned Banks 42 Box 2.5: The Relative Importance of Demand and Supply Factors in Explaining Access 43 Box 2.6: State-Owned Banks Actively Involved in Microfinance in Egypt 46 Box 2.7: NGOs are Key Players in Microfinance in Egypt 47 Box 3.1: Major Insurance and Pensions Investors in Egypt 67 Box 3.2: The Government of Egypt’s Housing Finance Program for the Poor 69 Box 3.3: The Egyptian Mortgage Refinance Company 70 Box 4.1: Current Status of the Private Credit Bureau in Egypt 88 Box 4.2: The Importance of Good Financial Reporting for Firm Financing 89 Box 5.1: Lessons on Bank Restructuring from Other Countries 96 Box 5.2: Subsidized Lending Schemes in Egypt 100 Box 5.3: Lessons from Successful Postal Financial Systems: Case Studies from Brazil and China 102 Box 5.4: International Evidence on Institutional Policies to Enhance Access 104 viii Access to Finance and Economic Growth in Egypt

ABBREVIATIONS AND ACRONYMS IFRS International Financial Reporting Standards ABS Asset-Backed Securities IFI Islamic Financial Institutions AIM Alternative Investment Market IFS Islamic Financial Services ALM Asset and Liability Management IIC Islamic Investment Companies AML/CTF Anti Money Laundering IPOs Initial Public Offerings and Combating Terrorism Financing KOSDAQ Korea Securities Dealers Automated ATM Automatic Teller Machines Quotation AUM Assets Under Management LE Egyptian Pound BRU Bank Restructuring Unit M2 Broad Money CAGR Compound Annual Growth Rate MCSD Misr Clearing, Settlement and Central CAPMAS Central Agency for Public Mobilization Depository Company and Statistics MENA Middle East and North Africa CASE Cairo and Alexandria Stock Exchanges MFA Mortgage Finance Authority CBE Central Bank of Egypt MFIs Microfinance Institutions CCMAU Crown Company Monitoring Advisory Unit MIB Misr International Bank CFD Corporate Finance Division MIX Microfinance Information Exchange CGAP Consultative Group to Assist the Poorest MTPL Mandatory Insurance CGC Credit Guarantee Company NBFI Non-bank Financial institutions CIB Commercial International Bank NBD National Bank for Development CIBOR Cairo Interbank Offer Rate NBE National Bank of Egypt CIS Cooperative Insurance Society for NGO Non-governmental organization Small Enterprises NIB National Investment Bank CMA Capital Market Authority NPL Non-performing loans DB Defined Benefits NPS National Payments System DC Defined Contribution NSGB National Societe Generale Bank EAB Egyptian American Bank OECD Organization for Economic Co-operation EAS Egyptian Accounting Standards and Development EEGC Egyptian Export Guarantee Company OTC Over the counter EFG Egyptian Financial Group PBDAC Principal Bank for Development and EISA Egyptian Insurance Supervisory Authority Agricultural Credit EMRC Egyptian Mortgage Refinance Company PML Primary mortgage lending ESDF Egyptian Swiss Development Fund PSB Postal Savings Bureau FCI Factors Chain International R&D Research and development FIRST Financial Sector Strengthening Initiative RELC (Non-bank) real estate lending companies FSAP Financial Sector Assessment Program Repo Repurchase operations FSS Financial Self-Sufficiency ROA Return on assets GAFI General Authority for Free Zones and ROE Return on equity Investment ROSC-AA Report on Observance of Standards and GATS General Agreement on Trade in Services Codes Accounting and Auditing GCC Gulf Cooperation Council RTGS Real-time gross settlement GDP Gross Domestic Product SEDO Small Enterprise Development Organization GDR Global Depository Receipt SFD Social Fund for Development GEM Gender Entrepreneurship Markets SIF Social Insurance Fund GSF Guarantee and Subsidy Fund SME Small and Medium Enterprise HH Household SOE State-Owned Enterprises IAS International Accounting Standards SRC Social Research Center ICA Investment Climate Assessment SRO Self-regulatory organization ICS Investment Climate Survey TSX Toronto Stock Exchange ICT Information and Communications US$ U.S. Dollars Technologies WBES World Business Environment Survey IFG International Factoring Group WFE World Federation of Exchanges IntroductionContents ix

Foreword

This report was initiated at the request of the Egyptian Government to get a better understanding of why, as found by the Investment Climate Assessment, only 17.4 percent of Egyptian firms operate in the formal credit market. The report draws on surveys of firms, banks and households to determine why so few firms—and households—use formal financial markets for their investment and saving needs, and why banks and other financial institutions are reluctant to extend credit, even in conditions of high liquidity. The key findings are that: (i) significant public ownership of real and financial assets in Egypt has discouraged competition and the development of deep and well-regulated financial systems, including non-bank sources of financial services; (ii) a large fiscal deficit has encouraged financial institutions, particularly publicly owned ones, to invest predominantly in risk and tax free government securities; banks, and publicly owned ones in particular, have little incentive to lend to other than state-owned enterprises and large private firms; and (iii) smaller private and foreign banks are more active in expanding access to financial services by households and small and medium enterprises (SMEs) due to their capacity to better assess risk and capture opportunities. Improving access to financial services will require continuing the shift in the role of the government in the sector—away from asset ownership and towards creating an enabling environment for private (including foreign) financial service providers to innovate in providing services to firms and households. Here, as the report indicates, the government has a critical role to play in ensuring a stable macroeconomic environment, lower deficit and public borrowing, good supervisory oversight, and adequate institutional infrastructure. A number of the issues raised in this report are already being addressed by the government under the financial sector reform program initiated in November 2004. The objective of this report is help the government with the design of the second generation of financial reforms aimed at increasing the role of the private sector in financial services provision, particularly to SMEs and households, while strengthening risk management in financial institutions.

Michael U. Klein Emmanuel Mbi Zoubida Allaoua Vice President and Chief Director Sector Manager Economist Egypt, Yemen and Djibouti Finance and Private Sector Financial & Private Sector Country Department Development Development The World Bank Social and Economic International Finance Development Group Corporation Middle East and North Africa The World Bank Group Region The World Bank x Access to Finance and Economic Growth in Egypt Introduction xi

Preface

In September 2004, the Financial Sector Reform Program was launched and endorsed by the Government of Egypt at the highest political level. The five pillars of the program are reforming the banking sector, restructuring the insurance sector, deepening the capital markets, developing a well- functioning mortgage market, and activating other non-bank financial institutions and services. The program aims at improving the soundness of the financial sector and promoting an enabling environment for an efficient, competitive and agile financial system that serves Egypt’s development and growth objectives. The Egyptian government and the Central Bank of Egypt have been keen on the effective implementation of this program, and significant progress has already been made. Important achievements include, the turn around of the structure of the banking sector and the foreign exchange market as well as establishing a credible monetary policy framework, in addition to consolidating the banking sector, divestiture of the state- owned banks’ shares in the joint-venture banks, privatizing one of the four largest public banks, pursuing the restructuring of the remaining public financial intermediaries and building the supervisory capacity of the Central Bank. Meanwhile, major reforms aiming at improving the regulatory framework and enhancing the soundness and effectiveness in financial intermediation of non-bank financial services, have been undertaken. These reforms have contributed to the deepening of the capital market and enhancing its efficiency and liquidity, restructuring and liberalizing the insurance sector, developing the mortgage market, and reviving the role of other non-bank financial services and instruments, including leasing, factoring and securitization. This comprehensive reform program has been underpinned by capacity building of the supervisory authorities of all non-bank financial institutions. The progress and pace of the Egyptian Financial Sector Reform Program have been commended at home and abroad. However, we are aware that we still have some way to go to fully reform the sector and address its main challenges; one of which is ensuring better access to financial services which is imperative to economic growth and development. Improving access to finance allows businesses, especially small and medium enterprises, to capitalize on their growth potential, operate on a larger scale and turn initiatives and ideas into employment opportunities. Moreover better and wider access to financial services by households at all income levels positively impacts their economic and social welfare The Government of Egypt will continue to foster efforts on facilitating access to financeinEgypt.Wehopethatthefindingsandrecommendationsof this report would assist in the ongoing endeavors to meet this challenge.

Mahmoud Mohieldin Farouk El Okda Minister of Investment Governor Ministry of Investment Central Bank of Egypt Egypt Egypt xii Access to Finance and Economic Growth in Egypt Introduction xiii

Acknowledgments

The Access to Finance and Growth in Egypt is a joint product of the Government of Egypt and the World Bank. The study was initiated by the Minister of Investment, H.E. Dr. Mahmoud Mohieldin, as a follow up to the Investment Climate Assessment, which had identified access to financeas a main constraint to private-sector development; and H.E. Dr. Farouk El-Okda, Governor of the Central Bank of Egypt (CBE). This study was carried out under the joint leadership of Emmanuel Mbi, Country Director, and Zoubida Allaoua, Sector Manager in the Middle East and North Africa Region (MENA) of the World Bank. The study was led by Sahar Nasr, Senior Financial Economist in MENA, based on input from Stijn Claessens, Senior Adviser; Rodney Lester, Program Director, Financial Markets for Social Safety Net; David Scott, Adviser; Loïc Chiquier, Head, Housing Finance Practice; JaeHoon Yoo, Senior Securities Market Specialist; Robert J. Cull, Senior Economist; Luc Laeven, Senior Financial Economist from the Finance and Private Sector Development Vice Presidency; and Mohamed Yehia Abd El Karim, Financial Management Specialist; as well as Heba El Laithy, Senior Consultant; Bahaa Ali Eldin, Senior Legal Consultant; and Esen Ulgenerek, Consultant. This access to finance study is based on the findings of five main surveys: the Investment Climate Survey (ICS) of 1,052 enterprises from the manufacturing sector that was carried out between October 7 and December 10, 2004 using the World Bank standard methodology; the ICS recall questionnaire of 300 enterprises that was carried out in June 2005; the individual banks survey undertaken between February and March 2006, supported by CBE, based on the core questionnaire provided by Asli Demirguc-Kunt, Senior Research Manager at the World Bank, to which 35 out of 45 banks operating in Egypt responded; the insurance survey, carried out under the leadership of the Ministry of Investment in March 2006 and to which 20 out of 21 insurance companies responded; and the National Household and Income Survey for the fiscal year 2005, which covered 48,000 households in 1,500 communities. The first three surveys were carried out by the Social Research Center (SRC) of the American University in Cairo, under the leadership of Dr. Hoda Rashad, and xiv Access to Finance and EconomicAcknowledgments Growth in Egypt

coordinated by Dr. Ramadan Hamed; the fifth was undertaken by the Central Agency for Public Mobilization and Statistics (CAPMAS) under the Ministry of State for Economic Development. The development of the report entailed discussions with key policy makers and government counterparts, including, Tarek Amer, Deputy Governor; Tarek Kandil, Sub-Governor; Lobna Hilal, Assistant Sub-Governor; Mona Bassiouni, Assistant Sub-Governor; and Gamal Nigm, Assistant Sub-Governor. Valuable comments were received from Maged Shawki, Chairman of Cairo and Alexandria Stock Exchange (CASE); Hany Sarie El Din, Chairman of Capital Market Authority (CMA); Mahmoud Abdullah, Chairman of Egyptian Insurance Holding Company; Osama Saleh, Chairman of Mortgage Finance Authority (MFA); Ashraf El Kadi, Deputy Chairman of MFA; and Ziad Bahaa El Din, Chairman of General Authority for Investment and Free Zones (GAFI); as well as Abdel Hamid Ibrahim, Senior Advisor; Mona Zobaa, Advisor; and Ahmed Rostom, Economist in the Ministry of Investment. Strong support was provided all along for the missions and various consultations during the preparation of this work. The team would like to thank in particular the Ministry of State for Economic Development; Ministry of Finance; Ministry of Foreign Trade and Industry; Social Fund for Development (SFD); Economic Research Forum (ERF); EFG Hermes; Syndicate of Commerce; Federation of Egyptian Industries; Egyptian Center for Economic Studies (ECES); Egyptian Businessmen Association; Institute of Banking and Finance; Misr Clearing, Settlement and Depository Company (MCSD); Egyptian Postal Authority; and Egyptian Society of Accountants and Auditors. Feedback was also provided by the private-sector community in a roundtable organized by the American Chamber of Commerce in Egypt coordinated by Hisham Fahmy, Executive Director. Partners who are actively involved in the financial sector in Egypt, including USAID, European Commission (EU), and United Nations Development Program (UNDP), have made significant contribution to this study. Thoughtful comments from several World Bank colleagues and external reviewers are reflected in this study. The study benefited immensely from intensive reviews by Patrick Honohan, Senior Adviser; in addition to external reviewers Mohamed El Erian, President and CEO of Harvard Management Company; and Nasser Saidi, Director of Hawkamah Institute for Corporate Governance. Comments and contributions from several World Bank colleagues on an earlier draft have also been provided by Noritaka Akamatsu, Roberto Rocha and Ahmed Galal. The study also benefited from comments received from Gaiv Tata, S. Ramachandran, and Omer Karasapan. Valuable support was received from Marilou Jane D. Uy. World Bank, International Finance Corporation (IFC) and FIRST Initiative staff contributed to this study, including notably Bikki Randhawa; Carmen Niethammer; Isabella Segni; Jim Aziz, Jose Antonio Garcia Luna; Massimo IntroductionAcknowledgments xv

Cirasino; Murat Sultanov; Peer Stein; Peter Sheerin; Robert Keppler; and Thomas Jacobs. Laila Abdel Kader provided extensive support with document preparation. Amira Fouad Zaky, Steve W. Wan Yan Lun, and Sydnella E. Kpundeh provided invaluable logistical support throughout the process. Editorial support was provided by Laura Goodin and print production including book design was undertaken by Magdy Nassif. Early versions of this study have been presented and discussed at seminars and workshops in Cairo and Washington in which different stakeholders participated, including bank and non-bank financial institutions, private sector, civil society, donor agencies, academia, government officials, and the supervisory and regulatory bodies. Valuable comments received from these participants are reflected in this final version. We would like to take this opportunity to thank all the people in government, financial, donor, and academic communities who have provided their time, thoughts, and contributions to the team and to the study. xvi Access to Finance and Economic Growth in Egypt Introduction xvii

Executive Summary

Access to finance is important for growth and economic development. Having an efficient financial system that can deliver essential services can make a huge contribution to a country’s economic development. Greater financial development increases growth, reduces economic volatility, creates job opportunities and improves income distribution, as has been established by a large empirical literature. A well- functioning financial market plays a critical role in channeling funds to their most productive uses, and allocates risks to those who can best bear them. Getting the financial systems of developing countries to function Greater financial more effectively in providing the full range of financial services is development increases a task that will be well rewarded with economic growth. Where growth, reduces economic volatility macroeconomic environment is sound, the efficient and prudent and improves income allocations of resources by the financial system makes it crucial for distribution increasing productivity, boosting economic development, enhancing equality of opportunity, and reducing poverty. Empirical evidence has shown that the financial systems in advanced economies have contributed in an important way to the prosperity of those economies. A well developed financial market comprise spectrum of well- functioning banks, and non-bank financial institutions. Banks provide deposit and payments services, allocate resources, and monitor operations of firms. Equity markets provide financial leverage and ensure efficient allocation of resources. Well-developed capital markets force banks to pay more attention to smaller firms and households. Active domestic bond markets provide firms with long-term domestic currency finance and ease credit crunch during periods of bank stress. Housing finance is important for households and provides an important asset for entrepreneurs. Successful leasing, factoring, and venture-capital markets provide financing and enhance an economy’s productivity. The potential for financial development and growth in Egypt is The potential for large as macro economic policies and overall business environment financial development fundamentals are increasingly supportive. This is evident in in Egypt is large as macro economic accelerating economic growth, increased market confidence, strong policies and overall capital inflows, stability in the foreign exchange market, significant business environment increase in international reserves, and fall in inflation. The impact fundamentals are increasingly supportive xviii Executive Summary

of the broad range of structural reforms, particularly those affecting the investment climate, initiated by the government appointed in July 2004 is being reflected in the significant improvement in the investors’ perception of the business environment. This is largely due A cornerstone of the government’s comprehensive reform program to the broad range of is the Financial Sector Reform Program, endorsed in September structural reforms 2004. The program aims at improving the soundness of the financial initiated by the government since sector and fostering an enabling environment for the emergence of an mid-2004, of which efficient, increasingly private-led financial system that serves Egypt’s the “Financial Sector development and growth objectives. The program is underpinned by Reform Program” is a significant improvements in the legal, regulatory, and supervisory cornerstone framework across the bank and non-bank financial institutions, with the aim of enhancing competition, improving financial intermediation, fostering more efficient mobilization of savings, and ensuring systemic soundness. An integral component of the strategy is to promote the quality of information and market discipline by upgrading financial institutions’ accounting, auditing and reporting to international standards. Significant progress Significant progress has been made in the implementation of has been made in the these financial sector reforms. Achievements include consolidating implementation of the financial sector reform the banking sector, divesting the state-owned banks’ shares in the program joint-venture banks, privatizing one state-owned bank, pursuing the restructuring of the remaining three state-owned commercial banks, ...however, this has not and building the supervisory capacity at the central bank. For non- yet been translated to better performance and bank financial institutions, various reforms have been undertaken to enhanced financial further deepen the capital market, restructure the insurance sector, intermediation develop a well-functioning mortgage market, activate financialleasing, and factoring. However, such progress has not yet been reflected in improved performance and enhanced financial intermediation. Financial indicators Various financial indicators put the Egyptian financial sector still put the Egyptian at a moderate level in financial intermediation compared to other financial sector developing countries. Although mobilization of savings in Egypt is high at a moderate level in financial by international standards, the banking sector is not intermediating intermediation efficiently. Most savings are channeled through the financial system as bank deposits, where the deposit-to-GDP ratio of 100 percent is much higher than the world average and substantially higher than many developed economies. However, little of it is channeled to the real, productive private sector and is mainly used to finance government deficits or as loans extended to state-owned enterprises. Private-sector credit to GDP in Egypt is modest compared to other developing economies. Private credit as a share of total credit has been declining, to reach 66 percent in 2006, compared to 70 percent in 2003. Importantly, the distribution of bank financing is uneven, with most loans going to large and well-established enterprises. Consequently, family-owned firms and small and medium enterprises (SMEs)—the majority of firms in Egypt—rely heavily on the informal market. Formal financing, whether from banks or non-bank financial institutions, plays a limited role in financing enterprises, especially Executive Summary xix

SMEs. More than 37 percent of the firms consider access and cost of Formal financing, finance major obstacles to growth. The large majority of Egyptian whether from banks or non-bank financial manufacturers rely exclusively on their own funds; only 17.4 percent institutions, plays have access to finance from the financial sector. This is especially a limited role in striking for small firms—only 13 percent have access to finance, as financing enterprises, opposed to 36 percent for large firms. While the average for Egypt is especially SMEs comparable to the other countries in the Middle East and North Africa (MENA), it is significantly below that in other developing countries. Moreover, the financial sector plays a limited role in financing ...this is especially new investments. On average, only 7 percent of new investments striking for start-up and working capital in Egypt is financed externally through the enterprises that rely mainly on internal banking sector, compared to more than 13 percent in MENA region, funds and retained and 18 percent in the rest of the world. Banks often prefer to extend earnings credit to large corporate clients and connected individuals that are considered less risky, while start-up companies remain financially constrained. While the capital market can play an important role in financing growth and development, it only financed 3.8 percent of new investments in Egypt. The dependence on internal finance indicates that firms in Egypt are unable to take advantage of growth opportunities, with negative ramifications for overall economic and employment growth. Incentives for small firms and households to use deposits and Incentives for small other financial services are poor. Minimum required deposit amounts firms and households to use deposits and are too high to enable the poorer segments of the population to access other financial the banking system and tend to discourage the unbanked population services are poor to save through formal channels. The lack of deposit mobilization from small savers is not due to financial repression, as interest rates on deposits are relatively high. Although state-owned banks have a comparative advantage in attracting small depositors, with their huge branch network in governorates and villages, they have instead focused on large depositors, and extend very limited financial services to the relatively disadvantaged segments of society. Recently, however, banks have been trying to catch up and cater to small depositors for all types of financial services. Few Egyptian households use any kind of formal financial services. However, usage of Savings instruments are more common than credit, and the most financial services common is postal savings, roughly twice as prevalent as bank savings increases substantially with the level of among the illiterate and those who can read and write. Usage of education of the head financial services increases substantially with the level of education of the household of the head of the household. However, almost no households have formal credit or capital-market investments, where less than one percent of households surveyed had a formal loan.

Sources For Financial Services: The Banking Sector

Financial intermediation by the banking system that accounts for more than 60 percent of the ﬁnancial system’s assets is weak by international standards. While savings are high and banks collect xx Executive Summary

Financial large deposits, amounting to about 100 percent of GDP, they actually intermediation by lend little of these deposits. The loan-to-deposits ratio has been the banking system is declining over the last few years to reach only 58 percent in June weak by international standards 2006, well below the world average of 86 percent, and much less than the level of intermediation in many developed economies, where typically credit exceeds deposits. Most of the credit Only a small portion of the funds that are mobilized are lent to the extended to private productive sector, and even less to the private sector. Credit to the sector goes to a small private sector was at 54 percent of GDP in 2006, similar to country number of large comparators, yet half the OECD average. Credit to the private sector firms with most firms, especially has sharply decreased over the past few years, as private credit as a SMEs receiving little share of total credit has been declining to reach 66 percent in 2006, financing compared to 70 percent in 2003. Furthermore, much of the lending extended to the private sector goes to a few large firms, with most firms, especially SMEs, receiving little financing. Most of the funds that are mobilized financethebudgetdeficitandthe Banks, especially public sector. Banks, particularly state-owned banks, are increasingly state owned ones, investing in treasury bills and government bonds, holding about 91 increasingly invest percent and 70 percent of the outstanding respectively as of June 2006. in treasury bills and This reflects banks’ inefficiency in identifying profitable projects, as government bonds well as their cautious investment policies. Investing in treasury bills, in addition to being risk-free, is tax-exempted. Direct lending to the public sector–both the government and state-owned enterprises (SOEs)–has also increased in recent years. Lending to SOEs remains high for state-owned banks compared to private banks.

Access to Bank Financial Services

Relative to Egypt’s total Relative to Egypt’s total population, banks have few outlets for basic population, banks have banking services. Egypt has fewer bank branches and automatic teller few outlets for basic machines (ATMs) per capita than countries with similar per-capita banking services income. Relative to the developing world, Egypt’s branch density is low, and its ATM coverage is less than one-seventh that of the typical developing country. In general, banks tend to concentrate on the urban population. State-owned banks have the most balanced branch network overall, though their presence is still greater in urban than in rural areas. State-owned specialized banks are the only banks for which rural branch density is higher than urban. Private and joint- venture banks have much less rural coverage, while foreign banks have little physical presence in either urban or rural areas. State-owned banks lend mainly to large corporations, while private, joint venture, and specialized state-owned banks, followed by foreign banks, are more active in lending to SMEs. Foreign banks also reach out more than other types of banks to retail clients, possibly taking advantage of their own superior credit-scoring skills. Large corporate-sector loans are as large as 70 percent of total loans for many banks, with SME lending accounting for only 20 percent, and retail lending only 10 percent of total loans. The distribution of loans is quite concentrated in Egypt, leaving the banking system suffering from a high concentration of credit risk and lack of diversiﬁcation. Executive Summary xxi

Factors Behind Weaknesses in Supply of Banking Services The poor quality of financial intermediation is reflected in high transaction costs, large non-performing loans, and limited access for small firmsand households to financial services. This could be partially attributed to the dominance of state-owned banks, compounded by the ongoing process of institutional and operational restructuring, as well as the new and relatively untested regulatory and supervisory framework. The banking sector is dominated by state-owned banks that lag in State-owned banks, efficiency and generally in performance in financial intermediation that dominate the compared to their private counterparts. State-owned banks are banking system, undercapitalized, and suffer from poor asset quality and high levels of lag in efficiency and in financial non-performing loans. There are no incentives for them to proactively intermediation identify problem loans, maximize profits, or even minimize losses, as compared to their reflected in their relatively low profit margins, high operating costs, private counterparts and inadequate risk-management systems. Importantly for access to financial services, state-owned banks ...they are also slow to modernize and are also slow to modernize and innovate, and the volume and scope innovate, and the of products and services they offer have been limited. Although volume and scope of new products are being introduced, most loan products are quite products and services basic, generally straight lending with fixed interest rates. Fees and they offer have been commissions and treasury earnings are not significant sources of limited revenues, primarily because of a lack of product diversification. Banks are not offering hedging, forwards, factoring, or export receivables, discounting under letters of credits, and structured investment banking products. The recent increase in ATMs and credit/debit cards as well as retail lending suggest, however, that banks will see an increase in income from fees and commissions in the future. Skills to assess credit risk are generally weak, and the credit Skills to assess credit decision is centralized, especially in state-owned banks. A few banks risk are generally have internal exposure limits by sector or types of borrowers, and weak, and the credit decision is centralized require periodic financial statements from borrowers. A very limited number of banks conduct independent annual asset risk reviews, market and sector analysis sufficient to establish a solid strategy for growth or to target new markets. Most banks are characterized by lack of standard products, poorly functioning asset-liability management, and internal pricing mechanisms. The restructuring of non-performing assets in the state-owned banks has distracted management from focusing on extending credit. Another sign of a poorly functioning credit market is that lending Lending terms are terms are unfavorable, with very high collateral requirements. Usually unfavorable with very high collateral banks resort to over-collateralizing when there are problems associated requirements, and slow with foreclosure and loan-recovery procedures. Furthermore, since response times to set up banks have been operating under directed lending for some years, credit lines they are not trained to base their credit decision on cash-flows, and thus require more collateral. Slow response times to set up credit lines–excluding the setting up of the collateral requirements and registering the collateral–suggest low internal credit-approval limits, lack of competition, and overall inefficiency. xxii Executive Summary

...and there is not a While interest rates follow the government borrowing costs as a proper yield curve to benchmark, there is no proper yield curve to help price risks in the help price risks in the longer market. The lack of foreign-currency hedging instruments longer market leads banks to being overly cautious and charging high margins in foreign-currency lending. Spreads between lending and deposit interest rates are in general high, up to 10 percentage points. These high spreads reflect the need for high provisioning, and inefficiency due to overstaffing. The high spreads also show a supply- driven lending market, where banks take advantage of the lack of competition or collude in keeping spreads high. Only in lending to the large corporations do banks give evidence of much competition. Moreover bigger banks (as measured by total operating income) and more highly capitalized banks extend relatively more loans. This suggests that there are economies of scale, arguing for increased consolidation of the banking sector in Egypt. At the same time, banks with relatively more deposits—the cheapest source of funding—tend to extend relatively fewer loans, independent of bank ownership. Investigations suggest that, not having to compete for deposits creates incentives for easy forms of financial intermediation, such as lending to the government and large corporations. This analysis suggests that large private and foreign banks are best able to increase lending to the private sector in a sustainable manner in Egypt. However, state- Overall, the banking sector reform program launched in late 2004 owned banks have and changes in the business environment have rejuvenated banks. recently been subject The institutional and operational restructuring of the state-owned to institutional and operational commercial banks will further improve their efficiencyand profitability restructuring over time. Banks are improving credit policies and procedures, while provisioning for past problem loans; upgrading their banking services; ...and there has been widening the range of lending products available to the non-corporate slight improvements in banking system sector; and diversifying products as the regulatory framework adjusts performance to the new environment. The government is also making efforts to and capacity to address state-owned banks’ non performing loans (NPLs), including intermediate a time-bound scheme with resources from privatization proceeds earmarked for its implementation. The ongoing consolidation of the banking system with the exit of small private and joint-venture banks and the entry of several strong foreign banks is expected to enhance competition in the market. Such rapid consolidation will lead to opportunities to exploit economies of scale, lowering the cost of financial intermediation. The privatization of Bank of Alexandria—the fourth largest state-owned bank—in late 2006 is considered a milestone in this comprehensive reform program. The progress in the implementation of the banking reform program has been evident in the slight improvements in the banking system performance and capacity to intermediate indicators. Executive Summary xxiii

Sources For Financial Services: Non-bank Financial Services

Well-developed non-bank financial institutions can provide external Non-bank financial financing and help improve the risk and maturity profile of institutions are under developed, and face corporations’ external financing. Non-bank finance—capital markets, various obstacles insurance, contractual savings, mortgage finance, financial leasing, similar to those and factoring can serve as an important source of finance for the impeding effective real sector. However, to date, these forms of external financing are intermediation by the relatively underdeveloped in Egypt. banking system Non-bank financial institutions in Egypt face various obstacles, similar to those impeding efficient intermediation by the banking system: the still-large role of the state, through ownership as well as tightly prescribed (investment) regulations; the lack of well- functioning and efficient means of registering and enforcing property rights, especially on collateral; and limited and poorly available information bases on potential clients and borrowers. Although there is progress, further streamlining and more market-based measures are needed.

Capital Markets

Although noteworthy strides have been made, the development of The developments of capital markets in Egypt remains below potential, especially in terms capital markets in of primary markets. Egyptian firms’ access to long-term capital has Egypt remains below potential especially been hampered mainly by an inadequate legal framework, especially in terms of primary regarding new securities issuance; lack of active domestic financial markets investors; and a weak regulatory and supervisory framework. While the secondary capital markets are active, new capital market issuance–both bond and equity–have been very limited. The primary markets are much smaller than those of high-performing emerging markets. Little external financing has been made available for firms from both equity or bond markets, and what is provided mostly goes to the largest firms. As elsewhere, stock exchanges mainly target large, blue-chip companies; because of their size, low creditworthiness, and limited transparency, SMEs have more difficulties in accessing capital markets. The securities market as a source of investment financing is limited The corporate bond in Egypt. The private sector has made few corporate bond and public market is nascent and largely dominated by equity offerings in recent years. While there have been more equity commercial banks, issues than corporate bonds, many equity issues were public offerings while access to or sales of government shares in large state-owned companies, which international capital do not add to capital formation. Funds raised through corporate bonds markets is limited to large enterprises and were even less compared to equity financing. The corporate bond financial firms market is nascent and largely dominated by commercial banks, while access to international capital markets is limited to large enterprises and financial firms. No Eurobond has been issued by an Egyptian company to date. xxiv Executive Summary

Insurance and Contractual Savings Egypt’s insurance and Egypt’s insurance and contractual savings sector is small compared contractual savings to the size of its economy. Since growth of contractual savings is sector is small compared to the size of its economy typically linked to GDP per capita, with some low-income countries experiencing threshold effects, growth will take time. Still, Although penetration is higher than in other countries of the region, insurance and pension products have yet to gain broad public appeal. Only a small percentage of the working population participates in retirement plans. Furthermore, the sector does not yet do a good job of channeling resources to the private sector. The insurance sector is largely publicly owned; however, more foreign insurers are entering the market. The four largest insurers (including one reinsurance company) are majority state-owned, accounting for about 70 percent of premiums. The new foreign entrants in the insurance sector (particularly life insurers) are growing faster than both the domestic insurers and voluntary pension funds. While foreign life insurers have been able to make inroads, the largest insurers seem determined to maintain market share. The non-life sector is hardly developing, and non-life reserves are very limited. Institutional savings— Institutional savings–life insurance and other forms of long-term life insurance and savings–remain limited compared to their potential for financing the other forms of long-term real sector. The structure of the more developed non-life insurance savings—remain limited market has changed marginally over the past decade, and competition compared to their potential for financing tends to be based on price rather than product innovation. Importantly the real sector for access to financialservices,anddespitecurrentregulationsallowing insurance companies a limited degree of investment flexibility, most reserves continue to be invested in government bonds or bank deposits. This underlines the need to develop a modern corporate- finance culture with up-to-date institutional investment skills. At the same time, capital markets lack products suited to the insurance and contractual savings markets’ liability structures. Dominated by state- Dominated by state-ownership, the insurance sector’s investment ownership, the portfolios have been used for social purposes, to fund state-owned insurance sector’s banks and state-owned enterprises and to meet government borrowing investment portfolios have been used for requirements. Investment in the real sector has been relatively social purposes, to insignificant. The insurance sector suffers from a lack of investment fund state-owned skills, including lack of asset and liability management modeling banks and state-owned capacity and limited ability to assess credit and market risks. This is enterprises and to meet government borrowing exacerbated by a legal and social environment that discourages risk requirements taking and, in the state-owned insurers, a salary structure that makes it impossible to attract top graduates. The regulatory environment also places relatively tight limits on investment allocations, prudent in the absence of a risk-based supervisory regime and capacity, but limiting access to finance for the real sector. Investment decisions by private pension funds—an essential component of the contractual savings scheme—show even lower intermediation to the real and private sectors than in the insurance sector. Private pension funds tend to be managed in-house, encouraging Executive Summary xxv an overly conservative approach. Larger funds have recently begun to experiment with the use of external investment managers. Aside from insurers and private pension funds, NIB is the major potential long-term investor in Egypt. NIB has generally not invested in the real or private sectors; its main role has been to intermediate funds from a public pension system. Its investments have been for social purposes, to fund state-owned banks and the government borrowing requirement, with negligible investment in the real sector. Altogether, as a consequence of limited development and poor asset allocation, insurance, pension, and other long-term institutional investors do not provide much financing to the productive sector. However, in the context of ongoing sector liberalization and more However, in the context open entry for foreign companies, the government is undertaking of ongoing sector a major restructuring program—addressing skills misalignment, liberalization and more open entry for underwriting standards, risk management, and asset-investment foreign companies, policies—to allow state-owned insurance companies to withstand the government is competition, ensure ongoing technology transfer, and prepare for undertaking major privatization. Moreover, the success of the new foreign entrants restructuring of the insurance sector reflects product innovation, mainly investment-linked life products, and efficient distribution. It is clear that the major institutional investors are keen on expanding investment opportunities.

Mortgage Finance Several constraints limit households’ access to long-term finance for Mortgage finance is home ownership, and the consequent development of a mortgage constrained by limited access to long-term market. These include limited access to long-term funding for funding, cumbersome primary lenders, cumbersome property registration procedures, property registration inadequate collateral enforcement, lengthy court process, and procedures, inadequate untested foreclosure procedures; consequently, interest rates collateral enforcement, lengthy court approximate those for unsecured lending. Another key challenge is process, and untested the undeveloped regulatory framework for securitization to enhance foreclosure procedures the secondary mortgage market. As a result, most commercial banks—state-owned and private— are extending loans to homebuyers, mostly as part of their retail activities or their lending to developers, by using collateral other than mortgage pledges. Although most banks are liquid, they are reluctant to extend mortgage loans, mainly because of maturity mismatches between short-term deposits and long-term mortgage loans, and lack of registered titles. There are currently few non-bank real estate lending companies extending mortgage loans. Until a few years ago, only some individuals buying houses could obtain finance,but not in the form of mortgage loans. The most common finance arrangement was the deferred installment system where the developer receives a down payment of around 10 to 25 percent of the purchase price, followed by installments over four to eight years, and the title is formally transferred when the last installment is paid. Under this system, purchasers pay a significantly higher interest rate than if they could obtain a loan secured on the property, and xxvi Executive Summary

short maturities require high repayments. The system also ties up the funds of developers, who would rather invest into new projects, and can be constrained by an adverse cycle of real estate markets. In general, it prevents many from entering the housing market, and is only a second-best to genuine residential mortgage markets. Over the past few Over the past few years, the government has made progress years, the government in developing an enabling environment for a modern residential- has made progress in mortgage market. This includes setting the legal foundation and developing an enabling environment for a improving collateral enforcement and foreclosure procedures. The modern residential- government has significantly reduced fees for property registration, mortgage market alleviated bottlenecks in the new urban communities, and launched a systematic title adjudication, survey and registration process to modernize the property-registration system. The legal and institutional framework now also allows private-sector financial institutions to securitize mortgages. The recent Another major development has been the incorporation of the incorporation of the Egyptian Mortgage Refinance Company (EMRC), which will enable Egyptian Mortgage qualified mortgage lenders to access term refinancing for mortgage Refinance Company will enable qualified loans and better manage the risks of mortgage lending. EMRC will mortgage lenders to also offer banks a safe channel to lend excess funds to other credit access term refinancing institutions. The term finance that EMRC will provide to primary for mortgage loans and mortgage lenders will help them reduce the liquidity risk incurred in better manage the risks of mortgage lending providing long-term housing loans. The EMRC is expected to improve access through competition in the mortgage market (by creating a funding source of non-depository lenders), promote the development of safe and sound mortgage credit standards, and spur the development of fixed-income securities markets. All these developments will help shift most of the burden of housing finance from the government budget and develop access to mortgage finance through financial markets.

Financial Leasing Financial leasing is Financial leasing is comparatively little used in Egypt, and the annual comparatively little volume of leases is quite small relative to other forms of financial used, and the annual volume of leases is quite intermediation and economic activity. There is a small stock of small outstanding leases, and the number of leasing contracts and leasing companies is modest. Most leasing companies are controlled by banks or bank affiliates. The government has recently acted to develop the financial leasing industry, including exempting leasing companies from stamp duty and removing obligations to limit debt interest to a maximum of four times their capital; eliminating restrictions on leasing companies lease of assets including land, cars, and tourism buses; and simplifying the contracts-registration process. The Leasing Association was revived in 2005 to provide a forum to voice to leasing companies’ concerns and to ensure dissemination of best practice. In spite of these recent reforms, the development of the leasing industry is still hampered by an unsupportive institutional environment. One of the major impediments is the difficulty of Executive Summary xxvii

repossessing assets (due in part to the inadequate enforcement ...the financial of ownership rights), as well as delays in the collection of overdue leasing industry is still hampered by payments. Enforcement of court orders, especially for movable assets, an unsupportive is a major issue, and the costs associated with repossessions are very institutional high. It is also difficult to sue defaulted clients for breach of contract, environment and the time to collect on a dishonored check is between one and five years. Another impediment for the growth of the leasing industry, as for the financial system at large, is the unavailability of adequate and reliable credit information. The leasing industry is also constrained by the lack of long-term funding, and its relatively high cost when it is available. Together with poor market conditions, these factors have reduced leasing companies’ ability to seek clients, especially start-up enterprises.

Factoring

Factoring in Egypt is currently almost non-existent. Enterprises Factoring is almost finance their accounts receivables through banks or from their own non-existent in Egypt, enterprises finance sources, increasing their financing requirements. Like other non- their accounts bank financial institutions, factoring companies do not have access receivables through to potential clients’ creditworthiness information, and are impeded banks or from their by the inefficient legal mechanism for collection of receivables. The own sources government has recently undertaken numerous reforms to foster the factoring industry, including amending the Executive Regulations of the Investment Law, setting the main rules and regulations governing factoring activities; licensing requirements; registration requirements and procedures; and establishing surveillance that includes financial adequacy, credit risk protection, disclosure, accounts receivable bookkeeping, and collection services. The amendments also facilitate the entry of factoring corporations.

Access to Microfinance Institutions and Postal System The demand of household and small firms for microfinance is largely The demand of household and small unmet. A conservative estimate suggests that there are at least 2 firms for microfinance million micro enterprises in Egypt as of June 2006, accounting for is largely unmet 93.7 percent of establishments. While no formal aggregate estimates are available, it is estimated that the outreach of the microfinance industry in Egypt covers only about 10 percent of potential borrowers. Microfinance institutions, however, often do not have the necessary skills and scale. The recently endorsed National Strategy for Microfinance is expected to address the constraints to the development of the microfinance industry in Egypt. Egypt Post plays a limited role in financial intermediation despite Egypt Post plays a its huge branch network of more than 3,600 branches, many of them limited role in financial intermediation despite in remote areas. It provides low-cost savings and transaction account its huge branch services, supported by a centralized high-speed network linking all network main offices. Only 600 are connected via DSL lines, and many do not offer a full range of financial services. To date, Egypt Post cannot xxviii Executive Summary

exchange payments directly with other banks, but interoperability between its network and some inter-bank networks is under preparation.

INSTITUTIONAL ENVIRONMENT

Egypt does not have an Egypt does not have an enabling institutional infrastructure for enabling institutional a sound and efficient financial system. However, specific efforts infrastructure for a have been exerted to improve the infrastructure and institutional sound and efficient financial system environment for efficient intermediation include improving and strengthening the legal, regulatory and supervisory framework, information infrastructure, financial reporting, the payments system, and entry and exit policies. Regulatory gaps are being filled, and new institutions are being created. The overall direction is promising, but it will take much more time to develop institutions, particularly in the judicial area, that facilitate easy access to financial services.

Legal Framework

The prevailing legal The prevailing legal framework in Egypt still constrains the cost framework in Egypt and terms of finance. Some laws are poorly written, especially still constrains the cost and terms of finance those regarding secured transactions, bankruptcy, and settlement of disputes. Moreover, the court system, though well reputed for its impartiality and independence, suffers from several drawbacks that keep it from helping expedite debt collection and resolve other financial disputes. This is due to several reasons, the most important of which are backlog and delay; where loan recovery procedures for bankruptcy and foreclosing on defaulters can drag on for several years. There are no specialized courts for financial institutions, and no specialized judges with adequate knowledge of financial market risks. Judges are often not acquainted with complex banking transactions and debts recovery of financial institutions, a matter that can result in inconsistencies between courts’ judgments. Enforcing a final court judgment (after the three to five years needed to obtain it) is complex and time-consuming. Collateral legislation is poorly enforced. Property-rights registration and titling issues make it difficult for firms, especially SMEs, to use land assets as collateral. Even when collateral is registered, there is no information on its value. This inadequate legal and judicial system has resulted in uncertainty and high cost, making banks reluctant to lend or choose for over collateralizing of lending. An index of the costs to create collateral shows Egypt to be ranked among the most costly. The poorly enforced Shortcomings in rules for secured transactions have hindered collateral legislation, access to finance. Egyptian law recognizes three major forms of and the shortcomings security, mortgage, pledge, and business charge, which are governed in rules for secured transactions have by rules that have shown various shortcomings in actual practice. An hindered access to index of creditors’ legal rights shows Egypt to be ranked among the finance lowest developing countries. The rules on enforcement are complex Executive Summary xxix by design and formalistic in the extreme; procedures for enforcement are very time-consuming (notification, attachment, and sale by public auction); the process of sale is inefficient, resulting in very modest proceeds; and private sale and strict foreclosure are not legal. The bankruptcy rules adhere to historical perceptions of the The bankruptcy rules bankrupt betraying creditors’ trust. The law focuses on personal adhere to historical perceptions of the bankruptcy, as opposed to corporate bankruptcy. Moreover, the rules bankrupt betraying rely on liquidation and fail to provide any regulation for reorganization, creditors’ trust and the process is multi-layered, complex, and time-consuming. The court plays a very active role in supervising and approving all aspects of the process, leading to further delays. The eventual outcome which is the sale of the debtor’s assets via public auction, that results in very low proceeds. Internationally, Egypt compares unfavorably in terms of the time it takes (more than six years), the cost (more than 25 percent of the estate), and the recovery rate (less than 20 percent). Altogether, Egypt is ranked 106th globally in these dimensions.

Information Infrastructure—Credit Registry, Credit Bureau and Other Sources Credit information in Egypt is inadequate and unreliable, and market There is a lack of information is poor. Bankers and firms have difficulty making sound information on clients’ creditworthiness and credit decisions due to lack of information on clients’ creditworthiness sector-related statistics and sector-related statistics. The only source of credit information is the Public Credit Registry at the Central Bank of Egypt (CBE), which has until recently been accessible only by banks. However, a new strategy for expanding access to credit information and enhancing the information infrastructure is being implemented. Various legal, regulatory, and institutional reforms have allowed for establishing private credit bureaus and sharing credit information with non- bank financial institutions. This is expected to improve access to finance, particularly for SMEs, as well as facilitate the development of independent leasing and mortgage finance companies. The private credit bureau, ‘iScore’ is expected to improve the quality of information, decrease the cost of obtaining credit information, and hence the overall costs of intermediation.

Financial Reporting Environment

Another factor hampering access to finance in Egypt is the quality of The quality of financial financial reporting. External users of corporate financial information reporting is another generally do not have enough confidence in the reliability of firms’ factor hampering access to finance financial statements to make their decisions, but rather rely on the company’s reputation, its major shareholders, and other qualitative factors. Despite progress in the setting of accounting and auditing standards, numerous deficiencies in Egypt’s current financial reporting environment still exist. There are recurring incidents of divergence between accounting standards as designed and as practiced. Investors are concerned about enforcement mechanisms and the regulatory framework for accounting and auditing xxx Executive Summary

The modest quality of practitioners. The level of users’ confidence is further eroded by the corporate financial perception that university education places insufficient emphasis on reporting leads to keeping accounting curricula up to date. Small borrowers, especially, increased risks to lenders and investors, are overburdened with the high cost of maintaining appropriate and in turn higher accounting systems and the high cost of retaining qualified auditors. costs of borrowers The resulting modest quality of corporate financial reporting leads to increased risks to lenders and investors, and in turn higher costs for borrowers. Moreover there are Related to the quality of financial reporting are deficiencies in the deficiencies in the accounting and auditing regulatory framework and its enforcement. accounting and auditing regulatory There is no requirement for professional qualifying examination to framework and its practice auditing, no applicable peer-review practices through which enforcement auditors can provide cross-examination to each other’s working papers, and no supervisory body to monitor auditors’ working practices of auditors and enforce disciplinary actions violators. A company cannot appoint an audit firm, but rather appoints an individual partner of a firm; as a result audit firms cannot be held liable. Various legal and institutional reforms undertaken so far to enhance accounting and auditing practices represent important interim arrangements. However, they will eventually need to be integrated under legislation that comprehensively regulates the profession.

Financial Infrastructure Cash, cheques, and large-value inter-bank transfers are the basic means of making payments in Egypt. Cash is the major instrument for individuals, and cheques are primarily used for commercial transactions and some government payments. CBE operates the cheque-clearing system, and only one automated clearing house exists in Egypt. The CBE has led efforts to create a modernized payments- systems infrastructure to cover systems operations, policies and regulations, and oversight. To enhance efficiency, the maximum settlement period has been reduced from five working days to at most two; new instruments like direct debit have been added and payment cards have been introduced. Challenges facing Nevertheless, there are challenges facing the payments system, the payments system, including the legal framework covering payments and securities including the legal settlement systems, and the oversight function. Furthermore, framework for the settlement system, although Egypt is one of the five top countries in terms of inflows and the oversight of remittances, there are currently no particular measures in place function, as well as the to control the liquidity and credit risks of cross-border transactions, lack of mechanism to or regulations specifying minimum service levels or minimum regulate cross-border transactions transparency requirements for international remittances or other types of cross-border payments. There is also no structured framework to improve the efficiency of remittance services. Executive Summary xxxi

Entry and Exit Rules and Practices The Egyptian financial system has suffered from significant entry and The Egyptian financial exit barriers. The banking system is subject to restrictive regulations system has suffered from significant entry such as special licenses and permits, which have prevented new entry and exit barriers and branch expansion, limiting competition. At the same time, banks as a result of which in Egypt have not been allowed to fail. Weak banks were left to competition was operate, while measures such as restructuring, merging or liquidation limited and inefficient banks were allowed to were not applied early enough. As a result, inefficient banks were continue operating kept operating and encouraged to indulge in high-risk activities, while sound banks were forced to subsidize them. However, as part of the reform program, the government has improved the rules and practices for entry and exit of banks and other financial institutions, which will ultimately increase the competitive landscape in Egypt.

Policy Recommendations

The speedy completion of the financial-sector reform program and The speedy completion the restructuring of state-owned financial institutions are essential of the financial sector reform program and to enhance access to financial services. Equally important is the restructuring improving the quality of the institutional environment and corporate of state-owned governance. Enhancing the role of banks that have a huge branch financial institutions network, of the postal system, and of microfinance institutions is are essential to enhance financial crucial for the access agenda. It is essential to improve and widen intermediation the availability of financial services in Egypt, especially for small firms and poor households, to enhance growth in the economy. The securities issuance system; institutional investment deregulation; and the regulatory capacity and policy framework should be reformed to enhance the primary markets. Ultimately, the combination of financial restructuring and institutional reform will make Egypt’s financial sector more developed and efficient, leading it to provide better-quality financial products and services, exhibiting a lower cost of financial intermediation, and being more competitive. The gains of better financial-sector development apply especially Improving small firms access to finance allows to small firms. Small firms that have proven their ability to survive them to capitalize and grow in the marketplace can be important engines of innovation, on their growth job creation, and growth. Although both large and small firms need opportunities, operate efficient access to financial products to remain competitive, small on a larger scale, and contribute more fully to firms are typically much more growth-constrained by lack of finance. economic growth Small firms’ opportunities to develop into large, successful firms are influenced by a conducive overall investment climate—easy entry and exit, clearly established and protected property rights and good contract enforcement. Improving access to finance allows them to capitalize on their growth opportunities, operate on a larger scale, and contribute more fully to economic growth. xxxii Executive Summary

Enhancing the Role of the Banking Sector in Financial Intermediation

Restructuring the Restructuring the state-owned banks is important, not only for state-owned banks is stability and reducing fiscal costs and contingent liabilities, but important, not only for also for access to finance. The government should also continue stability and reduction of contingent liabilities, the institutional restructuring of the state-owned banks that but also for access to are likely to remain in public hands for some time, to assure they finance support a competitive market. Once the state-owned banks have been restructured and privatization is solidly underway, incentives for sound financial intermediation and a more competitive market structure will emerge. As private banks identify their comparative advantage and competitive niches, and as margins are squeezed in traditional markets, access to financial services for small firms and households can be expected to increase and the quality of financial services enhanced. However, lessons from other countries suggest that reaping benefits of banking reform require a comprehensive approach. In depth restructuring of the state-owned banks will take time to be completely implemented, but does ultimately pay off. Enhancing state-owned Enhancing state-owned banks’ corporate governance is a vital banks’ corporate step in the banking-sector reform agenda. It entails formulating governance is a vital quantifiable performance measures; specifying how the costs step in the banking- sector reform agenda associated with providing social-public services are to be covered; commissioning annual independent bank audits; and making an ongoing assessment of costs versus outcomes. The government should consider consolidating the responsibility for exercising ownership functions in the state-owned banks within a single ministry once the reform program is implemented. Sound corporate governance arrangements should clearly specify the respective responsibilities, authorities, and accountabilities of the owner, board, and executive management within a well-defined legal and institutional infrastructure. It is crucial to It is crucial to fasten the role of specialized state-owned banks fasten the role of in financial intermediation, and make better use of their branch specialized state-owned networks. This entails a comprehensive program for institutional, banks in financial intermediation, and operational, and financial restructuring for these banks. Prior to make better use of their restructuring these banks a formal assessment of their future is branch networks, which essential, including re-examining and clarifying their mandate entails re-examining in light of their current and prospective performance, considering and clarifying their mandate whether any social and public policy objectives that remain valid can be met more cost-effectively by other means. An important context for such an assessment is a rethinking of the role of subsidized credit. The government should ensure that any capital injected into specialized state-owned banks is done in conjunction with their operational and institutional restructuring. In the longer run, consideration could also be given to consolidating the ownership function for specialized banks. If there are no realistic prospects for significant and sustained progress in restructuring these banks, the government might consider privatizing them. However, if the banks Executive Summary xxxiii are needed to meet certain social objects, the government could consider alternatives such as transforming them into funds, such as the Social Fund for Development (SFD), that might be more successful in addressing the social agenda. The authorities should consider further privatization in the Further privatization banking sector. Even with the successful implementation of the should be considered since even when there Financial Sector Reform Program—the privatization of Bank of is a sound governance Alexandria, and the full divestiture of public sector shares in joint structure in place to venture banks–public ownership in the banking system is expected insulate state-owned to remain as high as 48 percent. Furthermore, divestiture of state- banks from direct political pressure; owned banks’ share in joint venture banks by itself will not assure the need to achieve their total privatization when other non-bank public entities, such various government as the state-owned insurance companies and the NIB, retain shares. policy objectives may Empirical evidence shows that banks that were majority privatized prelude the efficiency that a privately- performed better than those that were partially privatized. owned bank would Moreover, cross country experience has shown that even when achieve in financial there is a sound governance structure in place to insulate state- intermediation owned banks from direct political pressure; the need to achieve various government policy objectives may prelude the efficiency that a privately-owned bank would achieve in financial intermediation. Restructuring these banks does not guarantee better performance in the future since the restructured institution may not be able to depart from old lax management that had been at the root of current problems. The history of state-owned banks restructuring is replete with cases of recapitalization that had gone awry—sometimes requiring repeated waves of financial support that fail to improve the bank’s position on a sustained basis. In the meantime, it is important that the government make enhancing access to credit an explicit objective of the overall banking- sector strategy. With a large and stable flow of savings into the banking system, increased competition has significant potential to increase access. As private banks identify their comparative advantage and competitive niches, and as margins are squeezed in traditional markets, access to financial services for small firms and households can be expected to increase and the quality of financial services enhanced. Most successful efforts have in common a limited direct government The government role in credit granting and pricing. In promoting increased access to should de-emphasize finance in Egypt, the government should de-emphasize subsidized subsidized lending schemes, and instead lending schemes, and instead promote commercially sustainable promote commercially expansion of access. Government-subsidized credit programs mostly sustainable expansion have proven costly failures because they undermine the commercial of access incentives for both banks and borrowers as well as introduce other distortions; moreover, they can give rise to the potential for corruption in the allocation of subsidized funds. Governments should remove policies that either unnecessarily impede the ability of banks to design, price, and offer loan products, or that undermine the commercial incentive structure for banks or borrowers. xxxiv Executive Summary

Expanding Postal System and Microﬁnance Institutions

The postal system’s The postal system’s potential contribution to improved access to potential contribution financial services is great, especially in rural areas, and is crucial for to enhance access is enhancing access in Egypt as a whole. Authorities can make better use great, especially in rural areas of the network of postal offices to expand access by encouraging Egypt Post to diversify the range of services it offers. Such diversification may entail distribution of credit, provided it is regulated by CBE, which would require postal financial services being institutionally split from Egypt Post. Another option would be for Egypt Post to distribute credit on behalf of a commercial bank through a strategic partnership, which would not require a banking license. Such an ambitious diversification strategy entails capacity-building in many fields, including cost accounting, negotiations, market-driven product development, and information technologies. The government should promote the complete integration of all postal outlets into its online network to enhance postal payments and savings products, and consider using this distribution and IT infrastructure for credit extension, tapping relevant international expertise to promote successful expansion. Microfinance offers a Microfinance offers a mean of addressing the household and mean of addressing the small firms’ demand for access to financial services. Egypt appears household and small relatively well advanced in its adoption of the business and lending firms’ demand for financial services practices associated with the commercially sustainable provision of microfinance. This experience could be tapped to improve access to financial services, especially credit. Microfinance business practices, involving specialized lending techniques, incentive-based loan officer compensation policies, and information technology capabilities, have broad application to the SME lending market. Some banks might therefore profitably apply microfinance policies and practices toward the SME sector. Leveraging Egypt’s State-owned banks should be encouraged to make full use knowledge and of the opportunity. At the same time, banks that have recently experience with micro penetrated the small-business finance market and have been active lending and pursuing the national strategy in providing microfinance should be cautious in selecting credit for microfinance are policies or procedures and in employing sufficiently skilled staff. It important steps is also important to ensure that the current banks’ regulatory and supervisory practices do not unnecessarily inhibit the broader adoption of these practices. The constraints, for example, to wholesale lending by commercial banks to microfinance lenders that should be removed. Pursuing and leveraging the National Strategy for Microfinance is an important action.

Promoting Capital Markets in the Access Agenda

Egypt is relatively Egypt is relatively well endowed with the ingredients for a well- well endowed with the functioning primary securities market. The government’s reform ingredients for a well- commitment remains strong, the securities industry is becoming functioning primary securities market more active, and foreign investors’ interest remains high. However, capital-market reforms in Egypt to date have mainly focused on Executive Summary xxxv

secondary markets and have not extended to easing firms’ access to ...but the government securities markets through new issuance. Direct firm finance in the should place a higher capital markets should be recognized as a priority in Egypt’s overall priority on primary market development, financial sector reforms. The government should place a higher that would help raise priority on primary market development, which would help raise long-term funds for the long-term funds for the productive sectors. productive sectors Reform measures would involve reducing issuance costs, deepening investor base and creating an issuer-friendly policy and regulatory There is also a need to environment. On lowering issuance costs, various legal reforms are reduce issuance costs, needed, including improving legal procedures for securities issuance, deepen investor base, completing the recently begun shift from a merit-based to a disclosure- and create issuer- friendly regulatory based system, increasing managerial efficiency of regulators and framework streamlining any increased disclosure requirements and procedures, as well as, increase government bond liquidity. Deepening the investor base could be attained by enhancing collective investment schemes regulations, developing retail programs for privatization initial public offering (IPO), and expediting the consolidation among brokers and promoting competition. Creating a more issuer-friendly regulatory framework could be achieved through various measures, including reinforcing the new Corporate Finance Division (CFD) at the Capital Market Authority (CMA) with competent staff to champion direct corporate financing through securities issuance; improving CMA statistical system to conform to the World Federation of Exchanges (WFE) standards; strengthening its capacity in data and information dissemination; and improving information disclosure at CMA and the Cairo and Alexandria Stock Exchange (CASE) to enable investors obtain more information regarding corporate governance structure and important corporate actions. A more reliable yield curve should be created for private issuers A more reliable yield through reducing non-tradable government bonds and implementing curve should be regulations for repurchase and for securities lending and borrowing. created for private issuers through The authorities should also consider removing CMA approval of CASE reducing non-tradable board decisions and review the CASE ownership and governance government bonds structure. CMA should proceed with its public-awareness campaign, and implementing to increase the public’s information on the capital market instruments regulations for repurchase and for and develop a better understanding of the risks and returns involved securities lending and in investing in these instruments. This will also help enhance average borrowing retail investors’ basic knowledge of capital market investments. Raising awareness of new instruments, such as hybrid bonds with equity elements for corporate finance, is crucial. New equity markets for ventures and high growth firms need to be studied. Importantly, these actions should be implemented within the These actions should context of a well-designed overall strategy. A National Capital Market be implemented within Development Strategy should be established in coordination with a well-designed overall National Capital the government debt market and privatization policies, within the Market Development framework of the existing Financial Sector Reform Program. This Strategy strategy should include four main pillars: promoting the external financing of Egyptian firms; fostering more direct and indirect xxxvi Executive Summary

securities holdings by households; enhancing the competitiveness of the capital market industry; and accelerating the integration of the Egyptian capital market in the MENA region and the world at large.

Contractual Savings Industry Potentials for Growth The contractual The beneficial role of insurance and contractual savings for savings industry has economic development is becoming more evident. Recent research considerable potential for growth and has demonstrated that the development of contractual savings efficiency gains, thereby institutions is associated with efficiency gains at the firm level, improving access to including increased availability of long-term finance, reduced costs of finance for firms capital, and greater resilience in the private sector to external shocks. These benefits come about in more market-based economies through a decrease in firms’ leverage (at least in the formal sector). In more bank-based systems, insurance and contractual savings development leads to an increase in the maturity of debt. The development of insurance and contractual savings institutions also lets governments transfer common, good obligations, such as insurance against income loss, unforeseen natural events, adverse health, and old-age security– to markets, thus enabling governments to target their expenditures more efficiently at those functions that cannot be served by markets. The short-term reform The Egyptian contractual savings industry has considerable agenda entails the potential for growth and efficiency gains, thereby improving access restructuring of to finance for firms. Egypt should be able to at least double real long- existing institutions; developing a term funds under management within a decade. The contractual professional savings sector can then become an important source of investment investment- financing, as is usually the case in more-developed economies. This management industry; will require, besides general economic development, many specific encouraging better asset management; and reforms in both the near and long term. The near-term reform stimulating the supply agenda entails the restructuring of existing institutions; developing of investment-grade a professional investment-management industry; encouraging better schemes issued by the asset management; and stimulating the supply of investment-grade real estate sector schemes issued by the real estate sector. Further developing the contractual savings industry and ensuring ...while medium- that institutional investors become a major source of financing will term measures require in the medium-term enhancing the participation of the private include, enhancing sector, and continuing the restructuring of state-owned insurance the participation of companies; improving investment management; strengthening the the private sector, and continuing supervisory and regulatory authority; and adopting a long-term the restructuring pension-reform strategy. Other reform measures include easing the of state-owned investment limits for insurers and moving towards a prudent investor insurance companies; regime; and removing all direct taxes on savings and reviewing the strengthening the supervisory and finaltaxesonlong-termsavings.Specificactionsrecommendedinclude, regulatory authority; inter-alia, carrying out a thorough review of funding levels (using and adopting a long- international actuarial skills and working with the local actuarial term pension-reform profession); developing a resolution strategy if needed; developing strategy a larger cadre of local actuaries trained to do pensions work; and allowing outsourcing to professional fund managers and third-party administrators, including qualified insurance companies. Executive Summary xxxvii

Developing the Mortgage Finance Market Affordable housing finance not only provides a much-needed social Affordable housing good, but also generally facilitates access to finance by making an finance not only provides a much-needed important asset available as collateral. To improve access to housing social good, but also finance, it is crucial to have a private-sector-led mortgage finance generally facilitates system; market competition among primary lenders; longer-term access to finance by market-based funding from institutional and private investors; and making an important asset available as measures enabling primary lenders to alleviate and better manage collateral the associated financial risks, particularly credit risk. The key required reforms in the short-term include: strengthening Required reforms the regulatory and institutional framework for the mortgage market; include strengthening the regulatory streamlining property registration procedures; and developing the and institutional EMRC. However, in the intermediate and long term, the government framework for the needs to transform EMRC into a securitization company, and develop mortgage market; smarter and targeted housing subsidies. The Guarantee and Subsidy streamlining property registration procedures; Fund (GSF) also needs to adjust and monitor a new program of credit- and developing the linked subsidies to favor the accessibility of underserved groups, Egyptian Mortgage according to housing markets and credit-affordability limits. Refinance Company The development of an active secondary mortgage market will also require a comprehensive evolution of the regulatory framework. A specific aspect is the rules for those securities designed to be secure, as that will importantly drive the demand for securitized instruments. Also, banks and specialized mortgage companies will need to be placed on a level playing field with respect to permitted leverage ratios. Further regulations will be needed, notably by CMA, regarding the disclosure and listing of these specific instruments as far as information about the mortgage pool is concerned. To work efficiently and at low cost, securitization requires the In the long-term the existence of a robust institutional infrastructure. This includes rating mortgage refinance company needs to be agencies on which investors can rely for accurate information and transformed into a assessments of the issued securities and also of credit enhancement securitization company from collateral cash flow, such as subordinated securities or third parties (including pool insurance provided by mortgage insurers or bond insurers to manage the credit and agency risk inherent in third-party organization and servicing). It also requires large volumes of mortgages to be securitized in order to keep per-unit operating costs low.

Increasing Financial Leasing Industry’s Contribution to Access The financial leasing industry can play a very important role in The financial leasing developing financial markets and providing finance to enterprises. industry can play a very important role in Financial leasing companies have a dual role, they complement the developing financial banking sector by increasing the range of products and services; while markets and providing they compete with the banking sector, forcing it to be more efficient finance to enterprises and responsive to customers’ needs. Financial leasing companies can especially help small-scale firms that face problems obtaining credit from banks. In addition, leasing plant and equipment is extensively ii Executive Summary

used in many developed economies as a means of expanding large firms’ access to credit, including through term finance. This requires legal and Short-term measures that can boost the leasing sector in Egypt regulatory reforms, include, ensuring that the leasing law contains a clear, precise as well as enhancing definition of leasing; amending the law to remove any differentiation the institutional framework of the based on the type of assets leased, allowing leasing of non-commercial leasing industry purposes, and permitting banks to offer financial leasing products without having to establish separate entities, and enhancing the institutional capacity by upgrading registry procedures for leased assets. A dedicated regulator and an active organization of leasing companies would allow the leasing industry to have more visibility and attract more clients. Long-term measures include, building a supportive regulatory environment and a strong judicial system with clear rules for assigning property rights; strengthening the information infrastructure; improving the dissemination of information on the leasing industry enforcement of foreclosures; and facilitating repossession of assets in case of default. It is also crucial to impose accounting standards that comply with the International Accounting Standards (IAS) and adhere to Anti Money Laundering and Combating Terrorism Financing (AML/CTF) standards. Other long-term measures include providing leasing firms with better access to long-term funding sources, where developing the bond market and asset-backed securities market through effective implementation of the securitization law is important in this respect.

Developing the Factoring Industry The factoring industry The factoring industry should be strongly encouraged in Egypt. could be encouraged Developing this industry would require extensive efforts since by improving credit worthiness factoring involves the sale of (a portfolio of) receivables, where the information, and credit information on inter-enterprise credit is a major basis for developing an adequate analyzing the asset’s creditworthiness. It is crucial to give factoring legal mechanism for ﬁrms access to information on clients’ creditworthiness, and not just enforcing collection of receivables and legal require them to provide such information. Developing an adequate rights of creditors legal mechanism for enforcing collection of receivables and legal rights of creditors is important. While better enforcement is needed in general to enhance ﬁnancial intermediation, this recommendation applies particularly to factoring.

Improving the Institutional Environment

Fostering greater Fostering greater access to financial services requires improving the access to financial institutional environment, to allow for the emergence of an efficient, services requires increasingly private-led financial system, which will better serve improving the institutional Egypt’s development and growth objectives. Improving the legal environment framework, enhancing the credit-information system, improving financial reporting, and modernizing the payments system are key priorities. The quality and enforcement of property rights and the availability of information are especially important for SMEs’ access to financial services. Executive Summary xxxix

Legal Reforms Legal reforms to improve the lending environment relate not only Legal reforms to to how laws are drafted but to how they are being implemented. In improve the lending environment relate not the past, policy-makers have often avoided legal reforms because that only to how laws are they would only bear fruit after a few years after long debates at drafted but to how they the parliaments. This has deprived Egypt of the benefits of reforms are being implemented that, had they been initiated in the mid-1990s, would have resulted in a significantly different the legal landscape today. Therefore, it is paramount for Egypt to focus on legal reforms today, especially for secured transactions, bankruptcy, and the court system. A full appreciation by policy-makers of the role of collateral A full appreciation of in providing finance is the starting point for reforming the law on the role of collateral secured transactions. Reforms should entail revisiting the theoretical in providing finance is the starting point for foundations of the law, its policy objectives, and the substantive reforming the law on and procedural provisions the law should embody. The Model Law secured transactions on Secured Transactions, prepared by the European Bank for Reconstruction and Development (EBRD), serves as a useful model for policy-makers to consider. This Law introduces Common Law concepts that can facilitate the taking of security; in so doing it has provided some safeguards that reflect Civil Law traditions while departing from those Civil Law concepts that represent a major impediment. Legal reforms would have to address the core problems facing lenders and aim to provide legal solutions that eliminate difficulties. Policy-makers should opt for a comprehensive approach, avoiding piecemeal solutions that have complicated and confused the legal system in the past. It is not merely that minor legislative changes are needed; rather The entire system the entire system of bankruptcy rules should be re-conceptualized. of bankruptcy Lawyers, economists, bankers, and policy-makers need to agree on rules should be re- conceptualized the objectives of the law. It should be clear that the role of bankruptcy provisions is to provide ailing firms with an orderly means of exit through the liquidation process; to help reallocate assets to better uses through rehabilitation; and to ensure a timely resolution of the problems of insolvent or financially distressed firms, while at the same time ensuring a socially efficient disposition of distressed firms’ assets. Accordingly, the existing rules on bankruptcy should be amended to ensure that there are adequate provisions on corporate bankruptcy; a comprehensive regulation for reorganization; a simpler process; and a more proactive role for creditors. Reforming the judicial system to overcome its difficulties is a long- Reforming the judicial system is a long-term term process that requires policy-makers’ commitment and long- process that requires term vision. Judicial reform is not only important to lenders and commitment and long- related to access to finance, but a matter that affects foreign and local term vision investments. While recent efforts have partially improved the lending Policy-makers should environment, without comprehensive reforms it would be difficult to opt for a comprehensive envisage real improvements in the legal environment affecting access approach, avoiding to finance. Specific policy changes to address the judicial inefficiencies piecemeal solutions include streamlining the flow of cases to ensure that only genuine that have complicated and confused the legal cases, and not frivolous ones, are entertained by the courts. Here, the system in the past xl Executive Summary

introduction of the Common Law notion of “cost follows event” can provide useful results, at least in commercial cases. Moreover, appeal should cease to be “quasi-automatic” as practiced today and a “leave to appeal” process should be considered. The rotation and training of judges, whether as part of the Economic Courts under consideration today or independently, should be given serious attention.

Regulatory and Supervisory system Conducive to Efficient Delivery of Financial Services The regulatory and supervisory system in Egypt is relatively new and The regulatory and its efficacy and efficiency have only been tested in recent years. From supervisory system the analysis of banking practices, it is clear that there are a number of should be more areas where the design of regulations and the way supervision is being conducive to efficient delivery of financial conducted are not yet fully conducive to efficient provision of financial services services so as to increase access. To address the legal uncertainty, the government can issue a clear statement from the highest level that banks and loan officers will not be subject to criminal prosecution for loans that become non-performing, regularly issue a list of individuals with the largest NPLs, and remove remaining distortions impeding sound financial intermediation. There is a heavy emphasis on compliance, rather than risk-based supervision; this imposes a heavy burden on financial institutions. An integral component of the Financial Sector Reform Program is strengthening the capacity of the supervisory bodies, which entails moving to risk-based supervision, and addressing the redundancies and inefficiencies in the way supervisory data are requested and collected. Reporting requirements, especially those initiated during the foreign-currency shortage, should be reviewed, and the reporting requirements for tax compliance, foreign currency obligation tracking, and other non-banking purposes should be streamlined. Moreover, efforts to collect on-site and off-site supervision reports need to be further streamlined.

Credit Information System

Improving the quality To enhance access to finance, it is essential to improve the quality and credibility of the and credibility of the credit information system. Operationalizing credit information the private credit bureau is an important step forward. The private system requires developing the public credit bureau should set up its own credit-information database of credit registry and bank and non-bank financial institutions, as well as combine the data operationalizing the of the public and private credit bureau, which would be available to new private credit qualified users. Alternatively, there could be an interface linking the bureau public credit registry and a private credit bureau. The public credit registry would continue to exist to meet its legal mandate, until a decision is made about whether it would be combined with the private credit bureau or an interface would link both. The current credit marketplace’s focus on aggressive growth in the retail business requires continuing the expansion of the public credit registry at CBE. Were CBE to wait for the newly established private credit bureau Executive Summary xli to be fully operational, and cease adding credits to the public credit registry database, there would be a two- to three-year gap where significant credit and demographic data would not be available to banks active in retail lending. The amount, quality, and reliability of information on clients’ creditworthiness at the public credit bureau should be significantly improved. Data collections need to identify the manner of payment, the length of the outstanding loans, the history of loan balances and repayments, and any changes in the terms of the loan. These additional data will help identify cases of rescheduling and rolling over of loans—a significant problem in Egypt. It is also important for creditors evaluating potential clients to have information on individual loans, the origination date, the maturity, and the type and value of collateral. Introduction by the credit registry of a standard credit-report format and a unified credit-scoring methodology is necessary for financial intermediaries (currently each bank uses its own methodology, which they do not necessarily report to the registry department). Moreover, the central bank should introduce charges for both successful and unsuccessful searches of the registry database. Moreover, imposing stricter penalties on misreporting, and improving the enforcement of such penalties, should be considered to prevent malpractices and ensure the quality of credit information.

Financial Reporting Environment Enhancing the financial reporting environment will enhance financial Enhancing the intermediation, especially for SMEs. Advancing the new draft financial reporting environment will accountancy-profession law will strengthen the regulatory framework, enhance financial and its implementation will eventually restore users’ confidence. To intermediation, ensure wide recognition of the reliability of financial statements, the especially for SMEs Egyptian Accounting and Auditing Standards should be in consistent alignment with the IAS. This could possibly be done through a permanent committee entrusted with the continuous update of the standards. Moreover, strengthening the auditing profession is vital to ensure auditors’ empowerment, independence, and professionalism. This could be achieved through corporate governance mechanisms, such as audit committees. Finally, modernizing the university accounting education curricula so graduates have better exposure to IAS and International Standards on Auditing is a key tool for enhancing the financial reporting environment over the long term.

Payments System In order to enhance the security, integrity, and efﬁciency of the The Central Bank of payments system, the CBE needs to proceed with its National Egypt needs to proceed with its National Payments Reform Program. The reform program should be broadened Payments Reform to include upgrades to retail and securities settlement systems and Program to improve its incorporate improvements in the legal, regulatory and oversight security, integrity and environments. Recommended reforms include strengthening the legal efﬁciency and regulatory framework for payments and securities settlement and xlii Executive Summary

ensuring that the Systemically Important Payment Systems (SIPS) are safe and efficient and comply fully with the Core Principles for Systemically Important Payments System (CPSS) for SIPS. There is scope to realize the potential for electronic payments to substantially reduce transaction costs and support higher volumes of low-value transactions. Specific actions to achieve increased access include enhancing the efficiency and soundness of retail payment systems and supporting the availability of a wide range of payments instruments and services. Other reform measures include integrating government collections and disbursements with the National Payments System (NPS), and to support its smooth functioning; distributing Egypt’s remittances and other cross-border payments rapidly and conveniently and ensure cost-efficiency for users at both ends; and ensuring that the securities clearance, settlement, and depository systems are safe and efficient and comply fully with international standards. Clearly defining the oversight and supervisory framework for payments and securities settlement systems, ensuring that the central bank exercises its oversight authority effectively in cooperation with other regulators, and putting in place an effective, structured, and fruitful cooperation within NPS are also crucial for increasing access to finance.

Promoting Competition in the Financial Sector Promoting competition Reform efforts should also focus on encouraging competition in the leads to lower financial sector, thereby lowering the cost of financial intermediation costs for financial intermediation and providing better services. In terms of development and efficiency, and encourages the competition leads to lower margins and lower costs for financial provision of more and intermediation–lower cost of capital for borrowers and higher rates better quality services of return on investment for lenders, spurring growth. A fundamental means by which to expand access is to promote increased competition in providing the full range of financial services. Competition not only benefits users by reducing the cost of financial services, but drives providers to seek new products, clients, and geographic markets, resulting in expanded access. Competition also creates incentives for innovation in production and distribution of financial services, which helps to both expand access and reduce costs. To ensure contestable A basic foundation for competition is proper entry and exit policies markets, a basic to ensure contestable markets. Entry of foreign banks can result foundation is proper in the emergence of new and more diverse products, greater use of entry and exit policies, technologies, and spillovers of know-how. It also puts pressure on and a level playing field for different the authorities to improve regulation and supervision, and increase financial services transparency. In terms of exit, the government should evaluate carefully the position of the state-owned banks. A basic foundation is to ensure a level playing field for each financial service and between similar types of financial services across all type of providers. Furthermore, ensuring a fair, consistent, and competitive environment among public, private and foreign banks is crucial, which entails avoiding differences in the regulatory treatment of similar types of financial services. Executive Summary xliii

Overall, the institutional infrastructure of Egypt’s financial sector The overall direction is coming into place for more efficient financial intermediation. is right, but deeper Regulatory gaps are being filled, and new institutions are being institution-building is still needed and will created. The overall direction is right, but deeper institution-building, take much more time to especially in the judicial area, is still needed and will take much facilitate easy access to more time to facilitate easy access to financial services. The speedy financial services and adequate completion of the Financial Sector Reform is essential to enhance access to financial services. Ensuring sustainability and maintaining the course of the reform program, and promoting Ultimately, a more competition will be essential to reap the benefits in the form of an developed and well- efficient financial system capable of providing better financial products functioning financial system will enhance and services at low costs, catering to all types of clients. Ultimately, economic growth and a more developed and well-functioning financial system will enhance development in Egypt economic growth and development in Egypt. xliv Access to Finance and Economic Growth in Egypt Introduction 1

CHAPTER 1

INTRODUCTION

There is ample evidence showing a strong and causal relationship between financial sector development and economic growth. An efficient financial sector that responds to the needs of the private sector increases investment, enhances economic growth, and creates jobs—one of the major challenges for developing economies. By improving households’ access to financial services, it also helps reduce poverty and improve income equality.1 Financial exclusion can retard economic growth and increase poverty and in equality. Firms and households may not be receiving financial services either due to their own constraints—a usage-related issue—or because the formal financial system fails to adequately meet their needs—an access-related issue. Access is the availability of financial services at a “reasonable cost” (where “reasonable” is defined according to an objective standard and “cost” reflects all financial and non-financial costs), and refers only to the presence of financial services. Usage is the actual consumption of financial services. In a standard demand-supply framework, access refers to the presence of supply (at a “reasonable cost”) and usage is the actual intersection of supply and demand. The availability of financial services at a “reasonable cost” to a wide group of firms and households depends on a number of factors and constraints. For financial-service providers—whether banks, non-banks or microfinance institutions—the fixed costs in financial intermediation can constrain service to small clients in small markets. Moreover, the high transactions cost for providing small-volume financial services to newly established firms with no credit history, or to those with limited experience in business, often make it unprofitable to cater to small firms and poor households. Acquiring information on small firms to expand financial services profitably requires big investments. Reaching the poor-through increasing the number of branches and extending the network to rural areas-also entails a high cost. Consequently, small and medium enterprises (SMEs) and poorer households are often excluded from financial services. Country-level constraints tend to be both macro- and microeconomic in nature. The overall economic environment is often a barrier, especially for lending. For example, prospects for profitability-and, consequently, viable lending-are limited in times of macroeconomic instability and limited growth opportunities. Even when a business 2 Access to Finance and Economic Growth in Egypt

is viable, uncertain repayment capacity, given volatile income and expenditure and high exposure to systemic risks, can make it hard for financial institutions to lend. Often this weak overall economic environment is exacerbated by weaknesses in the enabling and regulatory environment, such as a poor-quality legal system, limited availability of reliable information, a weak payments system, and inadequate infrastructures. Lack of collateral, difficulties in contract design and enforcement, absence of credit information, and a poor business environment in general can constrain profitable lending.

Figure 1.1: Current versus Desirable Situation of Financial System

Banks

Large SME Firms

Non-bank and markets

Source: Claessens, 2005.

However, these constraints can be overcome. Economies of scale and better cost management can lower unit cost, leading to higher outreach and more attractive outcomes from the institutional perspective. More competition can further increase access, as it makes financial institutions more interested in providing basic financial services. A better institutional environment can ease the provision of financial services and lending. Ideally, a financial system balances banks and markets as finance suppliers against large and small corporations as finance users. The large diamond in Figure 1.1 displays the optimal allocation in each of these four dimensions. The striped figure represents the actual allocation in Egypt for each of these four dimensions. The figure indicates that the financial system is dominated by a banking sector that lends to large firms and has few households as clients—far from ideal. The share of non-bank and market-based financial intermediation is low. Banks, non-banks, and markets in Egypt cater predominantly to large corporate clients, while SMEs have little access to bank finance and almost none to capital markets. Introduction 3

Literature has shown that access to finance is crucial for growth (Box 1.1). In that context, this study analyzes the constraints on access to financial services in Egypt. This first chapter provides a conceptual framework, and reviews Egypt’s overall economic environment, including its macroeconomic management, financial intermediation, and business environment—essential ingredients in developing a sound financial system. It describes Egypt’s recent economic performance, and the main pillars of its Financial Sector Reform Program. The next two chapters analyze the various forms of financing and identify the supply-side constraints on access to finance. Chapter 4 reviews areas where institutional reforms are underway, emphasizing the legal system, information institutional infrastructure (including the credit bureau), and the financial reporting environment. The last chapter identifies policy recommendations to enhance access to finance and addressing financial institution-specific constraints. Institutional solutions cover the legal framework, creditworthiness information system, and other financial infrastructure issues, such as the payments system. Lessons from other countries and the general empirical literature on access to financial services are used to help identify the main constraints and prioritize reforms. The report entails both quantitative and qualitative assessments of impediments to access to finance. The quantitative assessment relies largely on five surveys (in addition to the secondary data):

(i) The Investment Climate Survey (ICS), conducted in December 2004 of a stratified random sample of 1,054 firms from the industrial sector in 16 Governorates in Egypt. The sample comprises mainly small and medium firms that are mainly individual- or family-owned (accounting for around 85 percent of the sample), while large firms (employing more than 100 workers) account for only 15 percent of the sample. More than 23 percent of the sample has women as a main shareholder, of which 15 percent are majority-owned by women;

(ii) the ICS follow-up conducted in June 2005 of 300 ﬁrms from the industrial sector, which is used to identify the degree of severity of access to ﬁnance for entrepreneurs;

(iii) individual surveys of each of the 45 banks operating in Egypt, with the objective of identifying more clearly the supply side, in terms of collaterals required, foreclosure problems, credit analysis, caliber of staff at the credit departments, rejection rates, reasons behind rejections, the usefulness of the credit information center at the Central Bank of Egypt (CBE), and banks’ perception on the effectiveness of the legal and judicial system;2

(iv) individual insurance company surveys to identify supply factors from the insurance and contractual savings side;3 and 4 Access to Finance and Economic Growth in Egypt

(v) the National Household and Income Survey conducted by the Central Agency for Public Mobilization and Statistics (CAPMAS) under the Ministry of Planning and Local Development for the fiscal year 2005, specifically the section of household access to financial services. This national survey is supplemented by a community survey providing information on the availability of financial institutions within community (district or village) and self-perception of the quality of services. The survey covers 48,000 households living in 1,500 communities. Separate models are presented for rural and urban households because the determinants of access to financial services differ slightly across the two groups.

Though only a handful of models are presented here, the qualitative results of the analysis are similar when the rural and urban data are pooled, and for a series of models in which access to financial services is defined more narrowly (e.g., a household member maintains a bank account). Results are also robust to changes in the definition of proximity to providers of financial services (e.g., geographical distance versus actual travel time). The study also relies on existing analysis of data provided by CBE, the Capital Market Authority (CMA), the Egyptian Insurance Supervisory Authority (EISA), Mortgage Finance Authority (MFA), individual public and private banks, insurance companies, and various stakeholders. This analysis is supplemented by analytical assessment of the institutional framework, including analysis of the incentive system, corporate governance, prudential regulation, legal and regulatory framework, and market discipline in the financial sector. The activity involves, in addition to the detailed survey work, reviews of existing policies, laws, regulations, administrative practices, and tax systems; and requires substantial dialogue with policymakers and representatives of financial institutions, corporations, and others from the private sector. Introduction 5

Box 1.1: Access to Finance as an Obstacle to Growth

Based on the Investment Climate Assessment (ICA) responses from entrepreneurs in 79 countries on the quality of a country’s business environment, recent research1 shows that access to finance is critical to growth. The survey reveals that financial and legal obstacles and corruption (especially of bank officials) are especially constraining for small firms. Other research finds financing, crime, and political instability to be the only factors having a robust, direct impact on firm sales growth (Table B1.1).2 By contrast, obstacles associated with anti-competitive behavior, infrastructure, taxes and regulation, judicial efficiency, corruption, inflation, and exchange rates are not directly associated with lower firm growth. The importance of this access to finance-growth nexus, therefore, provides the intellectual underpinning for this report.

Obstacles to Growth obstacle GDP per Firm Political Exchange Street Taxes Infra- Country Financing Inflation Corruption capita Growth Instability Rate Crime Regulation structure Albania 807 0.22 3.04 3.48 2.75 2.61 3.42 3.34 3.15 3 Armenia 844 -0.2 2.45 2.87 2.73 2.69 1.85 1.96 3.39 1.93 Ukraine 867 0.03 3.45 3.22 3.43 3.05 2.49 2.51 3.7 2.22 Bolivia 939 0.04 3.03 3.1 2.58 2.46 2.76 3.56 3.15 2.63 Indonesia 1045 -0.05 2.83 3.14 3.21 3.4 2.69 2.69 2.59 2.37 Egypt 1108 0.16 2.91 3.14 2.68 2.9 2.24 3.14 3.43 3.23 Philippines 1126 0.07 2.69 2.85 3.36 3.43 2.8 3.13 3.08 2.88 Bosnia/Herzegovina 1178 0.63 3.09 3.19 1.33 1.25 1.86 2.56 3.16 2.65 Kazakhstan 1315 0.1 3.29 2.88 3.62 3.48 2.6 2.7 3.37 2.1 Romania 1372 0.07 3.26 3.44 3.75 3.19 2.45 2.88 3.57 2.44 Bulgaria 1415 0.15 3.16 3.03 2.76 2.37 2.64 2.64 3.1 2.23 Mexico 3395 0.24 3.24 3.27 3.48 3.13 3.37 3.31 3.21 2.23 Chile 5003 0.09 2.36 2.58 2.16 2.59 2.40 1.86 2.36 1.86 Czech Republic 5158 0.1 3.18 2.95 3 2.46 2.09 2.1 3.44 2.5 Argentina 8000 0.08 3.01 3.07 1.77 1.73 2.39 2.58 3.34 1.93 Sweden 28258 0.23 1.83 2.46 1.66 1.78 1.54 1.18 2.67 1.52 Full Sample Average 4643 0.15 2.8 2.72 2.76 2.49 2.41 2.56 2.9 2.34 Notes: GDP per Capita is real GDP per capita in $US averaged over 1995 to 1999. Firm growth is the average percentage growth in firm sales from 1996 to 1999. The obstacle data are average responses from firm owners as reported in the World Business Enviroment Survey (WBES). Responses take values from 1 to 4, with higher values indicating greater obstacles. Source: Ayyagari, Demirguc-kunt, Maksimovic, 2005.

Further decomposition of the financial obstacles shows that high interest rates most constrain firm growth. Complaints about high interest rates are associated with perceptions of high collateral requirements, inability to access long-term loans, greater paperwork requirements to secure loans, and the need for special connections. The results suggest that the Egyptian reform efforts should focus on, besides macroeconomic stability, creating more competition in the banking sector, thereby lowering spreads and lending interest rates. Specific reforms that reduce collateral requirements and improve access for borrowers without special connections are also important. Table B1.1 compares Egyptian entrepreneurs’ responses to questions about obstacles to firm growth with those from entrepreneurs in other countries, including the 10 countries closest to Egypt in per-capita income, and with the average for all 79 countries in the World Business Environment Survey (WBES) database. Responses on financing, political instability, and exchange rates place Egyptian entrepreneurs slightly above average, meaning Egyptian entrepreneurs rated the obstacle as being relatively more severe. While neither street crime nor inflation was rated a severe obstacle, Egyptian entrepreneurs rated corruption, taxes and regulation, and especially infrastructure as more severe obstacles than entrepreneurs in other countries. Reforms in those three areas might also pay large growth dividends.

1 Beck, Thorsten, Asli Demirguc-Kunt, and Vojislav Maksimovic, 2005. “Financial and Legal constraints to Firms Growth: Does Firms Size Matter?” Journal of Finance, 60(1): 137-177. 2 Ayyagari, Meghana, Asli Demirguc-Kunt, and Vojislav Maksimovic, 2005. “How Important are Financing Constraints? The Role of Finance in the Business Environment.” World Bank Database. 6 Access to Finance and Economic Growth in Egypt

A. MACROECONOMIC AND BUSINESS ENVIRONMENT

1. Macroeconomic Environment

The potential for financial development and growth in Egypt is large, as macroeconomic policies are increasingly supportive and overall business environment fundamentals are coming into place. The macroeconomic environment has stabilized in recent years and the overall performance of the Egyptian economy—a necessary condition to developing a sound financial sector—has continued to improve. Results are reflectedin an accelerating economic growth rate, improved market confidence, strong capital inflows, stability in the foreign exchange market, significant increase in international reserves, decreases in inflation rates, and expansion in the stock market. a. Macroeconomic management. Egypt has a history of relatively prudent and continually improving macroeconomic management. Since 2004, the Government has undertaken various and wide- ranging measures. On the trade front, an outdated tariff structure was revamped by cutting average tariff rates (rates on 359 tariff lines were reduced in 2005) and reducing the number of tariff bands; and Qualified Industrial Zones Accords with the US and Israel and a Free Trade Agreement with Turkey were signed. On the fiscal front, prices of subsidized fuel and electricity were raised; a new income tax code, with major cuts in corporate and personal income tax rates, was adopted in 2005; and tax-administration procedures were simplified. In foreign exchange markets, an interbank market for foreign exchange was set up; the surrender requirement on export proceeds was abolished in 2004; and the black market disappeared. In monetary and financial markets, the Coordination Council on Monetary Policy was established in April 2005; and the Monetary Policy Committee of the CBE started announcing the monetary policy stance on a monthly basis and has set the interbank rate as its operational target since June 2005.

b. Recent economic performance. The restored confidence associated with recent reforms, along with favorable external conditions, have led to improved economic performance. Growth has been reviving since 2004, and real GDP grew by 5.1 percent in fiscal year 2005 compared to 4.2 percent in 2004, after a low growth rate of 3 percent during 2001-03 (Table 1.1).4 Growth is projected to be 6 percent through 2007 despite some concerns, particularly over the budget deficit. The large current-account surplus and low international indebtedness help insulate the economy from external shocks. The current account surplus was US$2.9 billion in 2005, accounting for 3.3 percent of GDP. Inflation fell from 18.2 percent in October 2004 to 3.7 percent in March 2006. Introduction 7

Consequently, the macroeconomic environment has become more supportive of ﬁnancial intermediation. The stock market has reacted positively to these changes, reporting a substantial increase in market capitalization and liquidity, and by mid-2006, stock market capitalization stood at about 50 percent of GDP. External conﬁdence has been boosted, as signaled by the revised Fitch and Standard & Poor ratings of Egypt’s economic outlook from negative to stable.

Table 1.1: Main Macroeconomic Indicators in Egypt (2001-2006)

Fiscal Year 2001 2002 2003 2004 2005 2006 Rate of Growth Real GDP (at factor cost) 3.4 3.2 3.1 4.2 4.6 6.9 Real Consumption 4.1 2.7 2.4 2.1 4.5 6.0 Real Gross Domestic Investment -2.2 5.5 -8.7 6.2 14.2 13.8 Exports Volume (G&S) 3.3 -7.8 13.8 25.3 20.2 21.3 Imports Volume (G&S) -1.1 -6.0 1.3 17.2 23.8 21.8 GDP Deflator 2.4 2.4 3.2 11.5 9.7 7.3 Percent of GDP Gross Domestic Investment 17.7 17.8 16.3 16.4 17.2 18.7 Net government debt 64.9 71.3 75.8 73.8 76.0 76.0 -of which: net domestic debt 54.3 58.4 60.4 60.3 64.8 64.8 Outstanding Foreign Debt 28.5 33.7 42.5 38.1 31.2 27.6 Current Account Balance 0.0 0.7 2.4 4.3 3.3 1.6 Gross National Savings 17.8 17.6 17.9 17.6 17.8 16.3 Overall Government Budget Deficit - 10.2 10.5 9.7 9.6 7.9 * Net government debt is defined as the sum of the government’s external and domestic debt: the latter includes net claims on central and local governments, municipalities, and public service authorities. (Ministry of Finance, Financial Monthly, February 2006). Source: Ministry of Finance and Central Bank of Egypt, (2006).

However, many weaknesses in macroeconomic management still affect the ability of the financial system to intermediate. The government budget deficit remains relatively high, about 8 percent of GDP. With the high stock of domestic debt, any upward pressure on interest rates could widen the overall budget deficit further. Importantly for financial intermediation, the Government’s large fiscal deficits crowd out private investment. The budget deficit is financed largely through domestic borrowing, with the Social Insurance Fund (SIF) holding 40 percent of the domestic debt, and the banking system funding about 4 percent of GDP on average during each of the last five years, less than the net lending it extends to the private sector. 8 Access to Finance and Economic Growth in Egypt

c. Financial intermediation. Within Egypt’s good macroeconomic environment-relatively low inflation and positive real interest rates-overall savings are solid in Egypt. Egypt’s level of financial intermediation (as measured by M2-to-GDP) is above other countries at its income level (Figure 1.2). Most savings have been channeled through the financial system in the form of bank deposits. The deposit- to-GDP ratio of 100 percent is much higher than the world average and substantially higher than many developed economies. However, the most commonly used aggregate measure of access to finance, private sector credit-to-GDP, is modest compared to other developing economies (Figure 1.3). Private credit as a share of total credit has actually been declining, reaching 66 percent 2006 (compared to 70 percent in 2003).

Figure 1.2: M2-to-GDP in Selected Countries across the World (2006)

300

200 Percent

100

0 India Chile Brazil Benin China Belize Bolivia Turkey Ireland Jordan Algeria Poland Mexico Bhutan Tunisia Croatia Estonia Belarus Bahrain Srilanka Bulgaria Armenia Hungary Morocco Pakistan Thailand Australia Lebanon Malaysia Romania Lithuania Colombia Barbados Argentina Indonesia Botswana Cambodia Singapore Azerbaijan Philippines El Salvador United Arab United Bangladesh Korea, Rep. South Africa South United States Czech Republic United Kingdom Macedonia, FYR Egypt, Arab Rep. Egypt, Iran, Islamic Rep. Hong Kong, China Syrian Arab Republic Syrian

Source: World Bank database.

2. Business Environment

Since 2004, the Government has had a strong commitment to improving the investment climate. Progress has been reflected in the significant improvement in investors’ perception of the business environment over the last few years, as evident in the ICS conducted in 2005 compared to that of 2004. The earlier survey had highlighted numerous constraints confronting entrepreneurs operating in Egypt.5 However, the ICS (2005) showed much progress in entrepreneurs’ perceptions, in large part due to the broad range of structural reform programs initiated by the Government appointed in July 2004. These reforms included streamlining companies’ registration procedures through the establishment of the one-stop shop, and ensuring easy entry for firms in the market, leading to lower transaction costs. Introduction 9

Figure 1.3: Private Sector Credit-to-GDP in Selected Emerging Economies

1.8

1.6 Denmark 1.4

1.2 Malaysia 1 Korea

Percent of GDP 0.8 Tunisia Morocco 0.6 Chile Kuwait Egypt 0.4 Turkey 0.2 Czech Rep. Poland Argentina 0

Source: IMF, IFS, 2006.

To address corporate governance and protecting investors’ rights, the Institute of Directors was established and decrees were issued to improve disclosure and related party activities. In addition, the Competition Law was issued, setting up the Competition Agency with the mandate of ensuring a fair, consistent, and competitive environment, prohibiting anti-competition practices, and sanctioning abuse of dominance position. All these reforms made Egypt one of the “Top Reformers” in the Doing Business Report 2006. There is also a program of privatization of state-owned enterprises (SOE), and operational and financial corporate restructuring. Although to date only 150 out of 314 SOEs have been privatized, the pace of SOE privatization has picked up recently.6 However, Egypt’s business environment is not yet conducive to firms’ efficient operation: the 2005 ICS still reveals numerous constraints facing entrepreneurs, mainly in the areas of contract enforcement, access to finance, access to land, and property registration. Egypt scores poorly in terms of corruption, business infrastructure, and innovation, when compared both to other countries in Middle East and North Africa (MENA) and to the rest of the world (Table 1.2).

Table 1.2: Business Environment in Egypt

Corruption Egypt Region All countries Unofﬁcial payments for ﬁrms to get things done (percent of sales) 8.02 5.02 1.38 Infrastructure Egypt Region All countries Delay in obtaining an electrical connection (days) 80.00 58.84 27.05

Delay in obtaining a telephone connection (days) 89.00 75.90 36.88

Innovation Egypt Region All countries

Spending on research and development (percent sales) 0.19 2.18 0.71

Source: World Bank Investment Climate Survey, 2005. 10 Access to Finance and Economic Growth in Egypt

A typical firm spends over 8 percent of sales on bribes to officials, compared to 5 percent in the MENA region, and only 1.4 percent in the world. It also takes much longer for businesses to obtain a telephone or electricity connection. Given the weak business environment, it is not surprising that firms in Egypt spend much less on research and development compared to other countries, hampering growth.

B. FINANCIAL SECTOR REFORM PROGRAM 2004-2008

An integral part of the Government’s reforms is the Financial Sector Reform Program, endorsed in 2004. The program aims to improve financial-sector soundness and foster an enabling environment for an efficient, increasingly private-led, financial system that serves Egypt’s development and growth objectives. Specifically, the program seeks to enhance competition, upgrade financial institutions’ governance, strengthen prudential regulation, and ensure systemic soundness. The reforms, already showing some success, are designed to encourage competition and innovation, so that financial institutions can thrive in an increasingly competitive and liberalized environment.

1. Main Pillars of the Reform Program

The five pillars of the program are reforming the banking sector, restructuring the insurance sector, deepening the capital markets, developing a well-functioning mortgage market, and activating other financial institutions and services. This is underpinned by improving the framework for providing financial services, as well as harmonizing the regulatory regime for comparable financial products and services. An integral component of the strategy is to promote the quality of information and market discipline by upgrading accounting, auditing and reporting by financial institutions to international standards. Assuring the effectiveness of financial-sector supervision involves a comprehensive institutional capacity building program for the various supervisory bodies, including the CBE, CMA, EISA, and MFA. The banking-sector pillar includes consolidating the banking system through reducing the number of operating banks; fully divesting state-owned bank shares in joint-venture banks; and privatizing the fourth-largest state-owned commercial bank (Bank of Alexandria), which accounts for 7 percent of system assets. The program also includes the operational and institutional restructuring of the remaining three state-owned banks to allow them to operate on a commercially viable basis in an increasingly open and competitive market. The main non-bank financial-institution pillar involves restructuring state-owned insurance corporations and improving regulation and supervision. The program represents the most far- reaching, substantive and comprehensive drive towards financial- sector strengthening so far in Egypt. Introduction 11

2. Progress in the Implementation of the Banking Sector Reforms

Significant progress has been made in the implementation of banking reforms; the following are some of the achievements: Consolidation of the banking sector. The policy of banking consolidation seeks to create banks with the necessary economic scale to expand the range of financial services and the bank network. Through a series of acquisitions, mergers, and revoking of licenses of banks that do not comply with the minimum capital requirement, the number of banks and branches of foreign banks was reduced from 57 to 43 as of June 2006, and is expected to reach 34 by 2007. Divestiture of the state-owned banks’ shares in the joint-venture banks. An important component is the divestiture of state-owned banks’ shares in the 17 joint-venture banks that account for more than 20 percent of the banking system’s total deposits. Although in principle these banks were not subject to centralized management control, their structure of ownership often led to unwelcome governance and conflict of interest issues. Full divestiture of the state-owned bank shares in the joint-venture banks will alter the governance of the domestic banking system to spur increased competition. As of June 2006, 12 out of 17 holdings in joint-venture banks have already been divested, including the four largest holdings.7 However, there are other public-sector shares (state-owned insurance companies and National Investment Bank NIB) that have not been divested. Privatization of one state-owned bank. The Government is actively pursuing the privatization of one state-owned commercial bank, Bank of Alexandria, through sale to a strategic investor. Bank of Alexandria, that is 100 percent state-owned, is the fourth-largest commercial bank accounting for 6 percent of the system’s deposits, and offers a wide range of corporate and retail financing products and services through a network of over 188 branches and outlets across the country and in most government. Its privatization is expected to bring enhanced management practices, new technologies, and additional capital through higher levels of foreign participation (Box 1.2).8 Restructuring of state-owned banks. The Government has launched the process of operational and institutional restructuring, as well as financial restructuring of the state-owned banks that will remain for some time in public hands. For the two remaining state-owned banks (National Bank of Egypt, and the merged Banque Misr-Banque du Caire), restructuring plans are proceeding, through in-depth capacity- building programs. Independent comprehensive audits have been conducted to assess portfolio quality and non-performing loans and distressed assets. These audits also diagnosed the adequacy of policies and procedures related to lending, credit administration, risk management, accounting and internal controls. The Government has developed a time-bound, clear, and transparent process for resolving non-performing assets, with a large portion of the proceeds of selling 12 Access to Finance and Economic Growth in Egypt

state-owned enterprises allocated to recapitalizing these banks. The restructuring process of the three specialized state-owned banks has not started yet; complete implementation of reforms in this area will take time.

Box 1.2: Rationales for the Privatization of Banks

Views on government ownership of banks have evolved over time. Policy-makers in the 1950s and 1960s were more inclined towards state ownership, as a result of which many countries nationalized their private banks.1 This was in part based on the “development view” of state-owned banks, where government ownership stimulates growth when economic institutions are not sufficiently developed for private banks to meet financing needs. There were, however, also political motives, since state-owned banks were considered means of providing employment, subsidies and other benefits to meet social and political objectives. The rationale of state-owned banks is to finance projects that would otherwise not be funded. The effective outcomes under both views can be quite different: on the one hand, real economic development; on the other, a retarded financial system, with large non-performing loans and little economic progress. Many of the countries that nationalized their banks faced acute economic crises in the 1980s, and state-owned banks’ costs clearly outweighed the benefits. The costs and drawbacks of state-owned banks stemmed not only from political influence, but also from the conflict between commercial viability and social and development objectives. Even with a sound governance structure to insulate against direct political pressure, the need to achieve various government objectives, may not lead to the financial intermediation efficiency levels of a privately-owned bank2 Explicit or implied requirements to finance inefficient SOEs or directly finance government deficits further impaired the ability of state-owned banks to operate on commercial terms. Not only did this increase the banks’ losses, it also led to misallocation of capital and made banks contribute less to growth. Moreover, state-owned banks were more vulnerable to macroeconomic shocks. Lower profits reduced their ability to use earnings as the first line of defense against unexpected losses and their ability to generate capital. In sum, state-ownership of banks tended to be associated with financial repression, poorly developed banking systems, higher interest-rate spreads, slower financial development, and lower economic growth [Caprio and Cull (2000)]. However, since the mid-1980s, most governments have opted for private-sector-led banking. The main objective has been to ensure that financial intermediaries contribute effectively to economic growth through sound and market-driven allocation of resources. This in turn requires encouraging competition and enhancing the participation of the private sector. Many governments, over the past decades, have opted for the privatization of banks, through foreign bank investment. Entry of foreign banks not only improves financial system efficiency by enhancing competition and stability, but also enhances access. Analysis of borrowers’ perceptions across 36 countries finds that financing obstacles are lower in countries with more foreign bank penetration.

1 For a summary on the evolution of views on state-owned banks, see La Porta, Lopez-de-Silanes, and Shleifer (2002). 2 See Goldstein and Turner (1996), Lindgren et al. (1996), Roe (1998), Caprio and Cull (2000), Caprio and Martinez-Peria (2000), and Barth, et al. (2000). Introduction 13

3. Progress in the Implementation of the Non-Banking Financial Institutions

Strengthening and developing non-bank financial institutions has also been one of the Government’s main priorities. Various reform measures have taken place under the newly established Ministry of Investment, which is responsible for overseeing non-bank financial institutions (along with other mandates, including investment promotion and the privatization program). The insurance sector will be restructured both at the regulatory and company levels. A new chairman for EISA was appointed to lead the authority’s internal reform and upgrade the regulatory regime, while benchmarks were set enabling adequate monitoring of the sector. The reform program aims at strengthening insurance regulations, accounting principles, and commercial codes, and achieving full compliance with GATS commitments regarding the liberalization of the insurance sector. The restructuring of the state-owned insurance companies is underway and governance has been strengthened. A holding company for the four state-owned insurance companies was established in August 2006. The need for a major overhaul of the state- owned insurance companies, with a possible reallocation of market sub-segment activities, is being assessed. The due diligence and diagnostic reports, as well as the recommendations for restructuring and privatization, has been completed in december 2006. Capital market. The Government’s long-term vision is to position Egypt as a financial hub for the region by developing more efficient and deeper capital markets. Various capital-market reforms were recently undertaken, including opening the market to foreign investors; imposing stricter standards and rules for exchange listing and delisting; requiring more disclosure and transparency required; and improving the quality of the listed companies on Cairo and Alexandria Stock Exchange (CASE). Other measures include (i) establishing the Institute of Directors to develop and train middle- and upper-level managers in adopting and implementing good corporate governance procedures and rules; (ii) establishing the Insurance Protection Fund to protect investors against non-commercial risk; and (iii) introducing the new system of primary dealers in treasury bonds to increase market liquidity and efficiency. New provisions governing price manipulation and insider trading were added to the executive regulations of the Capital Market Law in April 2006. CMA is enhancing its own performance and boosting its capacity and efficiency in accordance with the highest international standards through a comprehensive capacity-building program, adopted in July 2005. New departments have been established, including corporate finance, corporate governance, inspections, communications and public awareness, human resources, and risk management. CMA has stressed the importance of efficient intermediaries as a foundation for capital-market development. Intermediaries currently face several challenges, including low capitalization, capital adequacy, and 14 Access to Finance and Economic Growth in Egypt

liquidity levels, resulting in an increase in operational and settlement risks. CMA is in the process of approving new CASE membership rules. Following international best practices, only members meeting financial and technical requirements to limit risks will be allowed to deal on the Exchange. Mortgage market. Developing a new system of mortgage finance for more-sustainable housing finance is one of the main priorities of the Ministry of Investment. To this end, reforms have involved capacity- building for the MFA, developing its technical and managerial skills, and developing its regulatory role to ensure market efficiency and protect its customers; and establishing a computer network and IT infrastructure. The authorities are also developing and ensuring the usage of standardized mortgage agreements; setting new regulations for portfolio acquisition from developers; establishing regulations and controls for the Guarantee and Subsidy Fund (GSF) to ensure it is properly allocated to low-income citizens; and developing a code of ethics for appraisers. There is also progress in terms of securitizing performing housing loans to create liquidity, helping finance additional housing units. Financial leasing. The General Authority for Investment and Free Zones (GAFI) attaches high priority since early 2005 to developing the financial leasing industry. Main actions include issuing Ministerial Decree 1690 of 2006, which exempts leasing companies from Article 52 of the Income Tax Law (limiting leasing companies’ debit interest to four times their capital). A new Ministerial Decree permitted leasing companies to lease buses to tourism-related businesses. The revival of the Leasing Activity Association helps in voicing leasing companies’ concerns, ensuring dissemination of best practice, and exchanging important information. These changes are expected to boost the leasing sector. However, the leasing industry still faces a number of challenges, particularly poorly functioning asset repossession, especially when it comes to targeting SMEs. GAFI is working on enhancing the capacity in areas such as upgrading lease registration procedures and training for judges, in addition to facilitating market- entry and registration rules for leasing companies. Factoring. Developing factoring for Egyptian production and exports and SMEs is another objective of the financial-sector reform program. A key reform measure has been amending the Executive Regulation of the Investment Law, which governs factoring activities. It assigns GAFI the responsibility for setting factoring rules according to international best practices as followed by groups such as Factors Chain International (FCI) and International Factoring Group (IFG). The law also covers rules regulating factoring activity, licensing requirements, financial adequacy, financial statements, the role of external auditors, working-capital financing, credit-risk protection, accounts-receivable bookkeeping, and collection services. Introduction 15

C. ACCESS TO FINANCE IN EGYPT: STATE OF AFFAIRS

1. Firms’ Access to Finance in Egypt

As in many other developing countries, lack of access to finance and high cost of financing is considered a major constraint to firms’ growth (Figure 1.4), with around 37 percent of ICS respondents citing them as obstacles.

Figure 1.4: Investment Climate Constraints in Egypt as Perceived by Businesses

Percentage of ﬁrms mentioning each constraint as major or severe 90% 79.80% 80% 73.10% 68% 70% 62.70% 60.40% 60% 50.20% 50% 40% 36.60% 29.70% 28% 27.40% 30% 26.40% 24.70% 20.50% 20% 10% 0% policy Labor Tax Tax rates Tax issues Electricity Corruption Regulatory uncertainty regulations and cost) stability Competition and cost) Land (access administration environment Customs and Macroeconomic Skills of workers Finance (access trade regulations Legal and judicial

Source: World Bank ICS (2005)

Formal financing, whether from banks or from non-bank financial institutions, plays a limited role in financing enterprises in Egypt. On average, only 7 percent of new investments and working capital is financed externally through the banking sector, compared to more than 13 percent in the MENA region, 18 percent in the rest of the world, and 60 to 70 percent in most Organization for Economic Co- operation and Development (OECD) countries (Table 1.3). While capital markets can play an important role in financing growth and

Table 1.3: Various Sources of Finance in Egypt, MENA and the World (percent)

Finance Egypt Region All Countries Internal finance for investment (%) 86.15 72.38 61.85 Bank finance for investment (%) 6.93 13.07 17.71 Informal finance for investment (%) 0.90 4.30 4.35 Supplier credit financing (%) 1.43 6.03 7.32 Value of collateral needed for a loan (% of the loan amount) 123.60 166.34 141.39 Loans requiring collateral (%) 89.41 84.01 80.61 Source: World Bank ICA (2004). 16 Access to Finance and Economic Growth in Egypt

development, they only financed 3.8 percent of investments in Egypt. Almost 86 percent of new investments are financed from internal funds and retained earnings, compared to 62 percent in other countries. There is consequently a great reliance on the informal market, mainly family and friends, especially in family-owned firms and small and medium enterprises (which form the majority of firms in Egypt).9 The picture is similar for the self-employed. Like most firms, the self-employed receive almost no credit from formal providers, relying instead on internal funds and informal sources. The self-employed are also no more likely to have formal savings. Only 6 percent of those who employ others, 5 percent of those employing only themselves, and 6 percent of salary earners have formal savings. Only 17.4 percent of Egyptian firms report that they have access to finance from the financial sector. While the average for Egypt is comparable to the other MENA countries, it is much below that in other developing countries. This is especially true for small firms— only 13 percent have access to credit. For large firms of more than 150 employees, 36 percent have access, comparable to countries with more efficient financial markets.

Figure 1.5: Percentage of Firms Currently with a Loan Figure 1.6: Enterprises Access to Finance from a Financial Institution in Egypt in Egypt and Selected MENA Countries

40% 25 36% 35% 20 30%

25% 15

20% 17% 10 15% 13%

10% 5 5%

0% 0 All Small Large Oman Egypt Syria Algeria Morroco

Source: Egypt ICS (2005). Source: World Bank ICS.

Access to bank finance or other forms of formal finance in any country is typically limited to firms that operate in the formal sector. A large share of Egypt’s economy—more than 35 percent—is informal. The low use of financial services among SMEs and the self-employed is in part attributable to demand factors: many business owners prefer to remain in the informal sector, because formality implies substantial cost. Firms prefer to operate informally in Egypt for various reasons, Introduction 17 including avoiding taxes, labor regulations, and other onerous business regulations. Additionally, many bankers expressed that most business owners do not know how to approach banks with adequate financial information and business plans. (Indeed, some banks are starting programs to train SME owners in preparing such information.) Even though the lack of formal finance is partly explained by the large share of the informal economy in the overall economy, along with limited growth opportunities, there are also various institutional and regulatory constraints from the supply side.10 Banks often prefer to extend credit to large corporate clients and wealthy individuals, considered less risky. Even when firms have access to financial services, banks do not provide much financing to SMEs. The dependence on internal finance indicates that many firms in Egypt are unable to take advantage of growth opportunities, with negative ramifications for overall economic and employment growth.

2. Households’ Access to Financial Services

Data from the 2005 Household Survey of Income and Expenditure indicate that few Egyptians use any kind of formal financial services. Though savings instruments are more common than credit, less than 1 percent of households surveyed had a formal loan. As with firms, low use of financial services among households could be attributable to demand factors. Table 1.4, which stratifies usage by the education level of the head of household, illustrates the importance of demand- side factors in explaining usage. Among households headed by individuals with a secondary-school education or less, only 4 to 7 percent have formal savings. Most common is postal savings, roughly twice as prevalent as bank savings among the illiterate and those who can read and write but have no formal education.

Table 1.4: Household Use of Financial Services by Education Level in Egypt (percent)

Can read Primary Secondary Above University Graduate Type of Finance Illiterate and write school school Secondary Degree Degree Capital Markets Stocks and Bonds 0.2 0.2 0.2 0.1 0.2 0.2 0.7 Deposits in Investment Co.s 0.0 0.0 0.1 0.0 0.0 0.1 0.4 Banks Deposits & Savings Accounts 1.2 1.8 2.8 3.3 3.9 8.9 19.6 Investment and Credit at NIB 0.1 0.3 0.4 0.5 0.8 1.3 2.6 Post Ofﬁce Savings 2.4 3.4 3.5 3.5 4.5 4.4 3.3 Credit 0.2 0.3 0.4 0.5 0.5 0.7 0.4 Debit 0.1 0.2 0.5 0.4 0.4 0.2 0.0 Formal Savings 3.7 5.2 6.3 6.7 8.1 13.0 22.2 Formal Savings or Investment 3.8 5.4 6.7 7.1 8.6 13.8 23.3 Source: Egyptian Household Survey of Income and Expenditure (2005). 18 Access to Finance and Economic Growth in Egypt

Usage increases substantially with the level of educational attainment. Fourteen percent of households headed by someone with a university degree have formal savings or investment; 23 percent if the head of household holds a graduate degree (Figure 1.7). Most in these two groups use bank savings. Indeed, those are the only two educational groups for which bank savings are more prevalent than postal savings.

Figure 1.7: Households Share in Access to Financial Services by Educational Attainment in Egypt

25%

20%

15%

10%

0% Illiterate Primary University Graduate School Degree Degree

Post Ofﬁce Savings Savings In Banks Formal Savings or Investment

Source: Egyptian Household Survey of Income and Expenditure (2005)

Even at the highest education levels, however, almost no households have formal credit or capital-market investments (stocks, bonds, and deposits in investment companies). Usage also varies by the employment status of the head of household (Table 1.5).

Table 1.5: Use of Finance by Employment Status of Head of Household in Egypt (percent)

Salary Owner/ Self-Employed Non-Salary Type of Finance Earner Employer with No Employees Earner Capital Markets Equity and Stocks 0.2 0.2 0.1 0.0 Deposits in Investment Companies 0.0 0.1 0.0 0.0 Banks Deposits and Savings Accounts 3.0 2.6 1.9 4.3 Investment and Credit at NIB 0.5 0.3 0.3 0.0 Post Ofﬁce Savings 3.5 3.2 2.8 0.0 Credit 0.4 0.2 0.3 0.0 Debit 0.3 0.1 0.2 0.0 Formal Savings 6.3 5.7 4.7 4.3 Formal Savings or Investment 6.7 5.8 4.9 4.3 Source: Egyptian Household Survey of Income and Expenditure (2005). Introduction 19

Box 1.3: Egyptian Women’s Access to Finance

Enhancing the active participation of women in entrepreneurship activities and giving them access to markets, especially financial markets, is essential at the macroeconomic level, as it leads to a rise in the number of economically active members in the society; this will ultimately result in long-run economic prosperity. Ensuring that investors, both men and women, have equal access to the financial market is essential. There is a need to allocate funding to its most productive uses; otherwise economic growth will be hampered. Hence removing any gender bias is crucial. While access to finance remains a business constraint for both men and women, evidence seems to suggest that women are facing higher hurdles. The ICA shows that women suffer more from constrained access to finance compared to men, whether in terms of the cost of finance, ability to gain approval for financing, or legal disputes and conflict resolution in case of bankruptcy. In addition, banks request more strict collateral requirements when dealing with women investors. In fact, the proportion of women who complained about collateral requirements was double that of men. Although law gives women ownership rights, they often have less productive assets, and lack independence in managing these assets (being under the guardianship of their brother, husband, or even son). In many cases they are prevented from using their property as collateral for loans, limiting their ability to participate as independent agents in private-sector activity. The allocation of resources within the family is greatly influenced by the perception of roles, where the men are seen as the main, if not the sole bread-earner (even in the cases when they are not). Women are more active in the informal credit market compared to men, and are more likely to draw funds from family and friends. Very few women entrepreneurs resort to commercial banks for credit (around 20 percent), but those who resort to banks are confronted with higher rejection rates (6 percent compared to 4.5 percent for men). Of the numerous banks in the Egyptian banking sector, only about 4 serve the micro and SME market, with a very small number of programs targeting women specifically. Banks estimate that women account for 10 to 25 percent of bank clients, most of whom are microfinance clients.1 Banks in Egypt do not systematically collect gender-disaggregated portfolio information and so do not have a good understanding of the needs of women SME owners as potential customers. IFC’s Egypt Country GEM Assessments found that many businesswomen are in need of financial and business-management training. However, women are often not identified as target groups for technical training, and cultural and social restrictions, in addition to time constraints, often make it difficult for them to attend training courses. Commercial banks are beginning to see the benefits of providing business-skills training to enhance the management performance of women- owned and managed small and medium enterprises. This training—when provided for the banks’ preferred women customers as part of their membership services—not only helps women acquire better financial management skills, but also enables commercial banks to interact more personally with their women clients. And as the training enables women to become more creditworthy, it also contributes to a reduction of the credit risk for the banks.

Finance as a Major Constraint Banks Loan Rejection Rates in Egypt (percent) Facing Women Entrepreneurs in Egypt

60 7

50 6

5 40 4 30 3 20 2

10 1

0 0 Cost of Access to Legal system & Women Men financing finance conflict resolution women men

Source: ICS (2005) 1 IFC’s Gender Entrpreneurship Markets (GEM). 20 Access to Finance and Economic Growth in Egypt

These figures are very low, even given the income level of Egypt, and come with some caveats. Household surveys can under-represent access because respondents are reluctant to divulge information about financial assets, fearing tax implications, or in some countries outright theft or confiscation.11 Respondents also might not fully understand what is being asked of them, especially those with little or no education. In recent surveys in other countries, therefore, the questionnaire cues the respondent by offering, for example, the names of institutions that offer specific products (lending, savings, payments, or insurance), which the enumerator reads to the respondent.12 Supply data indeed suggests that usage is more plentiful in Egypt than household surveys indicate. The postal agency has reported that it has 15 million savings accounts. If this is accurate, and individuals do not have multiple postal savings accounts, about one-fifth of Egypt’s residents would have postal savings. This figure is substantially higher than that from the household survey, perhaps for the reasons described above, or because many of those accounts may be dormant. Based on the reported figures, however, the upper bound on use of any formal savings or investment is likely to be no higher than 25 to 33 percent, substantially higher than the 5 to 10 percent from the household survey, but still relatively low by international standards.

CONCLUDING REMARKS

Considerable progress has been made in financial-sector reform in Egypt. However, maintaining and enhancing reforms will be essential to ensure an efficient financial system that provides financial services at low cost and caters to all types of clients. Financial integration will be important to maintain the program of bank restructuring and privatization and to intensify reforms in the insurance sector and capital markets. This is necessary as the access to financial services still remains quite skewed in Egypt, with limited access for small firms and poor households. Avoiding the costly continuation of lost economic and employment growth will require ongoing restructuring and the removal of institutional barriers.

Notes

1 Financial Sector Strategy for the World Bank Group, 2007. 2 Banque Misr, Bank of Alexandria, Banque du Caire, National Bank of Egypt (NBE), Egyptian Arab Land Bank, Industrial Development Bank of Egypt, Principal Bank for Development and Agricultural Credit (PBDAC), Commercial International Bank (CIB), Misr International Bank, Misr Romanian Bank, BNP Paribas, The Nile Bank, Commercial Egyptian Bank, Cairo Far East Bank, Delta International Bank, Faisal Islamic Bank of Egypt, Egyptian Saudi Finance Bank, United Bank of Egypt, Port Said National Bank for Development, HSBC Bank,Egyptian Workers Bank, Misr Iran Development Bank, Cairo Barclays Bank, Société Arabe Introduction 21

Internationale de Banque, Calyon Bank, National Société Générale Bank, Housing & Development Bank, Islamic International Bank for Investment and Development, Arab African International Bank, National Bank of Abu Dhabi, Citibank, The Bank of Nova Scotia, Mashreq Bank, National Bank of Greece, and National Bank of Oman. 3 Misr Insurance Company, Al-Chark Insurance Company, National Insurance Company, Suez Canal Insurance Company, Mohandes Insurance Company, Delta Insurance Company, Pharaonic American Life Insurance Company (Alico), Commercial International Life Insurance Company (CIL), Allianz Life Assurance Company Egypt, ACE Life, NSGB Life Insurance Company, AIG Insurance Company, Arab Misr Insurance Group (AMIG), Allianz Insurance Company Egypt, ACE CIIC Insurance Company (Non Life), Royal & Sun Alliance, Egyptian Saudi Insurance Home, Co-operative Insurance Society for Small Enterprises, Export Credit Guarantee Company (ECG), and Egyptian Reinsurance Company. 4 Fiscal year 2005 starts from July 1, 2004 to June 31, 2005. 5 Macroeconomic instability, regulatory-policy uncertainty, high tax rates, cumbersome tax administration, and competition issues were identified as major impediments to private-sector development. These were followed by factor-markets issues, such as access to finance and cost of financing, availability of skillful labor, and access to land; and to a lesser extent, by infrastructure. 6 The Government is committed to continuing the SOE restructuring and privatization program. This has been evident in the recent high pace of divestiture, as reflected in sales proceeds amounting to LE 5.6 billion in fiscal year 2004/05, and projected to yield LE 10 billion in fiscal year 2005/06, of which LE 5.3 billion is already achieved. This is a total of LE 11 billion, which exceeds the 10 percent threshold. 7 Namely, National Société Générale Bank (NSGB), Misr International Bank (MIBank), Egyptian American Bank (EAB), and Commercial International Bank (CIB). 8 On October 17, 2006, 80 percent of Bank of Alexandria was sold to an anchor investor—San Paolo IMI (an Italian bank) with a total transaction value of US$ 1.6 billion. This privatization transaction is considered a “signal” for government’s serious commitment to reform, and a “milestone” and “centerpiece” for the implementation of the ‘Financial Sector Reform Program’. Transfer of ownership took place on December 12, 2006, and since then the bank has been operating fully under new private ownership. 9 Small firms employ 10 to 50 employees, medium firms employ 51 to 100 employees, and large firms employ more than 100 employees. 10 Institutional and regulatory constraints are discussed in further detail in Chapter 4. 11 As survey designers and enumerators in Egypt gain greater experience in asking financial questions, access figures may increase. 12 See for example the FinScope financial survey for South Africa (2005). 22 Access to Finance and Economic Growth in Egypt Introduction 23

CHAPTER 2

SOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR

Banking plays a central role in Egypt, accounting for more than 60 percent of financial-system assets. There were 43 banks operating in Egypt as of June 2006, of which four are state-owned commercial banks,1 29 are private commercial banks and joint-venture banks, seven are branches of foreign banks, and three are state-owned specialized banks2 (Annex 1, Table A1.2). The intermediation by the banking system in Egypt, however, is weak by international standards. While savings are high and banks in Egypt collect many deposits, they actually lend little of these deposits—and have lent less over time—to the real sector. The quality of financial intermediation is also poor, reflected in high costs, non-performing loans, and limited access for households and small firms to financial services. Underlying these problems are issues of incentives and governance, and a still weakly developed institutional infrastructure for lending.

A. ACCESS TO BANK FINANCIAL SERVICES

1. Supply of Financial Services from the Banking Sector

Total bank deposits in Egypt amount to about 100 percent of its GDP, high by many developing countries’ standards. Unfortunately, little of these deposits go to the real sector, as banks prefer to invest in government paper or other, non-loan assets. The loan-to-deposits ratio in Egypt is only 58 percent, well below the world average of 86 percent, 24 Access to Finance and Economic Growth in Egypt

and much less than the level of intermediation in many developed economies, where typically credit exceeds deposits (Figure 2.1).

Figure 2.1: Loans-to-Deposits Ratio in Egypt

200

100 Percent

0 Iran USA UAE India Syria Chile Brazil Egypt Benin China Belize Czech Bolivia Turkey Jordan Ireland Algeria Poland Mexico Bhutan Tunisia Croatia Estonia Belarus Bahrain Srilanka Bulgaria Armania Hungary Morocco Pakistan Thailand Australia Lebanon Malaysia Romania Lithuania Colombia Colombia Barbados Argentina Indonesia Botswana Singapore Azerbaijan Philippines Macedonia El Salvador Bangladesh Korea, Rep. South Africa South

Source: World Bank Database

The loan-to-deposit ratio in Egypt has been declining over the last few years (Figure 2.2). Furthermore, only a small portion of the funds mobilized are lent to the productive sector, and even less to the private sector.3 Banks are increasingly investing in treasury bills and government bonds (Figure 2.3). They held about 91 percent of outstanding treasury bills as of June 2006; public banks alone held 70 percent. This reflects banks’ inefficiency in identifying profitable projects and their cautious investment policies, and the fact that treasury bill investment is not only risk-free, but exempt from taxes.4 Direct lending to the public sector-both the Government and

Figure 2.2: Loan-to-Deposit Ratio in Egypt Figure 2.3: Treasury Bills-to-Total Assets in Egypt

100 16 14 80 12 60 10 8 40 6 4 20 2 0 0 2000 2001 2002 2003 2004 2005 2000 2001 2002 2003 2004 2005 2006

Public Banks Private Banks Public Sector Banks Private Sector Banks

Source: Central Bank of Egypt, 2006. Source: Central Bank of Egypt, 2006. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 25

Figure 2.4: Government Sector Loans-to- Figure 2.5: State-Owned Enterprises Loans-to- Total Loans in Egypt Total Loans in Egypt

7 25 6 20 5 4 15

3 10 2 5 1 0 0 2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006

Public Sector Banks Private Sector Banks Public Sector Banks Private Sector Banks

Source: Central Baank of Egypt, 2006. Source: Central Bank of Egypt, 2006.

state-owned enterprises-has also increased in recent years: state- owned banks have increased such lending from 4 percent in 2000 to 5.5 percent in 2006 (Figure 2.4). Lending to SOEs remains high for state-owned banks compared to private banks: 15.2 percent versus 2 percent as of June 2006 (Figure 2.5).5 In other words, banks finance the budget deficit and are not playing an active role in financial intermediation. At the same time, credit to the private sector has sharply decreased. Currently, it stands at 54 percent of GDP, similar to country comparators, yet half the OECD average of 110 percent. Furthermore, data from CBE show that the distribution of loans in Egypt is quite concentrated (Table 2.1). As of December 2005, 22 clients with loans of more than LE 1 billion accounted for some 11 percent of total credit outstanding. The next 47 clients, with loans between LE 500 million and LE 1 billion, accounted for some 10 percent of total credit outstanding, meaning that 69 clients accounted for almost one-quarter of total credit outstanding. Adding the next 486 clients means that more than 50 percent of total loans are represented by a scant 0.19 percent of all clients (Figure 2.6). Even

Table 2.1: Frequency Distribution of Private Sector Credit in Egypt

As a percent of total Average loan Number Credit Loan Description credit to the private size of clients (million LE) sector (million LE) Less than LE100 million 289,039 157,483 48 0.5 LE100 million and less than LE500 million 486 99,856 31 205 LE500 million and less than LE1 billion 47 31,835 10 677 LE1 billion and more 22 37,261 11 1,693 Total 289,594 326,435 100 1.13 Source: Central Bank of Egypt, General Department of Compilation of Credit Risk. This does not include loans less than LE 30,000, which need not be reported to the CBE credit registry. 26 Access to Finance and Economic Growth in Egypt

when including loans less than LE 30,000, the average loan size is still as high as LE 159,906, which compares very unfavorably with other countries at similar income levels, and with other countries in the region, such as Lebanon and Iran.

Figure 2.6: Credit Extended to Private Sector* in Egypt

51%

0.19% of clients

Source: CBE (2006). * This covers only loans above LE 30,000 that are recorded at the Credit Registry at CBE

Such a high fraction of loans to a limited number of borrowers means a heavy concentration of credit risk, although limits exist (according to Law 88 of 2003, credit facilities to an individual client can not to exceed 20 percent of banks’ capital),6 and a lack of diversiﬁcation. Large corporate-sector loans are as much as 70 percent of total loans for many banks, with retail lending accounting for only 10 to 20 percent of total loans and SME lending only 20 to 22 percent.7

2. Deposit Mobilization and Financial Services for Households

Banks have so far targeted a limited segment of households for deposit mobilization and other financial services. Incentives for households to use deposits and other financial services are poor. Minimum required deposit amounts8 are too high to enable the poorer segments of the population to access the banking system and tend to discourage the unbanked population to save through formal channels. Although the commercial state-owned banks have relatively high branch density in both urban and rural areas (Figure 2.8), they do not extend many financial services to relatively disadvantaged segments of society. For example, only 3 percent of the savings accounts at state-owned banks have less than LE 5,000 in them (Table 2.2). By contrast, 42 percent of state-owned specialized bank accounts and 66 percent of foreign bank accounts have less than LE 5,000. Over 90 percent of the accounts at state-owned specialized and foreign banks have IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 27

LE 500,000 or less. The public banks, which have an advantage in attracting small depositors due to their branch network, have instead focused on large depositors, with one-third of their accounts larger than LE 500,000 and 22 percent larger than LE 5,000,000.

Table 2.2: Share of Savings Accounts by Size of Deposits in Banks in Egypt (percent)

Public Commercial State Specialized Private & JV Deposit Size Foreign Banks Banks Banks Less than LE 5,000 3 42 34 66 LE 5,000–LE 500,000 65 52 49 27 LE 500,001–LE 5 million 11 6 13 5 Over LE 5 million 22 0 4 3 Source: World Bank Survey of Banks in Egypt, (2006). The ﬁgures are for accounts denominated in Egyptian pounds. The size distribution of dollar-denominated accounts is very similar to the one presented here.

The lack of deposit mobilization from small savers is not due to ﬁnancial repression. Interest rates on deposits are relatively high, about 6 percent for one-month time deposits in Egyptian pound, and 10 percent to 13 percent for deposits with maturities of one year and above, comparable to government bonds paying 9 percent to 11 percent for 15 years (Table 2.3). The interest rates for saving instruments vary from 6 percent to 13 percent depending on tenor and size. Foreign- currency deposit rates are in line with international market rates. Deposits are subject, however, to 14 percent liquidity and reserve requirements, which increase ﬁnancial intermediation costs.

Table 2.3: Local Currency Deposit Interest Rates in Egypt

Time Deposits Current Saving A/C A/C 7 Days 1 month 3 months 6 months 1 year 3 years+

State-owned banks 8.3 8.1 2.4 4.1 5.7 6.6 7.3 7.3 Public specialized banks 3 9.4 2.4 6 6.9 7.3 7.5 8.5 Foreign branch 4.75 6.4 2.6 5.7 6.2 6.45 6.36 9 Private and joint venture 3.33 7.54 3.1 5.9 6.6 6.8 7.1 8.25 banks Source: World Bank Individual Banks Survey(2006).

Banks, however, have been recently trying to catch up and cater to the lower segments for all types of ﬁnancial services. As part of their retail efforts, banks have recently been actively offering credit and debit cards, with public banks generally offering debit cards, and 28 Access to Finance and Economic Growth in Egypt

private and joint-venture banks offering credit cards (Table 2.4). The large and rapidly growing volume of card issuance helps capture salaries of public- and private-sector employees, thus enhancing low interest bearing current account volumes (credit-card usage limits are usually set to the amount of customers’ time deposits).

Table 2.4: Number of Credit and Debit Cards Issued in Egypt during 2005

Credit Cards Debit Cards State-Owned Commercial Banks 44,947 373,692 Foreign Bank Branches 20,875 - Private and Joint Venture Banks 193,534 92,963 Source: World Bank Individual Banks Survey (2006).

B. FACTORS BEHIND WEAKNESSES IN SUPPLY OF BANKING SERVICES

Weaknesses in the supply of banking services, especially to small ﬁrms and poor households, arise from a number of factors. These include poor market structure, limited number of access points and branches, poor performance of banks, lack of skills (particularly assessing credit risk) and incentives, poor credit policies and practices, weak external and internal governance (especially in state-owned banks), and newly implemented and relatively untested regulations and supervision. Many of these weaknesses can be attributed to the dominance of state-owned banks, compounded by the ongoing process of institutional and operational restructuring. But the supporting institutional infrastructure is also poor. The judicial infrastructure is weak, with long backlogs, high processing costs to support collateral, and cumbersome foreclosure procedures. The credit-information base is weak and transaction costs are still high.

1. Market Structure

The banking sector is dominated by state ownership, in terms of assets and number of branches. Collectively, state-owned banks account for more than 60 percent of total assets, and 85 percent of branches as of June 2006 (Annex 1, Table A1.3). In addition to their extensive branch networks, state-owned banks hold equity capital and de facto governance sway in most joint-venture banks. Public-ownership stakes in these joint-venture banks has been at the root of unwelcome governance and conﬂict of interests issues. Indeed, although joint-venture banks are not, in principle, subject to centralized management control, their links to the large state-owned banks translate into weak governance, affecting overall competition and quality of ﬁnancial intermediation. Effectively, the public sector’s dominance in the banking system goes beyond the 60 percent level. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 29

Although the legal preparation for privatizing the banking system started in 1998, ownership of the banking system has not changed as rapidly as was expected. While the share of state-owned banks declined in the late 1990s, an increase has occurred since 2000 (Figure 2.7). Despite the recent sale of some state-owned banks’ shares in joint-venture banks, for many joint-venture banks majority public ownership is still maintained through ownership of insurance companies, NIB, and other public entities. With government majority control, minority shareholders’ rights in joint-venture banks are highly restricted-in terms of board nominations, distribution of proﬁts, auditing and access to information-and, although there is some private-sector board representation, the public sector dominates the decision-making process.

Figure 2.7: State Owned Banks’ Share of the Banking System Total Assets in Egypt

57 2000 2001 2002 2003 2004 2005 2006

Source: Central Bank of Egypt, 2006

International experience and Egypt-speciﬁc evidence shows that banks that are partially privatized-especially those in which the state maintained a controlling ownership stake-perform worse than those that are majority privatized. This is important, since even with the successful implementation of the ﬁnancial-sector reform program—the privatization of Bank of Alexandria,9 the merger of the two commercial state-owned banks, and the full divestiture of state-owned bank shares in the joint-venture banks-public ownership in the Egyptian banking system is expected to remain as high as 48 percent. Furthermore, divestiture of state-owned banks’ share in joint-venture banks by itself will not assure their total privatization when other non-bank public entities retain shares. For the near term, the banking system will remain dominated by two huge state-owned commercial banks: the National Bank of Egypt, and the merged Bank Misr-Banque du Caire. 30 Access to Finance and Economic Growth in Egypt

Through a series of acquisitions, mergers, and revoking of licenses of non-compliant banks, the number of banks and branches of foreign banks has declined from 57 in 2000 to 43 as of June 2006, and is expected to reach 34 by 2007.10 The consolidation of the banking system-with the exit of small private and joint-venture banks and the entry of several strong foreign banks-is expected to enhance competition in the market, especially when accompanied by a strengthened regulatory framework and a healthier business environment.

2. Branch Network

Egyptian banks have few outlets for basic banking services. Egypt has fewer bank branches and automatic teller machines (ATMs) per capita than other countries within the region and other countries with similar per-capita income (Table 2.5). Relative to the developing world, Egypt’s branch density is low, and its ATM coverage is less than one- seventh that of the typical developing country (1.8 versus 13.3 ATMs per 100,000 residents). Branch and ATM density is linked strongly to

Table 2.5: Branching and ATM Presence, Cross-Country Comparisons

Branches ATMs GDP per Capita Country per 100,000 people per 100,000 people (US $, 2003) Honduras 0.73 3.56 1,001 West Bank-Gaza 3.27 3.24 1,026 China 1.33 3.80 1,094 Egypt 3.62 1.78 1,220 Bosnia 3.86 5.36 1,682 Colombia 8.74 9.60 1,747 Belarus 4.79 5.06 1,770 Dominican Republic 6.00 15.08 1,821 Jordan 10.02 9.38 1,858 Albania 2.11 2.37 1,933 Kazakhstan 2.47 7.01 1,995 Iran 8.39 1.25 2,061 Lebanon 18.01 16.81 4,224 Chile 9.38 24.03 5,462 Mexico 7.63 16.63 5,968 Czech Republic 11.15 19.57 6,123 Argentina 10.01 14.91 7,483 Saudi Arabia 5.36 14.7 8,366 Bahrain 13.48 26.83 10,791 Kuwait 8.27 19.69 14,848 Israel 14.74 18.81 16,686 Sweden 21.79 29.56 28,858 Regional Average 9.46 12.5 6,787 Industrialized Average 35.31 73.54 28,983 Other Developing (average) 6.89 13.3 2,748 Source: World Bank, Measuring Banking Sector Outreach, Indicators of Access to and Use of Financial Services across Countries, Thorsten Beck, Asli Demirguc-Kunt, and Maria Soledad Martinez Peria (2005). IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 31

GDP per capita, making comparisons with higher-income countries in the region such as Bahrain and Kuwait potentially misleading. Even so, Egypt has fewer than half the number of branches of either Iran or Jordan, although their per-capita are incomes substantially less than double Egypt’s.11 Within the region, only the West Bank and Gaza has fewer bank branches, and Egypt trails all countries in Table 2.5, including those with similar income levels, in ATM density.12 By bank type, state-owned specialized banks have 1,236 branches, state-owned commercial banks have 969 branches, private and joint- venture banks have 657 branches, and foreign banks have 42 branches. In general, banks tend to concentrate on the urban population, with branch networks concentrated in Cairo and Alexandria; the number of branches per 100,000 people is about 80 percent higher for urban areas than rural. Urban and rural bank-branch density varies signiﬁcantly, though, by type of bank (Figure 2.8). State-owned banks have the most balanced branch network overall, though their presence is still greater in urban than in rural areas (three versus one branch per 100,000 people). Private and joint-venture banks have three urban branches per 100,000 residents, but much less rural coverage, 0.5 branches per 100,000. State-owned specialized banks are the only bank type for which rural branch density is higher than urban, roughly ﬁve times as high. With only 42 branches, foreign banks have little physical presence in either urban or rural areas.

Figure 2.8: Urban and Rural Branch Density by Bank Type in Egypt (Branches per 100,000 people)

3.5

3 Urban 2.5 Rural 2

1.5

0.5

0 Public Commercial Public Specialized Private & JV Foreign

Source: Central Bank of Egypt (2006). Urban governorates include Alexandria, Cairo, Port-Said, and Suez. 32 Access to Finance and Economic Growth in Egypt

Branch-density figuresdo not reflect the postal system and its potential contribution to improved access to financial services, especially in rural areas (Box 2.1). There are currently 3,600 postal branches, though only 600 are connected via DSL lines, and many do not offer a full range of financial services.13 A major effort is underway to assess and train staff in financial-service provision, and restrictions on how post deposits are invested have recently been lifted. Thus, there is an opportunity to enhance postal payments and savings products, while at the same time using this distribution and IT infrastructure for credit extension.

Box 2.1: Egypt Post Ofﬁces

Egypt Post is present in 218 cities and 4,500 villages throughout Egypt. With 47,000 employees, 3,600 post offices and 6,500 licensed postal agents (franchised post offices through private-public partnerships), Egypt Post serves 15 million customers, including 13 million savings-account holders. In the Upper Egypt and Delta regions, where there are very few bank branches, there are 2,800 postal outlets, placing Egypt Post in a unique position to improve access to finance in these regions.

Postal financial services: strong growth and anchorage within the middle and low- income households. In the past four years (2002-2005), 40 to 60 percent of Egypt Post’s annual revenues have been generated through postal financial services: savings accounts, transfers of funds, pension payments, postal cheques, and e-payments and services offered as intermediary (car insurance, investment account with the Faisal Islamic Bank, bill payments for Egypt Telecom). Revenues from savings have increased by 150 percent over the past four years. Domestic money transfers have also shown strong growth (131 percent), while international money orders have decreased (down 49 percent). Pension payments have grown by 58 percent. According to official figures, Egypt Post has about 10 percent of market share in the savings segment (estimated at around LE 34 billions), and 20 percent in the money transfers. In view of the average deposit per account, middle- and low-income households represent the bulk of Egypt Post customers.

Preparing for a strategic turn around. Egypt Post used to transfer postal financial deposits to the NIB for 0.5 percent, while savings books carried an interest rate of about 12 percent. Since early 2006, a new regulation has allowed Egypt Post to invest the postal savings in the financial markets, an opportunity to rebalance interest yields. Egypt Post has also invested intensively in its network in the last few years (computerization and interconnection of post offices), and further capacity-building is planned, at both the infrastructure and system levels (management and information systems, back office systems, and operational systems). Information and Communication Technologies-based financial services are a prerequisite to better-managed financial services. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 33

3. Performance of Banks

Compared to their private counterparts, state-owned banks lag in efficiency and in performance generally, as evident in their financial indicators.14 State-owned banks are undercapitalized (Figure 2.9), and suffer from poor asset quality and high non-performing loans (NPLs). The incentive for these banks to identify and resolve problem loans before they become non-performing, maximize profits, or even minimize losses barely exists, as reflected in their relatively low profit margins, high operating costs, and inadequate risk-management systems. Being backed by the Government and protected from closure on constitutional grounds, they are not subject to the same level of strict banking supervision, making them more inclined to roll over and “evergreen” loans.

Figure 2.9: Equity-to-Assets Ratios of Banks in Egypt

0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Public Banks Private Banks

Source: CBE, Annual Report. 2006

State-owned banks have also been slow to modernize and innovate. The volume and scope of products and services these banks offer to the market has been limited. Past heavy public-sector control and restriction of competition has led to lethargy among these banks. In the past, most lending was toward a few large private corporations and large public-sector projects. Lending to the private sector was based on “relationship” or “name” lending, and mostly to major suppliers or contractors for the public sector. This type of lending has led to substantial NPLs and has hindered resource-allocation efficiency. State-owned banks have been trying to adjust their operations and become profitable and efficient business entities in a short period. However, the restructuring of non-performing assets is distracting management from lending. 34 Access to Finance and Economic Growth in Egypt

Box 2.2: Status of Islamic Finance in Egypt

Islamic financial services (IFS) are expanding worldwide. More than 200 Islamic financial institutions reportedly have in excess of $200 billion in total assets. Some expect Islamic finance to attract 40 percent of the total savings of the Muslim population worldwide. Currently Islamic financial services have a significant presence-in addition to GCC countries-in Malaysia, Indonesia, and Pakistan, and are emerging in a number of non-Muslim countries. To capitalize on the potential, a number of global financial institutions—including Citibank, HSBC, Goldman Sachs, BNP- Paribas and UBS—have established Shariah-compatible services. Capital market instruments are also developing, mainly in the form of Sukuks, with outstanding issues of about $40 billion; and insurance products in the form of Takaful are gaining ground. Egypt pioneered Islamic finance with the 1963 establishment of Mitghamr Savings Association. Notwithstanding its early start and Egypt’s large, predominantly Muslim population, Islamic financial services have limited penetration, with only three major fully Islamic financial institutions (IFI) and some Islamic windows at conventional banks. Assets of full fledged IFIs were about 3 percent of total banking assets at the end of 2004. The limited penetration of IFIs is in part due to the collapse of Islamic Investment Companies (IIC) in the 1980s, which contributed to skepticism towards institutions operating with an Islamic finance label and led depositors to shift their accounts to Islamic windows of conventional banks.1 Faysal Islamic Bank is the largest Islamic bank in Egypt today, followed by the Islamic International Bank of Investment and Development and the Egyptian Saudi Finance Bank. These banks have formal Shariah Boards to assess Shariah compliance. Islamic banks are under the same regulatory framework as conventional banks-with requisite adjustments made for reporting and compliance requirements-and are under the purview of the Central Bank of Egypt. In general, like most IFIs elsewhere, assets are predominantly allocated to financing trade and services activities, as these provide generally higher returns and have short maturities. The share of agriculture and industrial sectors is small.2 Hard data on Islamic activities of conventional banks are less readily available. Bank Misr was the first conventional bank to set up an Islamic branch, and has a dominant position in deposit mobilization. At the end of the 1990s, there were some 62 Islamic branches of 23 conventional banks. It is estimated that the Islamic banking sections of the four largest state banks account for more than 10 percent of total deposits.3 Despite a growing network of branches, the local Islamic finance sector still lags behind regional and international growth because of the underdeveloped services they offer. This is especially so in the capital markets and insurance sectors. Hermes EFG and Faisal Islamic bank launched the first, and still only, Egyptian Islamic fund in October 2004, which only invests in Shariah- compliant companies. Shariah-compliant insurance services are not commonly available, with the exception of the Islamic Arab Insurance Company, which offers its services in Egypt through its local subsidiary Saudi Insurance House. Sukuk (Islamic) bonds have not yet made a noticeable appearance in Egypt’s financial markets.

1 IIC grew spectacularly, accumulating billions of dollars in deposits. Dividends distributed by IIC were more than double those offered by conventional banks. IICs were not subject to supervision or regulation until some IICs’ large losses gold and foreign-currency speculation became known. 2 Mahmoud Mohieldin (1997), p. 13. 3 Islamic branches do not have a board of religious scholars to verify the banks’ operations and assure their compliance with Islamic law in all transaction. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 35

Analyzing banks by performance and differences in capital adequacy, asset quality, NPLs, management soundness indicators, earnings, and proﬁtability sheds light on which banks have been able to increase their loans in a sustainable manner. Analysis (Box 2.3) shows that Egyptian banks with more focus and more capital are more proﬁtable, and that private banks outperform state-owned banks. Analysis which compares the size of banks’ loan portfolios to their funding capacity, shows large private and foreign banks are best able to increase lending to the private sector in a sustainable manner in Egypt.

Box 2.3: Bank Performance Analysis by Size and Ownership

Financial data for a bank can tell a great deal about its efficiency in financial intermediation. Because most banks in Egypt are not listed, accounting data must be used to measure bank performance; specifically the ratio of operating income-to-total assets. Analysis controls for the diversity of income streams (fees versus non-fee income) and includes several other bank-specific variables, including bank-specific measures of bank ownership. All bank-specific data are from Bankscope, a commercial database of financial information on most large banks around the world. Analysis for this study uses data for the period 2001 to 2004. One basic conclusion is that banks in Egypt with more focus are more profitable, controlling for the fact that banks that generate more interest income tend to be more profitable. This is consistent with the notion that agency conflicts from engaging in multiple activities destroy value. Banks should focus on their area of expertise, be it making loans or underwriting securities. Also, more highly capitalized banks (as measured by the ratio of equity to total assets) are more profitable; this is consistent with the notion that higher-quality banks are both able to amass more capital over time and generate higher profits. This also suggests that some banks with relatively low levels of capital may be taking excessive risks that are not paying off in higher profits. In terms of the effects of ownership and type of specialization on bank performance, foreign- owned banks outperform domestically owned private banks, and both types outperform state banks. This suggests that opening the market to foreign entry could increase bank performance by increasing competition and improving incentives, consistent with the findings of a large cross- country empirical literature on this topic. Data do not indicate any difference in performance across different types of banks, such as commercial banks, investment banks, Islamic banks, or specialized government credit banks. Bigger banks, as measured by total operating income, and more highly capitalized banks, however, do extend relatively more loans. This suggests that there are economies of scale, arguing for increased consolidation of the banking sector in Egypt. At the same time, banks with relatively more deposits, which tend to be the cheapest source of funding for banks, extend relatively fewer loans, independent of bank ownership, suggesting that not having to compete for deposits creates incentives for easy forms of financial intermediation, such as lending to the Government and large corporations, leaving smaller borrowers without access to lending. 36 Access to Finance and Economic Growth in Egypt

a. Capital adequacy The average capital adequacy ratio of banks in Egypt is low compared to other developing countries facing similar risks. Capital is vital for ensuring soundness for a banking system, since it acts as a cushion against shocks, allowing banks to absorb losses and continue honoring claims. The amount of capital that a bank should hold depends primarily on the riskiness of its assets. Hence, banks with unsophisticated risk-management systems should maintain much higher capitalization levels. The Central Bank, Banking and Money Law 88, issued in 2003, signiﬁcantly raised minimum capital requirements.15 As a result, there have been several mergers, acquisitions, and revoking of licenses of non-compliant private and foreign banks. However, state-owned banks in Egypt still suffer from a low capital adequacy. The equity- to-assets ratio—a proxy for capital adequacy—shows that state- owned banks averaged at 4 percent in 2006, as opposed to 7 percent for private banks, indicating that the former are undercapitalized and less resilient to shocks (Figure 2.9).

b. Asset quality The quality of banking-system assets is adversely affected by the substantial NPLs from previous periods. The NPLs-to-total loans ratio rose from 11.7 percent in 1999 to 16 percent in 2003, and to 22 percent in 2005.16 Were strict past-due and loan-classification criteria applied and rolling-over of loans taken into account, NPLs would be even higher.17 It is estimated that around 63 percent of NPLs are to SOEs. This large volume of NPLs is the result of previous directed lending to loss-making SOEs, government-led initiatives (including mega projects), and connected lending to private enterprises. Although many SOEs were highly leveraged and overindebted (Annex 1, Table A1.9),18 state-owned banks continued to extend loans; more than 91 percent of claims on SOEs are owed to state-owned banks. Private- sector NPLs were mainly generated during the credit boom of the mid- 1990s, when many loans were allocated to connected and well-known business executives. Rapid credit expansion stretched the capacity of banks to carefully screen borrowers, especially as credit officers were not well equipped to analyze the feasibility and viability of the proposed projects. The situation was aggravated by the deteriorating macroeconomic environment of the late 1990s, which led to an increase in the number of companies declaring bankruptcy (Annex 1, Table A1.13). Many private-sector defaulters fled the country, leaving behind large bank loans that went unpaid. The Government is making efforts to address the state-owned banks’ NPLs. A scheme was outlined in late 2005, with resources from privatization proceeds earmarked to this effect.19 Under Law 88 of 2003, state-owned banks are requested to follow stringent lending policies, and since 2002, state-owned banks have stopped lending to non-viable and defaulting SOEs. Accordingly, new NPLs at state- owned banks should be much reduced. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 37

The portfolio of private banks today is, on aggregate, of better quality compared to state-owned banks, as shown by the lower ratio of NPLs and the smaller share of lending to loss-making SOEs. Reflecting their better credit-screening mechanisms, private banks have been mainly involved with viable public-sector institutions and large national and multinational corporations. They have also adjusted faster to the tighter regulations; in fact, most of them were already following prudent lending policies. c. Management soundness indicators and staffing Management indicators, such as expense ratios and earnings per employee, show that on aggregate the banking system is not operating efficiently, as it suffers from high operating costs and low earnings. This is largely due to a distorted incentive system, poor governance structure, and the dominance of state ownership. State-owned banks are, in general, characterized by weak internal governance, overstaffing, and lack of performance incentives. Employees of state- owned banks are treated as civil servants in terms of job guarantee and salary scale, which reduces their performance incentives and leads to overstaffing. Managers of state-owned banks have few incentives to innovate or to identify problem loans at an early stage. Disparities between private and state-owned banks in Egypt due to variations in management performance show up in performance measures. Inefficiency from overstaffing in state-owned banks shows in the relatively low (and declining) earnings-per-employee ratio (Table 2.6). Private banks offer their staff better compensation packages. Although this increases staff costs, leading to a higher expense ratio for private banks compared to state-owned banks in some recent years, (Table 2.7), private banks have also been investing more in innovation and introducing new financial instruments. The higher revenues and larger profits that result from these investments tend to offset higher staff costs. With the 2002 launch of banking-sector reform and the

Table 2.6: Earnings per Employee Table 2.7: Expense Ratio* of Banks of Banks in Egypt (LE million) in Egypt (in percent) State-Owned Private State-Owned Private Banks Banks Banks Banks 1998 16.32 22.79 1998 75.99 67.41 1999 18.35 25.21 1999 78.78 73.72 2000 20.82 28.49 2000 82.99 81.78 2001 20.45 28.98 2001 84.02 87.65 2002 19.81 29.14 2002 86.23 89.66 2003 18.98 29.87 2003 83.31 87.43 2004 18.91 29.87 2004 81.88 80.32 2005 18.88 29.97 2005 77.16 78.70 * Calculated as the ratio of expenses-to-total revenue. Source: CBE, Supervision Department. 38 Access to Finance and Economic Growth in Egypt

change in management, especially of state-owned banks, there has been a declining trend for expense ratios of both state-owned banks and private banks, reflecting higher efficiency levels. More than 75 percent of the banking sector’s income comes from interest earned, compared to 50 percent for the average bank in a developing country. While new products are being introduced, most loan products are quite basic, generally straight lending with fixed interest rates.20 Fees and commissions and treasury earnings are not significant sources of revenues, primarily because of a lack of diversification in products (hedging, forwards, factoring or export receivables, discounting under letters of credits, structured investment banking products are not being offered) and limited other services. Recent increases in ATMs and credit/debit cards as well as retail lending suggest, however, that banks will see an increase in income from fees and commissions in the future. While there have been recent efforts to improve efficiency through increased automation, staff breakdown (Figure 2.10) shows that public banks have more staff in back-office activities than private and foreign banks, as their accounting is not fully automated, lowering efficiency. Moreover, the lack of skills and sophistication in the banking sector, especially in state-owned banks, has led to a narrow range of products and services. While all banks indicate that they are active in credit marketing through the use of media and staff, most banks (16 of the 35) say they will not recruit new staff in the credit and lending areas.21 Thus the retooling of banks’ staff will take considerable time.

Figure 2.10: Distribution of Staff in the Egyptian Banking System

0 Branch Lending Account Audit Admin Treasury Mgmt. Other

Public Co. Public Sp. Foreign Br. Private Co.

Source: World Bank Individual Banks Survey (2006) IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 39 d. Profitability indicators Profitability indicators put banks operating in Egypt at a modest level compared to other developing countries. This is largely due to the poor performance of state-owned banks; returns-on-assets and returns-on- equity are much higher for private banks (Figure 2.11 and 2.12).22 To a large extent, the poor performance of state-owned banks can be attributed to sizable additions in recent years to loan-loss provisions. But it also reflects their continued inefficient allocation of funds and weak financial intermediation. Overall, the indicators demonstrate that private banks perform better than state-owned banks. Data reveal several areas of deficiencies in state-owned banks, including a relatively low capital-adequacy ratio, poor quality of banks’ assets, high ratio of non-performing loans, and modest earnings and profitability.

Figure 2.11: Return-on-Assets Figure 2.12: Return-on-Equity

3.0 24

2.5 20

2.0 16

1.5 12 Percent Percent 1.0 8

0.5 4

0.0 0 1995 1997 1999 2001 2003 2005 1995 1997 1999 2001 2003 2005 Public Banks Private Banks Public Banks Private Banks

Source: CBE, Annual Report.

4. Poor Credit Policies and Practices

Many banks in Egypt are accustomed to lending to select state-owned enterprises or private corporations on a relationship basis, with little regard for credit policies and procedures. The stock of NPLs shows that many banks have done a poor job in lending to the public sector and other large corporations. Data also show that banks have not been very active in allocating resources to retail clients and SMEs (Table 2.8). This is especially so for state-owned banks, although they are better suited to lend to SMEs given their large and low- cost deposit bases and their extensive branch networks. The big four state banks mainly lend to large corporations, while the smaller, specialized state-owned banks, followed by foreign banks, are more active in lending to SMEs. Foreign banks also reach out more than other types of banks to retail clients, possibly taking advantage of their superior credit-scoring skills. 40 Access to Finance and Economic Growth in Egypt

Table 2.8: Main Reasons for not Lending to SMEs* in Egypt

Joint Public Public venture Foreign Commercial Specialized banks & Total Branches Banks. Banks Private Banks Lack of proper financials 3 4.67 4.57 4.56 5 Poor audit quality of financials 3 4.5 4.05 4.06 4.5 Low banking experience of the SMEs 3 2.5 3.09 3.03 3.5 Poor financial skills of SME management 3.67 3.67 3.45 3.57 4 Preference of SMEs to use supplier credit 2 1.83 2.38 2.29 2.75 Lack of collateral 4 3 3.73 3.71 4.5 Unwillingness to provide collateral 4 2.67 4.18 3.89 4 Poor quality of collateral 3.67 2.67 3.64 3.57 4.5 Non-liquid collateral 3 2.5 3.64 3.4 3.5 Your bank’s internal exposure limits 2.5 2.67 3.41 3.03 2.5 Your bank’s lack of experience in SME lending 2 2.67 2.5 2.4 2 High cost of SME loan portfolio processing 1.5 2.5 2.9 2.59 1.75 High cost of registering collateral 1.5 2.83 3.14 2.94 1.5 Limited branch network of bank to reach SMEs 1.5 2.67 2.14 2.17 1.5 *Rank is 5-Most important, 4-Important, 3-Good to have, 2-Not important, 1-Not an issue. Source: World Bank Individual Banks Survey (2006).

A further sign of weak credit skills is that most banks consider the standard CBE credit guidelines to be sufficient, with only a few banks requiring additional information from borrowers. Furthermore, no bank has internal exposure limits by sector or type of borrower. Another sign of weak skills is that despite complaints about the poor quality of financial information provided, very few banks-public or private-require periodic financial statements (in addition to the required annual ones) from borrowers. And three out of the four state-owned banks and several joint-venture banks do not conduct an independent annual risk asset review. Also, most banks price loans on a client-by-client basis, suggesting lack of standard products and poorly functioning asset-liability management and internal pricing mechanisms. Nearly all banks have centralized credit decision-making structures, partly as a reaction to past problem-loan experiences, but presumably also due to a lack of branch staff skills-although banks did not indicate a need for skill- building. Few banks conduct sufficient market and sector analysis to establish a solid growth strategy and target new markets. Another sign of Egypt’s poorly functioning credit market is unfavorable lending terms: collateral requirements are very high (an average of 123 percent of the loan value; even higher for SMEs). Collateral requirements as a percentage of loan value are as high as most other MENA countries (Figure 2.13), but above those observed in many developing countries. Usually banks resort to over-collateralizing when there are problems associated with foreclosure and loan recovery procedures. Moreover, since banks in Egypt have been operating IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 41 under directed lending for some years, they are not trained to base their credit decision on cash-flows, and require more collateral. Another sign of weak operational efficiency is the response time to set up credit lines for a new borrower meeting all requirements. This varies from 20 to 24 days for corporate borrowers, 17 days for SMEs, and 10 days for individuals. These response times-excluding setting up collateral requirements and registering the collateral- suggest low internal credit-approval limits, lack of competition, and overall inefficiency. Response time is particularly high for the large four public banks, which have the weakest skills.

Figure 2.13: Collateral Requirements as a percent of Loan Values

300

250

200

150

100

0 Oman Egypt Syria Algeria Morroco

Source: Egypt, ICA, (2005).

Lending is not limited by pricing, as rates vary greatly according to “what the market bears”. Corporate-sector loans to the top 400 corporations in Egypt are charged 9 to 11 percent per year, whereas middle-market borrowers pay around 14 to 16 percent, and SMEs around 22 to 28 percent (Table 2.9). In addition to lending rates, private commercial banks and foreign branches charge between 1 and 5 percent for fees on loans, plus around 0.3 to 1 percent on collateral value for evaluation.23 While interest rates follow government borrowing costs as a benchmark, there is not a proper yield curve to help price risks in the longer market. And the lack of foreign-

Table 2.9: Lending Rates for Local Currency of Banks Operating in Egypt (percent)

15 Days Short Term Medium Term Long Term Public Sector Median 12 12.25 12.25 13 Maximum 12 13 13 14 Foreign Branch Median 6 12 14 15 Maximum 12 19.6 17.70 17 Private and Joint Venture Banks Median 13.5 13 13.5 13.75 Maximum 18 18.05 18.05 19 Source: World Bank, Individual Banks Survey (2006). 42 Access to Finance and Economic Growth in Egypt

currency hedging instruments leads banks to being overly cautious and charging high margins in foreign-currency lending. Spreads between lending and deposit interest rates are consequently high, up to 10 percentage points. These spreads reflect the need for high provisioning as well as inefficiency in the banking sector, due to overstaffing and the required return on shareholders’ equity. The high spreads also reflect that the lending market is supply-driven: banks take advantage of the lack of competition or collude in keeping spreads high. Only in lending to large corporations do all banks indicate much competition.

5. Corporate Governance in the State-Owned Banks

Certain corporate-governance practices in state-owned banks deviate from internationally accepted good practice in several important respects (Box 2.4). The deviations mainly involve the fragmentation of the ownership function and the potential for dominance of the board by executive management, both of which undermine the ability of the Government to hold the board and executive management

Box 2.4: Weaknesses in Corporate Governance in Egyptian State-Owned Banks

First, with respect to ownership, the principal deviations are that responsibility for the conduct of the ownership function is fragmented, resulting in a loss of accountability. In particular, since the General Assembly does not have the power to appoint or dismiss board members, its ability to hold the board accountable is significantly diminished. (Moreover, it is unclear to whom, in practice, the General Assembly is accountable.) This lack of clear accountability, and the corollary potential inability of the fragmented ownership function to hold the board (and, indirectly, executive management) accountable, are a significant impediment to effectively exercising the Government’s ownership rights, particularly when the Government wishes to assert its ownership rights for the purpose, for example, of pursuing its access agenda. Second, the current arrangements impose significant potential conflicts of interest on the CBE (the monetary authority and bank regulator). With the Governor of the CBE chairing the banks’ General Assemblies, and the Bank Restructuring Unit (BRU) within the CBE guiding the restructuring of the banks, the CBE is exercising considerable ownership functions (and, to some extent, board functions). This creates potentially serious conflicts of interest with respect to CBE’s bank-regulation and monetary-policy responsibilities. For example, the ability of bank regulators to effectively exercise their responsibilities is undermined when their superior, the Governor, plays an ownership role for a regulated bank.24 Third, the deviations with respect to the board-although less not to public banks and Egypt— relate mainly to the potential dominance of the board by executive management.25 The principal concern is that executive management may dominate the boards, which undermines their ability to evaluate management performance and hold management accountable. This concern is exacerbated by the fact that the top executive managers are, in effect, appointed by the Prime Minister. A consequence commonly seen in state banks in other countries is that management is able to function in a relatively autonomous manner. In Egypt this may further diminish the ability for the Government to guide the banks to incorporate access-related objectives into their business strategies. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 43 accountable. The deviations also involve a failure to separate government ownership from government regulatory functions, which creates conflicts of interest that can undermine the effectiveness of both functions. While these deviations may be expedient in the current situation and will likely persist over time (for example, as incumbents change), they impede the ability of the Government to effectively exercise its ownership rights.

6. Constraints on Household Access to Financial Services

As in other countries, demand-side factors-such as education-tend to dominate in explaining the use of ﬁnancial services. Yet analysis also suggests that use is driven by supply-side factors (Box 2.5). The importance of supply factors can be easily summarized through the importance of proximity to a bank or postal branch for access.26

Box 2.5: The Relative Importance of Demand and Supply Factors in Explaining Access

We use the following regression of demand and supply factors in explaining:

Where access is a dummy variable equal to 1 if household i has any formal savings or investment product. Male is a dummy equal to 1 if the household is headed by a man. Age is the head of household’s age in years. Education is vector of two dummy variables, one equal to 1 if the head of household has a university or graduate degree, the other equal to 1 if he/she holds a primary or secondary school degree. HH size is the number of household members. Expenditure is a proxy for income measured as total yearly household expenditures. Non-poor is a dummy equal to 1 if household expenditure is above the bottom quintile in our sample. This variable is intended to capture whether access is especially limited for households below the poverty line. Wage share is the share of household income derived from wages; agric. share is the share derived from agricultural activities. Bank branch is a dummy equal to 1 if there is no bank branch within 15 minutes of the household. Post branch is deﬁned similarly for postal outlets. Finally, self-employed is a dummy equal to 1 if the head of household employs him- or herself, and those who also employ others. We expect greater access for households headed by self-employed males, who are older, and have more education. We also expect better access for smaller households, with higher incomes (expenditures), and with lower shares of income from wages and agricultural activities. Finally, we expect less access for households located farther than 15 minutes from a bank or post branch. We ran separate regressions for urban and rural areas because the range of ﬁnancial services differs across the two (top half of Table B2.1). Financial assets comprise 6 percent of the total assets of urban households, less than 1 percent of the assets of rural households. Nearly half of the assets of rural households are land holdings, and the vast majority of those holdings are agricultural. For urban households, land holdings comprise only 14 percent of assets, with roughly 60 percent of that being agricultural land. 44 Access to Finance and Economic Growth in Egypt

Box 2.5: The Relative Importance of Demand and Supply Factors in Explaining Access (continued)

Among households with some financial assets, the composition of those assets differs for rural versus urban households (bottom half of Table B2.1). Bank deposits comprise a higher share of financial assets of urban households (79 percent versus 66 percent), as do certificates and other investments, most of which are investment credits at the National Bank (8 percent versus 4 percent). Postal savings comprise a substantially larger share of the financial assets of rural households than urban (26 percent versus 12 percent). Rural households that do not have easy access to a postal branch (within 15 minutes) are significantly less likely to have formal savings or investment. All urban households reported having a postal branch within 15 minutes, and thus that variable does not enter the urban regressions. For urban and rural households, proximity to a bank branch is significantly associated with access, though the coefficient is larger (in absolute value) for rural households. The branching coefficients therefore suggest that physical presence is more crucial for access in rural areas. For urban households, coefficients for all of the remaining explanatory variables are significant and of the hypothesized signs. Results are similar for rural households, except that neither the gender of the head of household nor the poverty-line indicator is significant. Though signs and significance levels of coefficients are similar for the rural and urban samples, magnitudes differ. Magnitudes also differ for coefficients in the same regression. To assess the economic importance of variables in the rural and urban contexts, therefore, we calculate the marginal effects of a change in status for the median household in each sub-sample. The median household is defined as being headed by a male who is not self-employed, and who holds no academic degrees. That household is also assigned the sample median value for age, HH size, expenditures, and the shares of income from wages and agricultural activities. Some of those calculations are shown in Figure 2.13.

Rural versus Urban Access to Financial Services

Type Urban Rural Category as a Share of Total Assets Financial Assets 5.8 percent 0.7 percent Cash Holdings 2.2 percent 0.9 percent Agricultural Land Holdings 8.4 percent 41.4 percent Land Holdings 13.6 percent 48.4 percent Net Lending 0.1 percent 0.0 percent Category as a Share of Financial Assets Capital Markets Stocks and Bonds 0.2 percent 1.4 percent Deposits at Investment Companies 1.1 percent 2.5 percent Banks Bank Deposits 78.6 percent 66.1 percent Certiﬁcates/Investments 7.8 percent 3.6 percent Post Ofﬁce Savings 12.3 percent 26.4 percent Total 100 percent 100 percent Source: Egyptian Household Survey of Income and Expenditure (2005). IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 45

Urban households located within 15 minutes of a bank branch are 14 percent more likely to have formal savings or investments (Figure 2.14). The effects for rural households are even larger, with those located close to a bank branch being 22 percent more likely to have access to ﬁnancing, and those close to a postal branch being 10 percent more likely. At the same time, the analysis conﬁrms the importance of demand factors, including education, income, and gender. The effects of supply factors are dwarfed by those for demand-side variables, particularly education. Households headed by an individual with a primary or

Figure 2.14: Marginal Effects of Branching and Education on Access to Financial Services in Egypt

120

Urban 100 Rural

60 Elasticity (%) 40

0 Bank Branch Post Branch Secondary University Degree Degree

Source: Egyptian Household Survey of Income and Expenditure (2005) secondary school degree are almost 40 percent more likely to use ﬁnancial services than those headed by individuals with no formal degree (Figure 2.14). Those headed by someone with a university or graduate degree are 99 percent more likely to use formal ﬁnancial services in urban areas and 80 percent more likely in rural areas.

C. ACCESS TO MICROFINANCIAL SERVICES27

Besides the many households with unmet demand for financial services, a conservative estimate suggests there were at least 2 million microenterprises in Egypt in 2006, accounting for 93.7 percent of establishments. In principle, microfinance offers a means of addressing the demand of households’ and small firms’ access to financial services. Microfinance institutions, however, often do not have the necessary scale. While no formal aggregate estimates are available, it is estimated that the outreach of the microfinanceindustry in Egypt covers only about 10 percent of potential borrowers.28 46 Access to Finance and Economic Growth in Egypt

1. Main Players in Microﬁnance in Egypt

A few banks have been active in providing microﬁnance in Egypt, with some banks having established microﬁnance units within their institutions over the past decade (Box 2.6). There are four main

Box 2.6: State Owned Banks Actively Involved in Microﬁnance in Egypt

National Bank for Development (NBD) is a private commercial bank that started the first microfinance unit in Egypt in 1987 from donors’ grants. This unit became profitable and contributed approximately 25 percent of NBD’s annual profit. Since 1997, it has relied on its own resources. It had an outstanding balance by 2000 of about LE 70 million, serving about 23,000 clients. Over the life of the program about 300,000 clients have been served, with total loans of LE 800 million. In addition to microfinance units in all of its 44 branches, NBD has mobile lending units to reach remote areas. Until 2000, the maximum loan size was LE 10,000, which was reduced to LE 3,000 in June 2003. For loans between LE 250 and LE 3,000 and for tenor of two months to one year, no collateral is required other than the presentation of an identity card. Credit decisions are based on the viability of the enterprise and its cash flow. NBD only provides credit to existing firms, not start- ups. Clients qualifying for amounts exceeding LE 3,000 are referred to NBD’s corporate branches. NBD charges a flat interest rate of 16 percent plus a number of administrative and insurance fees, which can increase the total charges up to 30 percent. Moreover, NBD requires the borrower to deposit an amount equal to 10 percent of the loan in a savings account with accrued interest of 8 percent, which may be used for early loan repayment. Loan officers are paid in accordance with a performance-based reward system. The repayment rate is 96 percent. NBD’s success can be attributed to careful evaluation of clients, close monitoring with on-site visits, weakly collection of installments, monetary incentive schemes for loan officers, and in-house enforcement units. Banque du Caire and Banque Misr are the second- and third-largest state-owned commercial banks, with a network of 400 branches and 120 branches respectively. In 2001, Banque du Caire embarked on a strategy to downscale its institution-building to service small and microenterprises, capitalizing on the outreach of its large branch network. More than 107 of its braches have a microfinance unit. Banque du Caire is drawing on a trust fund of US$ 8.2 million at the Credit Guarantee Corporation (CGC) for the purpose of full credit-risk coverage of small and micro borrowers. The lending policy follows the graduation principle, whereby micro borrowers would initially be granted a loan of LE 1,000 and, subject to proper loan servicing, receive increased loan amounts of up to LE 3,000. The lending rate is 16 percent, flat amounting to around 30 percent. Banque du Caire has established best-practice microfinance standards within its institution. The outstanding loan portfolio stands at LE 270 million as of June 2006, and there are 117,000 active borrowers. Banque Misr, which began microlending in September of 2003 with microfinance units in 13 of its branches, had 17,000 active borrowers as of June 2006. The decision to merge Banque du Caire with Bank Misr would leave the merged bank with 120 branches with microfinance units, and 117,000 active borrowers. Principal Bank for Development and Agricultural Credit (PBDAC) was established in 1930 as a specialized bank for rural finance. Today PBDAC covers the country with its extensive branch network in the form of 18 governorate banks, 1,016 village banks, and 312 satellite offices. PBDAC provides micro loans from LE 500 to LE 3,000, with terms from one to five years. Loans targeting agriculture are collateralized by land. PBDAC has a decentralized system for loan approval; the director of the village bank has the authority to extend loans up to LE 100,000. The director of the branch may approve loans up to LE 300,000. More than 90 percent of the loan portfolio is loans below LE 100,000. Repayment rates, however, have been below 90 percent. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 47 banks engaged in microfinance, which extend credit using their own resources, or in their capacity as loan-managers either on behalf of donors or, more typically, on behalf of SFD. While state-owned banks are engaged in microfinance,most private banks still do not make funds available to microenterprises, as they tend to perceive microfinance as too risky or as a developmental function that should be reserved to the Government, the Social Fund for Development (SFD), and non- governmental organizations (NGOs) (Box 2.7). The formal financial sector in general lacks familiarity with the specificity of microfinance and the particular needs of clients seeking microfinance.

Box 2.7: NGOs Are Key Players in Microﬁnance in Egypt

A large number of NGOs use grants and donations, and act as financial intermediaries for micro and small enterprises. The main funding sources of NGOs are donors including USAID, Swiss Fund, CIDA, Danida, GTZ, the Ford Foundation, Catholic Relief Services, UNICEF, UNFPA, and the ILO, amounting to more than 71 percent of the total. Credit programs, which started as an activity of NGOs in the late 1980s, have increased considerably and have become an important activity of community-based organizations in the 1990s in both rural and urban-poor communities. In addition to extending credit, programs provide technical training related to loan activity, upgrading existing businesses, starting new businesses, or improving the living environment, with the objective of alleviating poverty. The Egyptian Swiss Development Fund (ESDF) provides funds to income- and employment-generating projects, including microfinance projects. ESDF deals only with NGOs, which adopt their own interest-rate policy as long as they can prove their sustainability and participate by 10 percent of the total value of the project from their own or community resources. Organizations with focused small and/or micro credit programs are few, but include the Alexandria Business Association; the Association for the Development & Enhancement of Women; Street Food Vendors Associations; and the Ford Foundation. Both the NGO Support Center and CARE support microfinance programs through community based organizations in various governorates, in addition to providing technical assistance to community organizations and business associations.

SFD was established in the early 1990s to combat the adverse consequences of economic restructuring and liberalization. It is the largest national program, accounting for some 74 percent of total government credit programs aimed at small and micro firms. Its funds are mainly channeled through NGOs and banks, which earn a spread over the rate paid to SDF. The average loan size is about LE 1,500, the average maturity is one year, and the cost of loans to NGOs varies from 5 to 7 percent. Loans do not require collateral, but some group-lending programs require group guarantees. Micro-loans extended over the last 10 years total about LE 121 million to 92,000 borrowers; there are currently about 70,000 outstanding borrowers. The SFD manages a separate microfinanceand SME unit, the Small Enterprise Development Organization (SEDO). SEDO is the largest division of the SFD and distributed about LE 1.5 billion in loans by 2000. SEDO extends loans to banks at fixed low interest rates, and banks are allowed to charge a spread of about 3 to 4 percent. 48 Access to Finance and Economic Growth in Egypt

The ceiling imposed on the spread tends to undermine the sustainability of this model and slows its growth. Banks get around this problem by imposing miscellaneous additional charges. Still, this program is not sustainable without government and donor inflows. In June 2004, with the issuance of the Small and Medium Enterprise Law 141, the SFD was assigned the responsibility of overall coordinator of micro and SME finance, and in setting the development strategy of the small and microenterprise sector in Egypt. This law also gave the SFD the mandate to provide low-cost financing using its own funds, government appropriations, and donor grants. Consequently, the SFD provides loan capital and operational subsidies to a variety of finance institutions, primarily banks that retail credit to end borrowers. MicroStart Project was initiated by UNDP in partnership with the SFD under its job-creation program. Micro-Start aims to improve access to appropriate services offered by local organizations to enhance the poor’s informal economic activities, increase their revenues, and create employment. MicroStart provides grants to three microfinance NGOs in the El Fayoum Governorate, and the NGOs in turn charge their borrowers between 8 and 16 percent. The objective is to build these NGOs up into viable financial institutions. CGC is a joint-stock company established by nine major banks to provide credit guarantees to SMEs without the collateral to obtain loans from banks. By guaranteeing a portion of loans made by banks, CGC effectively reduces required collateral, one of the main impediments to SMEs’ access to finance. The CGC has an agreement with more than 55 banks to provide guarantees, and loans guaranteed range from LE 20,000 to LE 14 million. Total loans guaranteed amount to about LE 1 billion, for 19,000 clients. The CGC guarantees up to 100 percent of the loan amount for a fee of 0.5 percent of the amount up to LE 100,000, and 1 percent for larger loans. CGC also has several microfinance programs. Banks must approve potential borrowers before CGC issues a guarantee. In case of default, CGC covers any guaranteed funds after banks attempt all possible legal actions against the defaulting customer. To date, only about 8 percent of the total guarantees on defaulted loans have been partially or fully paid by CGC. This low percentage is in part due to lengthy court proceedings, because banks are required to take all possible legal actions before guaranteed funds can be released. Of course, this scheme also creates a disincentive for banks to collect on loans. The Cooperative Insurance Society for Small Enterprises (CIS) is another organization that offers guarantee facilities. It was established by the SFD in 1999, and serves as a credit insurance facility to small and microenterprises.

2. Challenges Facing the Microﬁnance Industry

The large unmet demand for microﬁnance is due to both demand and supply problems. On the demand side, potential clients do not know what services are available and which are appropriate to their needs. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 49

On the supply side, microfinance units within banks and NGOs operate within defined loan brackets, catering to specific segments. Microfinance products and services are limited to conventional forms (individual and solidarity group lending), while alternative credit and savings products remain largely unused. Although many NGOs have successfully addressed some of the credit needs of microenterprises and poor households, they lack the institutional capacity to expand beyond their local communities. There is also a lack of skills among credit officers and NGOs in extending loans to microenterprises.29 Furthermore, most micro-lending activities are largely donor- dependent, as they extend credit at subsidized interest rates and are not based on cost-recovery. Although state-owned and private banks offer savings accounts, the National Postal Authority remains the dominant provider of micro-savings due to its extensive outreach, and its low-cost, simple application procedures. State-owned companies remain the main providers of insurance services. While some of their products are affordable for microenterprises and micro-consumers, in general products are neither designed nor marketed to meet the needs of the micro sector. The development of the microfinance industry also lacks a supportive regulatory and legal framework, access to reliable information, adequate geographic coverage, and coordination among various stakeholders. Legal, regulatory, and institutional barriers include the conflicting policies and measures adopted by the line ministries and governorates engaged in microfinance, and the general absence of a common and shared understanding of the sector. The absence of information on creditworthiness and credit history is one of the main impediments facing the industry. The credit registry at CBE has a floor of LE 30,000, on current credits, and any loan below is not recorded (a planned private credit bureau is expected to address this deficiency). There is a sub-database of accounts more than 90 days past due and/or with legal proceedings initiated. The large majority of MFI lending occurs in the non-bank sector, which means most MFI loans are not reported to the CBE Registry. Another legal constraint is that NGOs are not allowed to collect deposits under Law 84 of 2002 and cannot access commercial funds from banks and/or private investors.30 At the same time, they cannot meet the capital requirements to establish themselves as banks, curtailing their ability to develop and introduce innovative approaches. Furthermore, NGOs experience significant delays when seeking obligatory approvals from the Ministry of Insurance and Social Affairs for the use of grant funds and loans from donor agencies and international organizations. Until recently, there has been a lack of coordination among various stakeholders (government, non-government and donor organizations), minimizing benefits to the industry. There have been instances of duplication of efforts by various microfinance institutions in the same governorates. In some governorates, little is done to encourage 50 Access to Finance and Economic Growth in Egypt

microﬁnance-institution interventions, despite unmet demand. In other governorates there has been a too-strong bias towards urban areas. Although Law 141 of 2004 addresses this lack of coordination, it is still not fully enforced.

3. The National Strategy for Microﬁnance

The National Strategy for Microfinance, endorsed in December 2005, attempts to address these legal, regulatory, and institutional barriers hindering NGO microfinance activities. The strategy is based on the premise that the commercialization of the microfinance industry promotes competitiveness and continued innovation, thus redirecting the sector’s trajectory from subsidy-based to market-induced. It aims to build an inclusive financial system that provides all the types of financial services needed by the poor. The banking system in Egypt will play a crucial role in this strategy, particularly through its large branch network. However, microfinance is considered a high-risk activity.31 As a consequence, to date there is segmentation, with loans above LE 500,000 usually provided by the banking sector, and those below often provided through NGOs. Still, experiences in Egypt and elsewhere show that microfinance can be scaled up and made effective through the banking system.

CONCLUDING REMARKS

The financial-sector reform program and changes in the business environment have rejuvenated banks in recent years. Banks are improving credit policies and procedures while provisioning for past problem loans; upgrading their banking services; widening available lending products to the non-corporate sector; and diversifying products as the regulatory framework adjusts to the new environment. Banks are being privatized and the banking system is consolidating rapidly; this is leading to opportunities for greater economies of scale, which can lower the cost of financial intermediation. However, the sector as a whole is still underperforming: the quality of financial intermediation is poor, costs are high, non- performing loans remain large, and access for households and small firms to financial services is limited. These deficiencies are primarily due to limited competition and a reluctance to change the status quo of significant state-ownership, leading to weak incentives and poor governance. Underlying these problems is a still weakly developed and tested institutional infrastructure for lending and financial intermediation. IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 51

Notes

1 Namely, National Bank of Egypt, Banque Misr, Banque du Caire, and Bank of Alexandria. 2 Namely, Egyptian Arab Land Bank, Industrial Development Bank of Egypt, and Principal Bank for Development and Agricultural Credit. 3 Furthermore, not all the increase in credit advances to the private sector can be considered a net credit or an indication of fresh funding to the private sector, as there is an issue of rolling over or evergreening of loans. It is very hard to find information and data that differentiate between fresh funding and rolling over of credit. 4 Although Law 5 of 1998 effectively removed this tax exemption, banks were still granted an exemption equal to 95 percent of income earned from investing in government securities. Under the new Tax Law 91 of 2005, banks are once again enjoying the full tax exemption. Another constraint is the high minimum limit for subscription, resulting in the exclusion of small savers as investors. 5 Although in 1991 the Government eliminated banks’ preferential treatment of loans granted to public enterprises, actual enforcement only happened in 2002 when state- owned commercial banks were no longer subject to government-directed lending policies and were no longer extending credit to public enterprises unable to service debt. Over the past four years, public-sector banks have extended few new loans or overdraft facilities to defaulted SOEs. Today, SOE loans on public-sector bank books are largely a stock of aged loans-current maturities rang from five to 10 years, having been largely committed between 1996 and 2001-with no meaningful transactions in overdraft facilities over the last four years. 6 Before this law, there was a 30 percent limit imposed in 1993 on all claims on individual clients, including equities, not just credit facilities. Previously, banks could have an equity investment in a company equal to 100 percent of the bank’s capital and credit exposure of 25 percent of its capital (i.e., an exposure of 125 percent of its capital in a single client). The effectiveness of credit limits is also undermined by the lack of consolidated accounting standards. Despite the risk associated with credit concentration, the central bank supervisory body focuses mainly on ensuring that loans extended to an individual borrower by each bank separately are within the stipulated limits. Moreover, the central bank supervisory body estimates credit-concentration risk on the basis of loans extended to a specific company, rather than an individual borrower. To be of significance, limits should apply to groups of related companies on a consolidated basis. This is particularly important when dealing with customers who have multi-economic activities. 7 Foreign bank branches and public specialized banks have reported higher lending to the SME and retail segments, but these banks do not have a large market share in the lending sphere. 8 For checking and current accounts LE 1000 in state-owned banks, LE 5,000 in private sector banks; for time deposits LE 5,000 on average for all the banks. 9 Bank of Alexandria is only the smallest of the state-owned commercial banks, only accounting for some 7 percent of the system’s assets. 10 Transactions completed to date include: (i) September 2004 merger of Misr Exterior with Banque Misr; (ii) April 2005 merger of Crédit Agricole with Crédit Lyonnais under the new name of Calyon-Egypt; (iii) June 2005 merger of American Express with Egyptian American Bank; (iv) July 2005 merger of Arab African International Bank and Misr America Bank; (v) October 2005 merger of Mohandes Bank with National Bank of Egypt; and (vi) December 2005 merger of Bank of Commerce & Development with National Bank of Egypt. 52 Access to Finance and Economic Growth in Egypt

11 Data from a World Bank survey on access to and use of financial services (World Bank, Measuring Banking Sector Outreach, Indicators of Access to and Use of Financial Services across Countries, Thorsten Beck, Asli Demirguc-Kunt, and Maria Soledad Martinez Peria (2005).) The cross-country figures are for 2003, and thus may under- represent the current outreach of the Egyptian financial sector if the branch network has expanded in recent years. 12 For the country as a whole, the CBE figures imply 4.3 branches per 100,000 residents. The figure for the rural areas is consistent with that of the cross-country data in Table 2.5; however, the figure for urban areas is higher. A part of the under-count for Egypt in Table 2.5 is likely due to new branch creation, but it also seems likely that the cross-country calculations do not contain information on all banks operating within a country. To the extent that branch density is under-represented similarly in all countries in the World Bank survey, the comparisons across countries in Table 2.5 are valid. In any event, the figures from the CBE also indicate that branch density is not high, even by the standards of developing countries. 13 2,400 postal outlets have indirect electronic access via phone line, and 600 are not connected at all. 14 There are two main limitations regarding the data used. First, available data is not very accurate, as some banks indulge in practices such as “window dressing”. Second, aggregation of bank data can potentially conceal problems by offsetting positive and negative signals from individual banks. Deterioration in individual banks may not be apparent in aggregate data. Still, despite limitations associated with data quality and aggregation, these micro-prudential ratios can give a rough indication of areas of vulnerabilities and weaknesses in the banking system . 15 Minimum capital requirement increased from LE 100 million for domestic banks and US$ 15 million for branches of foreign banks to LE 500 million and US$ 50 million respectively. Banks were supposed to meet these requirements within one year, which was extended to a maximum of three years at the discretion of the central bank. 16 These figures are from the General Department for the Compilation of the Banking Credit Risk, as of the end of the fiscal year (June 30th). 17 The actual level of NPLs is expected to be higher if strict loan classification criteria were applied, and if rolling-over of loans is taken into account. A large portion of the loans is in the form of overdraft facilities that are not categorized as nonperforming, and hence the past-due classification has not accurately captured NPLs. It is also worth noting that a sizable number of NPLs have been restructured, some of which under very concessional terms. These may represent hidden weaknesses in the banks’ portfolios. 18 SOEs’ indebtedness increased from around LE 24.9 billion in 2002 to LE 28.6 billion in 2005. 19 Within that framework, all of Bank of Alexandria SOEs’ NPLs, amounting to LE 6.9 billion, were settled in cash in February 2006. Settlement agreements of 46 percent of private-sector NPLs in state-owned banks have been developed; with total collection amounting to 12 percent of these NPLs. 20 All banks provide trade-finance facilities, letters of guarantees, notes discounting, overdrafts, syndications, club deals, project finance and local- and foreign-currency loans. Forwards on foreign exchange are limited to specific trade transactions by the regulations of the CBE. 21 Two out of the four public commercial banks have indicated a need for credit officers, which could be due to their privatization plans. 22 Return-on-assets of the four state-owned banks ranged between 0.5 percent and 0.2 percent during the period 2000 to 2005, while that for private and joint-venture banks ranged between 1.1 percent and 1.5 percent. Similarly, state-owned banks’ return- on-equity ranged between 9.8 percent and 4.0 percent, against 20.6 percent and 17.8 percent for state-owned banks (Annex, Table A.8 and A.9). IntroductionSOURCES FOR FINANCIAL SERVICES: THE BANKING SECTOR 53

23 There is also a 1 percent registration charge for mortgages. 24 It can also give rise to claims of an unfair environment with respect to the regulation of private banks. 25 In general terms, the principal responsibilities of a board of a state bank are i) to help formulate, approve, and monitor the bank’s strategy, in the context of objectives defined by the owner; ii) to approve key policies; iii) to ensure a functioning system of internal financial and operational controls; iv) to establish performance indicators and benchmarks; v) to monitor disclosure and public communications processes to ensure that financial statements and other disclosures fairly present the bank’s performance, financial condition, business, and risks; vi) to evaluate executive-management performance and hold management accountable; and vii) to develop a succession plan for executive managers. 26 We acknowledge that these associations are not necessarily causal, and thus can be taken as an upper bound on the effects of expanding branch networks to unserved areas. 27 Microfinance services aim at providing support to low-income groups operating small-scale income-generation projects and businesses by overcoming one of the main obstacles faced by poor people around the world: insufficient access to credit and other financial services. The formal financial system often perceives the poor as “un-bankable”, due to their lack of collateral, small loan sizes, and low potential for repayment. Without access to formal financial services, the poor must often resort to borrowing from moneylenders at exorbitant interest rates; or participate in local rotating savings and credit circles. These informal financial services are often very costly, risky, and inconvenient. 28 UNDP (2006). 29 Recently, CGAP, in cooperation with the regional network for microfinance institutions (SANABEL), has started offering training on some microfinance management and operational topics, including operational risk management, financial analyses, accounting, and product development. 30 NGOs are regulated by the Ministry of Insurance and Social Affairs, and governed under Law 84 of 2002. 31 Kheir El-Din, El-Leithy and Tabbala (1999). 54 Access to Finance and Economic Growth in Egypt SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 55

CHAPTER 3

SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES

Non-bank finance—capital markets, insurance, contractual savings, mortgage finance, leasing, and factoring—can be an important source of finance for the real sector. In well-developed financial markets, non-bank financial institutions serve as a source of finance for start- up or recently formed companies, which do not have the credit history or the collateral needed for bank and market funds. However, to date, these forms of external financing are relatively underdeveloped in Egypt. And while non-bank financial institutions account for around 40 percent of the financial system in Egypt, most of these funds do not reach the real sector. According to ICS 2005, only 3 percent of firms have access to funding from non-bank financial institutions. The percentage is even lower for small firms, where only 1.8 percent obtain funds from non-bank financial institutions, compared to 6.2 percent of large firms.

A. CAPITAL MARKETS

Empirical evidence that capital markets contribute to economic growth is mounting. Equity markets provide funds for financial leverage, and help monitor the management and investments of firms, thereby ensuring an efficient allocation of resources in an economy. Active venture markets enhance the productivity of an economy through facilitating technical innovations and encouraging entrepreneurship. Active domestic-bond markets provide the corporate sector with efficient tools for long-term finance in domestic currency and can ease the credit crunch during a period of bank restructuring. Corporate bonds provide large companies with good credit ratings through long-term financing, forcing banks to pay more attention to the SME sector and freeing up bank funds for trade and other forms of finance. Finally, well-developed capital markets enable firms to use structured finance and hybrid products, lowering their funding costs and diversifying the risks of their investments. Although there have been noteworthy strides, the development of capital markets in Egypt remains below potential, especially in terms of primary markets. While the secondary capital markets 56 Access to Finance and Economic Growth in Egypt

are active, new capital market issuance-both bond and equity-have been very limited. Little external financing has been made available from either equity or bond markets, and mostly goes to the largest firms. According to ICS, only 2.7 percent of firms have access to the capital market. Because of their size, low creditworthiness, and limited transparency, SMEs have more difficulties in accessing capital markets, unless there is a specific market for SMEs.1 ICS data show that 5.2 percent of large firms have access, compared to only 1.6 percent of small firms. The bond market in Egypt is weakly developed, with few outstanding bonds, very limited new issuance, and low levels of trading.

1. Firm Financing from the Capital Market

The equity market as a source of investment ﬁnancing is limited in Egypt. There have been few corporate-bond and public-equity offerings in recent years. The total value of new issuances in Egypt

Figure 3.1: Equity Finance and Corporate Bonds as Sources of Investment Funding in Selected Emerging Economies

30 30 Taiwan, China 25 South Korea 25 20 20 Hungary Chile 15 15 Malaysia Colombia 10 Egypt India GFCF (%) South Korea 10 Colombia New equity to GFCF (%) 5 Chile Poland 5 Peru Peru Hungary India Egypt Malaysia 0 to Domestic Corp bond offering Poland Taiwan, China 0 2000 4000 6000 8000 10000 12000 14000 0 0 2000 4000 6000 8000 10000 12000 14000 Per capita GDP Per capita GDP

30 South Korea 25

20 Hungary Chile

15 Colombia

GFCF (%) 10

5 Peru India Egypt Malaysia Domestic Corp bond offering to Domestic Corp bond offering Poland Taiwan, China 0 0 2000 4000 6000 8000 10000 12000 14000 Per capita GDP

Source: Annual reports of the World Federation of Exchanges, 2000-2004. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 57 averaged 1.2 percent of GDP between 2001 and 2004, compared to 6.0 and 13.6 percent for Chile and Korea respectively.2 As a ratio to total gross fixed capital formation, total capital raised through markets in Egypt was only 7.5 percent, compared to 27.5 percent and 45.9 percent in Chile and Korea respectively. The primary market is much smaller than those of high-performing emerging markets such as Chile, Korea, Malaysia, and Taiwan, and even below what would be expected based on Egypt’s income level (Figure 3.1). While there have been more equity issues than corporate bonds, many were public offerings or sales of government shares in large state-owned companies, which do not add to capital formation. Funds raised through corporate bonds were even less than those raised through equity financing. Thecorporate bond market is nascent and largely dominated by commercial banks. Of the 21 corporate bond issues listed on the Cairo and Alexandria Stock Exchange with a total outstanding of LE 6.3 billion, only seven issuers are private- sector companies, while the rest are mainly issued by commercial banks. There were no bond issuances in 2003, three bond issuances in 2004 and four in 2005. Access to international capital markets is limited to financial firms and large enterprises. Out of 11 Egyptian GDRs, two are state-owned enterprises, and the remaining are private companies and banks. No Eurobond has been issued by an Egyptian company to date. The low activity of the primary market contrasts with a relatively active secondary equity market. Due to fast-rising stock prices3 and despite continued delisting of illiquid stocks, market capitalization to GDP was 87 percent at the end of 2005. Since then, there has been a correction in the market, and the ratio is now about 70 percent, though this is still above developing countries’ average.

2. Weaknesses in the Capital Market

Egyptian firms’ access to long-term capital has been hampered in part by an inadequate legal framework, especially regarding new securities issuance; lack of active domestic financial investors; and a weak regulatory and supervisory framework. Finally, the importance of direct firm finance in the capital markets is not recognized as a priority in Egypt’s overall financial-sector reforms. a.Weakness in the securities issuance and the listing system Securities issuance regulation. The Capital Market Law 92 of 1995 and its executive regulations lack an appropriate public offering system, which normally covers items such as the definition of securities, scope of offering, and specific filing procedures for different securities at CMA. Although the law sets notification procedures, until recently the actual filing procedures operated under an “approval” culture, where commercial merits are examined and determined by the regulator. The consequent regulatory uncertainty for potential security issuers has led to an increase in issuance costs and makes capturing the most 58 Access to Finance and Economic Growth in Egypt

suitable issuance timing more difficult. Transaction costs4 for issuing corporate bonds in Egypt are estimated to be high, at 3 percent of the total issued amount, comparable to Argentina, Brazil, and Chile. (Mature markets such as the US and Japan, however, show costs of only 1 to 2.5 percent.) Though listing and legal fees in CASE are only 0.02 percent, other administrative and intermediary charges are not insignificant. Furthermore, the current system imposes cumbersome procedures on new securities issuances. The Capital Market Law 92 of 1995 requires, for example, approval of the general assembly of the company for issuing corporate bonds, as well as the maintenance of an association of bondholders, which deters new issues. Securities listing system. The current CASE listing system, which comprises four schedules of the main board and two sections of the over-the-counter (OTC) market, is too complicated,5 fragmenting the market and increasing costs. Simplification becomes more important as the need to segregate quality shares from artificially listed shares, a result of past tax incentives, decreases. The automatic listing system of SOEs impedes further improvement in investors’ confidence. SOEs are exempted from requirements for minimum number of shareholders and prior pubic subscriptions (financial requirements are not derogated). Despite the possible benefits of facilitating privatization, the easy listing of SOEs could hinder the development of a primary market. SOEs that are not sufficiently liquid can create unrealistic market prices, remote from fundamental valuations. And shares that are not immediately for sale can inflate the total market capitalization of CASE. Lastly, limits to CASE’s authority in listing and delisting vis-à-vis the SOEs undermine its credibility and functioning. The OTC market is functioning as a residual market accommodating all de-listed and unlisted shares,6 and has no specific mandate to support high-growth SMEs and start-up companies. Though CASE is operating the OTC market, it is not responsible for the dissemination of unlisted companies’ disclosure information. CASE’s delisting policy in the last few years has enhanced the credibility of the market. CASE has been pursuing strengthened listing and delisting policies to remove illiquid shares, resulting in a sharp decrease in the number of listed companies (from 1,151 in 2002 to 701 in April 2006). Notwithstanding, the ratio of market capitalization to GDP has increased from 32 to 87 percent in the same period. But there remain a large number of illiquid stocks on CASE. As the FSAP of 2002 and the Report of Observance of Standards and Codes (ROSC) of 2002 pointed out, in order to avoid possible market manipulations, non-liquid stocks should be traded using a different method (such as auction) or be de-listed urgently. A reliable benchmark for bond issuers. Despite the successful shift to a market-based issuance system of government bonds using the primary dealer system, a fully reliable yield curve has not been formed. This is in part because marketable government bonds account for only 23 percent of total government debt, while the rest is in the form of CBE underwriting diverse non-tradable treasury bonds (46 percent) SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 59 and borrowing from NIB.7 On the buyer side, most institutional investors adopt a “buy and hold” investment strategy due to a lack of investment knowledge and institutional rigidities. Furthermore, as the mark-to-market principle is not applied to pension and insurance companies, the incentives to actively trade government bonds are weak among these institutional investors. b. Imbalance in the investor base The Egyptian capital market lacks active domestic financial institutional investors. Domestic institutional investors are reported to own 43 percent of total listed shares, while retail investors own 12 percent and foreign investors 45 percent. These figures should be interpreted carefully, however, as they include non-financial institutional investors characterized by holdings of family companies. Mutual funds are the most active in domestic financial institutional investors’ trading, accounting for 3.3 percent of total market capitalization. Contractual savings institutions such as pensions and insurance companies have to date allocated their assets largely by Government direction, and do not play an active role in investing in long-term market products. Although domestic institutional investors are growing, they are hampered by some rules. Currently, asset-management companies adopt a backward pricing system: the price used is that computed before receiving the requests that create arbitrage possibilities. For example, when securities prices generally are rising, a speculator could buy a large number of mutual-fund shares at a previously determined price, and then redeem them at a profit with little risk of loss after the net asset value is calculated. Therefore, backward pricing can lead to significant dilution in the investments of existing fund investors.8 Overall the disclosure system for mutual funds needs to be strengthened to better help investors evaluate the risk of investments.9 The mutual-funds investment requirements for sponsor banks and insurance companies are also burdensome. Sponsors are required to invest 5 percent “seed money” in new funds at establishment, but also to maintain their share of investment as the mutual funds grow. As the required seed money increases, the sponsor banks are charged more risk capital, which prohibits them from expanding their mutual fund business, particularly when the market is growing rapidly. The Capital Market Law 92 of 1995 does not stipulate a separate definition of related agents of mutual funds. Apart from portfolio management, sponsor banks execute all other back-office functions of custodian, transfer agent, and administrator, resulting in incomplete checks-and-balances in the management of funds. A recent household survey indicates that only 0.2 percent of households possess securities, including equities, bonds, and investments funds. Altogether, investment assets represent only 2.6 percent of total financial assets held by Egyptian households. Furthermore, retail investors who respond to privatization initial public offerings (IPOs) show highly short-term investment behavior, 60 Access to Finance and Economic Growth in Egypt

increasing market volatility signiﬁcantly. While retail investors own only 12 percent of total shares, they account for 60 percent of turnover. A preferential discount scheme and the poor after-listing trading performance of previous privatization IPOs have aggravated the short-term behavior of individual investors, most of whom lack investment education.10 There are 124 active brokerage houses, but the four big houses account for 40 percent of total securities transactions. CMA consequently faces two main supervisory challenges in the brokerage industry: to prevent a loss of overall market conﬁdence that could be caused by a failure of big companies; and to accelerate restructurings of small and dormant brokers to enhance market transparency. Recently, CMA has increased the minimum capital requirement for a securities broker from LE 250,000 to LE 5 million.

c. Lack of an issuer-friendly policy and regulatory framework Regulatory capacity—CMA. Recent assessments reveal that the quality of the public and private enforcement system in Egypt is lower than the regional average level and below that in many other regions (Figure 3.2). Furthermore, CMA staff do not have the skills to properly regulate securities issuance and to supervise the securities industry. CMA has been implementing an ambitious business plan to address the above issues, including an overall reorganization, increased IT investment, and more diverse training programs. But these reforms are still to bear fruit. While secondary market activities are relatively well recorded in the current statistical system, primary market activities are being poorly captured, in part as CMA also functions as the registrar for

Figure 3.2: Assessment of Enforcement in Egypt’s Capital Markets

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0 Egypt, Total Middle East Europe Latin Arab East and Asia and and America Rep. North Paciﬁc Central Africa Asia

Public Enforcement Private Enforcement

Source: World Bank Database. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 61 companies, confounding data. First, data on initial and secondary offering include not only IPOs and capital increases at CASE, but also capture issued shares of new and existing firms at the time of company registration at CMA, even when the firms are not listed at CASE. Second, detailed statistics on types of issuers, securities, and use of funds are not available. CMA plans to revamp the statistical system as well as its information management system, which will be crucial in promoting financial innovations. d. Limited Overall Capital market development strategy and new financial instruments market Capital market strategy. A capital market development plan has been generated at the CMA and Ministry of Investment levels, but without a close linkage with ongoing banking and insurance reforms. Government debt market development and privatization policies could have produced better outcomes if they had been coordinated more closely with CMA. The current Financial Sector Reform (2004- 2008) addresses mainly secondary market issues, such as improving the primary dealer system and introducing margin and short-selling system; more emphasis is needed on the primary markets. New financial instruments for firm finance. There is substantial room for introducing and promoting new financial products in Egypt. First, firms seldom use equity-linked corporate bonds such as convertible bonds, exchangeable bonds, and bonds with warrants. Considering the relatively high liquidity of CASE 30 shares and market trends, bonds leveraging the equity element would contribute to lowering corporations’ funding costs. Second, while two Asset Backed Securities (ABS) have been issued, they are mortgage or future cash flow related securitization schemes, not a more advanced form of securitization. Third, while there are currently 14 venture- capital companies and 80 private equity firms, most them are operating as buy-out funds to transform financially stressed state- owned enterprises, rather than investment vehicles to incubate start-up venture businesses. Lastly, the current OTC market does not provide an efficient exit-market function for venture capital firms aiming at innovative firms with a high risk profile.

B. INSURANCE AND CONTRACTUAL SAVINGS

The beneficial role of insurance and contractual savings for economic development is becoming more recognized and some evidence that insurance and contractual savings contribute to economic growth is starting to become available. Recent research11 has demonstrated, for example, that the development of contractual savings institutions is associated with efficiency gains at the firm level, including increased availability of long-term finance, reduced costs of capital, and greater private-sector resilience to external shocks. These benefits come about in more market-based economies, through a decrease in firms’ 62 Access to Finance and Economic Growth in Egypt

leverage (at least in the formal sector). In systems that are more bank-based, insurance and contractual-savings development leads to an increase in the maturity of debt. The development of insurance and contractual-savings institutions also lets governments transfer common-good obligations-such as insurance against income loss, unforeseen natural events, adverse health, and old-age security-to markets, thus enabling governments to target their own expenditures more efﬁciently at those functions that cannot be served by markets. While Egypt’s insurance and contractual savings sector is small compared to the size of its economy, it has considerable potential for further development and efﬁciency gains. Although penetration is higher than in other countries of the region, insurance and pension products have yet to gain broad public appeal. Only a small percentage of the working population participates in retirement plans. Furthermore, the sector does not yet effectively channel resources to the private sector.

1. Structure of the Sector

The insurance sector is largely publicly owned, with the four largest insurers (including one reinsurance company) majority state-owned and accounting for about 70 percent of premiums. The new foreign entrants in the insurance sector (particularly life insurers) is growing faster than both the domestic insurers and voluntary pension funds (Table 3.1). However, while foreign life insurers have been able to make inroads, the largest domestic insurers seem determined to maintain share of market (Figure 3.3).12 The non-life sector is hardly developing at all, and non-life reserves are not a significant source of incremental long-term funds.13 The success of the new foreign entrants to the insurance sector reflects product innovation, mainly in investment-linked life products (often denominated in hard currencies), and efficient distribution (bancassurance). It is clear that the major institutional investors14 are keen on expanding the universe of investment opportunities.

Table 3.1: Compound Annual Growth Rate (CAGR) by Sub-Sector in Egypt

Notional CAGR over 4 2004/2005 Deﬂated CAGR years EL 000s (percent) (percent) Private pension funds 14449.3 15.7 7.9 State-owned insurers 13955.2 7.3 0.1 Foreign and joint-venture insurers 1276.9 41.1 31.6 Local private insurers 1580.6 7.8 0.6 Total insurance 16812.7 8.8 1.5 Note: Pensions to 2004 Source: EISA (2006). SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 63

Figure 3.3: State-Owned Insurers’ Share of Insurance Assets in Egypt

88 87 86 85 84 83 82 81 80 2001 2002 2003 2004 2005

Source: EISA.

In the context of ongoing sector liberalization and more open entry for foreign companies, the Government is undertaking a major restructuring program—addressing skills misalignment, underwriting standards, risk management, and asset investment policies—to allow state-owned insurance companies to withstand competition, and to ensure ongoing technology transfer and preparation for privatization. Although there has been progress, institutional saving-life insurance and other forms of long-term savings-remains limited compared to its potential for ﬁnancing the real sector. The structure of the more developed non-life insurance market has witnessed minimal changes over the past decade, and competition tends to be based on price rather than product innovation. Despite current regulations allowing insurance companies a limited degree of investment ﬂexibility, most reserves continue to be invested in government bonds or bank deposits (Table 3.2).

Table 3.2: Statutory Investment Limits—Life Insurers in Egypt

Asset Class Rule Comment Government paper Minimum 25% Bonds Maximum 20% Sub-limits apply Stocks and investment funds Maximum 25% Sub-limits apply, no geographical limit mentioned Real estate Maximum 20% Sub-limits apply Policy loans No limit Real estate lending Maximum 20% Cash and term deposits, etc. Maximum 50% Can be multi-currency Source: EISA (2006).

Table 3.3: Assets and Investments in Egypt (LE million) Insurers Private Pensions Funds Year 2001 2002 2003 2004 2001 2002 2003 2004 Total assets 14,577 15,386 17,040 18,614 10,938 12,193 14,199 16,556 Investments* 12,162 13,005 14,288 15,779 10,202 11,063 12,751 14,780 *Mainly held at book value. Source: EISA (2006). 64 Access to Finance and Economic Growth in Egypt

This in part underlines the need to develop a modern corporate-finance culture with up-to-date institutional investment skills. At the same time, capital markets lack the products suited to the insurance and contractual savings markets liability structures. Insurance and private supervised pensions are roughly equal in size today, but the real CAGR of pensions is higher (1.5 percent for insurance versus 7.9 percent for pensions over the period) (Table 3.1). Although there is some doubt that private pension plans are adequately funded on aggregate (most are defined-benefits arrangements), policy reform is underway to address this issue. Combined with the proposed reform of the social security system, this would result in funded pensions becoming easily the dominant force amongst the contractual savings institutions and a major source of funds for the real sector.

2. Recent Developments in the Contractual Savings Industry

Net funds under management by EISA-supervised institutions at the end of 2004 amounted to approximately LE 30 billion, or 6.5 percent of GDP, and 12.4 percent of local-currency term deposits. Funded pensions include private supplementary pension funds, pension funds contracted out of the generous social insurance system,15 and “syndicate schemes”, which cover self-employed professionals.16 The collective investment sector consists of approximately 20 mutual funds dominated by five management companies and amounting to LE 3 billion. It is largely aimed at foreign investors. Most funds are open ended, although there are at least three closed-ended funds. A small hedge fund, amounting to US$ 25 million, was promoted early in 2006. A significant proportion of long-term savings is also funneled into the NIB via Post Office and National Bank of Egypt (NBE) savings certificates. Since growth of contractual savings is typically linked to GDP per capita, with some threshold effects for low-income countries, growth will take time. Still, contractual savings can grow much further, as Egypt appears to be below its potential position (Figure 3.4). Egypt should be able to at least double real long-term funds under management within a decade. The contractual-savings sector can then become an important source of investment financing, as is usually the case in more-developed economies. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 65

Figure 3.4: Funds under Management: Egypt and OECD Pension plus Insurance Assets-to-GDP (2004)

180

160

140

120

100 Contractual Savings / GDP % Contractual Savings / GDP 80

0 0 Egypt 10 20 30 40 60 GDP/ Capita $US Source: OECD and WB analysis.

3. Challenges Confronting the Insurance and Contractual Savings Industry

While institutional investors can be major sources of long-term ﬁnancing for the productive, private sector, this requires appropriate investment policies and approaches. In Egypt, this has not been the case for either the insurance or the pension sector. As noted, the insurance sector is currently largely owned by the state, and its investment portfolios have been used for social purposes (to fund state-owned banks and state-owned enterprises and to meet the government borrowing requirements). Investment in the real sector has been relatively insigniﬁcant (Table 3.4).

Table 3.4: Insurance Investment Allocation in Egypt (percentage) 2001 2002 2003 2004 Deposits 38.4 36.8 37.7 39.4 Government Paper 22.4 27.2 26.4 25.4 Securities 33.2 30.4 30.4 30.2 Loans 1.2 1.3 1.3 1.3 Real Property* 4.8 4.4 4.2 3.8 * This is believed to be signiﬁcantly undervalued. Source: EISA. 66 Access to Finance and Economic Growth in Egypt

Table 3.5: Private Pension Investment Allocation in Egypt (percentage)

2001 2002 2003 2004 Deposits 29.3 29.3 29.0 27.7 Government paper 61.4 61.4 63.9 67.4 Securities 4.1 4.1 3.5 2.5 Loans 1.9 1.9 1.2 1.0 Real property 1.7 1.7 1.5 0.8 Other 1.7 1.7 1.0 0.5 Source: EISA.

Investment allocation for those private pension funds that are supervised by EISA, and which are not subject to government direction, shows an even lower intermediation to the real and private sectors than for the insurance sector (Table 3.5). The funds, with some exceptions, are not being optimally run for the benefit of their members or the country. Current contribution and investment revenue of supervised funds is very limited. Expense rates are excessively high for a number of schemes and there is a clear case for outsourcing, particularly for smaller funds. Although preliminary evidence points to the larger supervised schemes having reasonable actuarial overview, lack of trained personnel means that reviews may be more cursory for smaller funds, although EISA does maintain an overview role. It is likely that some very large syndicate funds, which are effectively unsupervised, are severely under-funded. The private pension funds are mostly organized on what is known as a deposit administration basis, with semi-guaranteed defined retirement benefits (DB) paid as lump sums and providing a range of ancillary benefits. They are administered by their sponsors or relevant vocational associations and are subject to out-of-date law and supporting regulation. The DB plans are required to undergo periodic actuarial review, but there is a severe shortage of fully qualified actuaries in Egypt. The bulk of the reviews fall to two actuaries, who are locally certified. The private pension funds tend to be managed in-house (Table 3.6), although there is now some experimental use of external investment managers by the larger funds. In-house management

Table 3.6: Investment Approach of the Contractual Savings Industry AUM 2004/ National CAGR Approach Commentary 2005 over 4 years In house—some Private pension funds 14449.3 15.7 Very risk-averse—some directed outsourcing In house—a little Risk-averse and strong cash State-owned insurers 13955.1 7.3 outsourcing culture. Substantial direction Signiﬁcant Foreign and joint venture 1275.1 39.3 Investment linked approach outsourcing

Local private 1582.5 8.2 In house Conservative

Source: Insurance Sector Survey. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 67

Box 3.1: Major Insurance and Pensions Investors in Egypt

Misr Insurance: Misr Insurance had LE 6.98 billion under management as at June 30, 2005, of which 36 percent was on fixed deposit with banks, and 27.3 percent in treasury bills and government bonds. Property and non-listed securities holdings (largely directed investments) amounted to 23.6 percent of assets, with another 1.9 percent in loans (mainly personal loans and to MIDOR). Only 11.1 percent was held in the form of liquid non-governmental securities, and largely consisted of listed equities and corporate bonds (with a good spread over those available). Unrealized capital gains on the asset book were estimated at LE 1.5 billion. The large bank-deposit base reflects the fact that the investment and finance functions have been separated in Misr Insurance, with a significant proportion of funds not being made available to the investment team for allocation. Approximately LE 50 million has been invested through an allowed vehicle with a fund manager, but the bulk of funds are managed in-house. Misr has 30 investment-department staff, including an investment director and two general managers (one for unlisted companies and the other for accounting and listed securities). It has no formal written statement of investment policy—this tends to be implicit in the annual budgeting process and is largely driven by the relevant limits under the insurance law. Aside from constraining overall allocations, investment limits are forcing rebalancing in some situations where high-return securities could be usefully held for a longer period. The investment process itself is rather bureaucratic, with very limited discretion in the hands of the investment team. Most decisions still go to the board and chairman. Misr management believes that it will be impossible to attract good graduates and trainees while it is subject to civil-service pay scales. Even though more-senior managers are able to supplement their incomes through meetings (which reduce productivity), bonuses, and other mechanisms (not all in the long-term interests of the sector), this does not compensate for the fact that private-sector pay scales are 10 times or more than civil-service levels.

Arab Contractors: At the end of 2004 Arab Contractors had LE 1.41 billion under management. The Group has 70,000 employees and the plan is managed by approximately 100 people (the pension team also acts as an administrative subcontractor for the social-insurance arrangements). The Board of Arab Contractors is also the board of the pension fund, and sets policy within the constraints of the relevant ministerial decree. In addition, they use one fund manager, with which they have LE 25 million placed, as a consultant. Asset allocation is very conservative, with 56 percent placed in NIB A and B series bonds (which are no longer available). Approximately 10 percent was in stocks and bonds and a little less in CDs. Real property accounted for 5 percent of assets. Of concern is the fact that the pension fund was being asked to fund car leasing (2 percent of assets) and accept work in progress and receivables in lieu of contributions (2 percent and 14.1 percent respectively).

encourages an overly conservative approach. The insurance sector suffers from a lack of investment skills, including lack of asset and liability management (ALM) modeling capacity and limited ability to assess credit and market risks. This is exacerbated by a legal and social environment that discourages risk taking and, in the state- owned insurers, a salary structure that makes it impossible to attract top graduates. The regulatory environment also places relatively tight limits on investment allocations (Table 3.2). This is prudent in the absence of a risk-based supervisory regime and capacity, but is limiting access to ﬁnance for the real sector. 68 Access to Finance and Economic Growth in Egypt

Aside from the insurers and private pension funds, NIB is the major potential long-term investor in Egypt. However, NIB has generally not invested in the real or private sectors; its main role has been to intermediate funds from a public pension system that is running a deﬁcit. Its investments have been for social purposes, to fund state- owned banks and the government borrowing requirement, with negligible investment in the real sector. Altogether, as a consequence of limited development and poor asset allocation, the insurance, pension, and other long-term institutional investors do not in aggregate provide much ﬁnancing to the productive sector.

C. MORTGAGE FINANCE

For years, the undeveloped housing-finance system has constrained access to affordable housing and home ownership for most Egyptian households. The banking sector has offered very little formal housing finance to households to date. Only a few commercial banks—either state-owned or private—have loaned limited amounts to homebuyers, mostly as part of their retail activities or lending to developers, by using collateral other than mortgage pledges. Although most banks are liquid, they are reluctant to extend mortgage loans, mainly because of maturity mismatches between their short-term deposits and long-term mortgage loans, and lack of registered titles. There are only two non-bank real estate lending companies (RELCs) at present; these have done a small amount of lending, also due to lack of long-term funds, and to difficulties and delays in registering property titles, especially in the new urban communities. Other RELCs are in the process of applying for a license. Some developers have been providing term financing under a system of deferred-installment sale contracts, but these have not offered secure or favorable conditions for borrowers, and loan maturities are too short.

1. Recent Development in Mortgage Finance

Until a few years ago, only some individuals buying houses in Egypt were able to obtain finance, and this would not be in the form of mortgage loans. The most common finance arrangement was the deferred-installment system, by which the developer sells a house and is paid by a downpayment of around 10 to 25 percent of purchase price, followed by installments over a period ranging from four to eight years. The title is formally transferred when the last installment is paid. Under this system, the purchaser pays a significantly higher rate of interest and higher repayments than if they could have secured a loan on the property. The system also ties up the funds of developers, who would rather invest into new projects, and can be constrained by an adverse cycle of real estate markets. In general, the system prevents many from entering the housing market, and only represents a second-best to genuine residential mortgage markets. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 69

Box 3.2: The Government of Egypt’s Housing Finance Program for the Poor

To help improve access to home ownership by lower-income households, the Government has in the past provided a range of subsidies. Social housing programs have focused on delivering finished housing units, mainly in new towns and satellite cities and at the fringe of existing cities. Many of these public-housing schemes continue to involve heavy government subsidies. Overall, they have imposed a heavy burden on public finances, making such efforts unsustainable, while satisfying only a small part of the demand. The Government is currently formulating proposals for a more efficient and targeted social housing finance program to serve some disadvantaged groups. The program may pilot an up-front downpayment, cash-subsidy scheme (15 percent of the value of the property of a maximum of LE 10,000 provided by the GSF) to assist in the purchase of a house within a limited price range by applicants meeting certain income and other social criteria. The proposed program would be expected to replace existing interest-rate subsidies.

Over the past few years, the Government has made significant progress in developing an enabling environment for a modern residential mortgage market. The new system has increased the affordability of housing for borrowing households, mostly through longer loan maturities.17 This would allow for the shift of most of the burden of housing finance from the government budget onto the financial markets and the private sector (Box 3.2). In 2001, a new Real Estate Finance Law (148) was issued, setting out the legal foundations for market-based housing finance, including improved collateral-enforcement and foreclosure processes. The legal and institutional framework for mortgage securities was strengthened through amendments to the Capital Markets Law 92 of 1995; this law has also provided the legal foundation for mortgage securitization by any private-sector financial institution that chooses to pursue securitization on its own. The Mortgage Finance Authority (MFA) was established as a new regulatory institution for real-estate activities. A Guarantee and Subsidy Fund (GSF) was formed partly to channel subsidies to some eligible lower-income groups of the society and a successful implementation on a large scale (500,000 families within the next six years) will represent a crucial challenge, notably given the relative inefficiency of past interest-rate subsidy programs. By law, the GSF must also provide temporary social safety for borrowers who experience adverse life events, such as a loss of employment, that lead to payment defaults. It would finance up to three monthly mortgage payments on behalf of borrowers in times of demonstrated social hardship; the costs of this program would be covered by fees charged on mortgage loans. But this is perceived as insufficient to ensure any positive impact.18 The dual activities of the GSF—subsidies and guarantees—should be clearly separated. One recent development has been the incorporation of the Egyptian Mortgage Refinance Company (EMRC) in June 2006, which will enable qualified mortgage lenders to access term refinancing 70 Access to Finance and Economic Growth in Egypt

for their mortgage loans and better manage financial risks related to long-term mortgage lending (Box 3.3). The participating lenders will be able to increase their lending for housing and improve their credit affordability through lengthening the maturity of mortgage loans. The EMRC will mostly rely for funding on issuing bonds and other securities in the capital market.19 The primary lenders will also be able to use the EMRC to improve the efficiency of their portfolio and risk-management activities, which should help lower financial spreads in the market to the benefit of borrowers. EMRC is expected to enhance access to housing finance in Egypt. It would be an important tool to develop the financial markets more generally. The EMRC will be a first-resort, market-based liquidity provider versus any last-resort role played by the CBE. It will help set up prudential lending standards while enhancing competition in the mortgage market by creating a funding source also accessible to non-depository institutions. Many public and private lenders have joined the capitalization of the EMRC, which indicates their interest in expanding their mortgage lending. The Government is making an effort to address property- registration issues to facilitate the primary markets. First, it has enacted major reductions in the fee structure that are expected to generate a significant increase in consumer demand for registration (from 3.5 percent to a maximum flat fee of LE 2,000). Second, the Government has undertaken to implement several urgent measures to alleviate current bottlenecks in the new urban communities, which are expected to be the main source of demand for mortgage loans, at least

Box 3.3: The Egyptian Mortgage Reﬁnance Company (EMRC)

EMRC is a joint stock, wholesale (second tier), specialized liquidity facility operating on commercial principles with a profit making goal. It is majority privately owned by the users of its financial services, mainly PMLs—active banks and real estate lending companies. CBE is a strategic investor with a 20 percent ownership share; the GSF will have a small, 2 percent ownership share. The EMRC will neither take deposits nor lend directly to households. Its business is the refinancing or purchase with recourse of longer-term residential mortgage loans originated by primary lenders for which it will raise term funding by issuing bonds and notes in the capital markets.* This narrow mandate will strengthen the credit quality of the bonds and thereby help to keep the EMRC’s cost of funds relatively close to rates on government bonds. PML, by borrowing from the ECMR, or at least by having the ECMR available when needed to serve as first resort source of finance, will be better enabled to offer longer-term financing for residential housing development on market terms and conditions that are favorable for many potential homebuyers. Lenders will view the EMRC as a source of liquidity they can tap at short notice.

* There are a number of international examples of liquidity facilities, including the Federal Home Loan Banks in the US, Cagamas Berhad in Malaysia, Caisse de Reﬁnancement de l’Habitat in France, the Jordan Mortgage Reﬁnance Company, and the Swiss Pfandbriefe Institute. These institutions have similar missions but somewhat different structure, powers and privileges SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 71

Figure 3.5: Developments in Mortgage Loans in Egypt

600

500 Banks Mortgage Finance Companies 400 300

300 LE Million

125 200

119 121 214 100 177

74 87

0 16 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06

in the initial stages of market development. Third, the Government has recently launched a systematic title-adjudication, survey, and registration process to modernize the property registration system over the next several years. Due to all these changes there has been a visible increase in the volume and value of mortgages offered through the two licensed RELCs and the commercial banks active in that lending sector (the value of mortgages has increased during the last 12 months to almost LE 500 million). More banks are offering mortgage products to their retail clients. The CBE has also authorized banks to lend up to 5 percent (almost LE 15 billion) of their portfolios for mortgage ﬁnance. More lenders are using training courses, which are tailored and offered to all market players such as mortgage brokers, appraisers, and foreclosure agents.20 All of these legal and institutional reforms have been reﬂected in the development of mortgage loans, which increased from LE 16 million in June 2005 to LE 514 million in June 2006 (Figure 3.5). The role of the banking sector in providing mortgage loans has been growing over the past year.

2. Main Challenges Facing Mortgage Finance

Access to mortgage loans has been impeded by various constraints, including access to long-term funding, cumbersome property registration procedures, inadequate collateral enforcement, cumbersome and/or untested foreclosure procedures, and an undeveloped regulatory framework for securitization. 72 Access to Finance and Economic Growth in Egypt

2.1. Lack of long-term funding. The lack of long-term funds available to primary lenders presents one major obstacle to the flow of private funds to housing. In order for households to afford housing, the payment stream needs to be spread out over a number of years. Most PMLs are commercial banks that rely mainly on abundant short-term deposits for their funding, and hence are reluctant to extend long-term (more than five years) loans for housing because of the liquidity and interest-rate risks inherent in funding such loans with short-term deposits. These risks will persist as long as the Real Estate Finance Law is interpreted to authorize only fixed-rate and fixed-payment loans. And most of the primary lenders do not have sufficient market capacity to raise long-term funds in the capital market at attractive financial terms. This issue is expected to be addressed by establishing the previously mentioned EMRC and the gradually increasing use of securitization techniques.

2.2. Constraints to property registration and transfer in urban areas. Property registration is one of the main factors that determine the ultimate success of access to affordable housing finance. Titles are not registered, mainly due to a costly and time-consuming registration process. Except for mortgage credit applications, the registration of property is not mandatory in Egypt for a legal real-estate transaction. High fees and cumbersome registration procedures have led to the growth of large informal housing stocks. This situation has led to slower economic growth, weakened social protections, and reduced collection of fiscal revenues. However, it is worth noting that some progress has recently been made to address problems of property registration, especially in the new communities, through a protocol in September 2006 (not yet implemented) between the Ministry of Investment, MFA, and the Ministry of Housing. Hopefully the costs of registration will be reduced, and the registration process simplified. The Government has undertaken to implement several urgent measures to alleviate current bottlenecks in the new urban communities, which are expected to be the main source of demand for mortgage loans. The Government has also launched a systematic title-adjudication, survey, and registration process to modernize the property registration system over the next several years. The concept of title insurance is also currently under study. Another positive step is the waiver of the 12 percent fee formerly applied to any land transferred from one owner to another.

2.3. Inadequate collateral enforcement and cumbersome foreclosure procedures. The repossession of real estate (notably through eviction) in case of borrowers’ default was a difficult if not impossible challenge, canceling any stronger collateral effect through applied credit rates (insecure lending). Part of the problem has been addressed through SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 73 the enactment of the Real Estate Law, a major breakthrough from past practices. The effectiveness of enforcement remains untested; therefore, lenders may hesitate until there is greater certainty that collateral can be recovered through the judicial system. The implementation of the first court cases according to clear and precise rules will therefore be critical, along with other training and explanatory efforts deployed by the Ministry of Justice for Property Registration Offices.

2.4. Adjust the regulatory framework for securitization. As securitization gradually expands, rules should be adjusted, notably for the sub-class of MBS designed to be particularly secure (eligible for a lower risk-weighting, repossession transactions, to be held by insurance companies with higher investment ceilings than the current 20 percent, to be held by pension funds Also, banks and specialized RELCs need fair and consistent systems that determine their permitted leverage ratios of debt issuance. Further regulations may be needed on the disclosure and listing of these speciﬁc instruments, notably as far as information about the mortgage pool is concerned. The development of securitization on a larger scale will also require the development of a supportive infrastructure, including rating agencies and external sources of credit enhancement (such as pool insurance). It will also require the further development of primary mortgage markets (larger volumes of standardized and seasoned mortgages).

D. FINANCIAL LEASING

The financial leasing industry can play a very important role in developing financial markets and providing finance to enterprises, especially small-scale enterprises that face problems obtaining credit from banks. Financial leasing companies have a dual role: on one side they complement the banking sector by increasing the range of products and services, while on the other side they compete with the banking sector, forcing it to be more efficient and responsive to customers’ needs. In addition, leasing plant and equipment is extensively used in many countries as a means of expanding enterprises’ access to credit, including through term finance.21

1. Recent Developments in the Leasing Industry

The leasing industry was established in Egypt by Law 95 of 1995, with further changes in late 2003 resulting from in Law 16 of 2001. The law and its amendments allowed the leasing of all assets, including cars, which had not been permitted under the initial law; and leasing of land as long attached to a productive activity. A recent Ministerial Decree permits leasing companies to lease buses to tourism, previously restricted by the Ministry of Tourism to companies with 74 Access to Finance and Economic Growth in Egypt

Figure 3.6: Volume and Number of Leasing Contracts in Egypt

1200 3500

1000 3000

2500 800 2000 600 1500

(LE million) 400 1000

200 500 Volume of Leasing Contracts Volume Number of Leasing Contracts 0 0 2000 2001 2002 2003 2004 2005 2006

Source: GAFI (2006).

a tourism license. Nevertheless, financial leasing is comparatively little used in Egypt. The annual volume of leases is quite small: in 2005 about LE 3.185 billion in new leases were agreed, and the stock of outstanding leases is about LE 16.902 billion, with 6,521 leasing contracts made (Figure 3.6). This is small relative to other forms of financial intermediation and economic activity. The share of leasing industry of total gross fixed investments, for example, is low in Egypt compared to other developing countries. The number of active leasing companies remains limited. Although there are 144 companies registered in Egypt, only seven are active (of which one is a “captive” firm subsidiary of a non-financial firm) and providing finance to third parties.22 Out of the remaining companies, 40 are essentially “single contract” companies,23 while 97 have never operated. The majority of the leasing companies in Egypt are controlled by banks or bank-affiliates. In terms of institutional setup, leasing companies come under GAFI,24 which is responsible for registering companies and checking their registration requirements, rather than for regulating the sector. Since 2005, the Ministry of Investment has given high priority to the development of the leasing industry. Actions to revamp the sector include a Ministerial Decree 1690 in 2006 exempting the leasing companies from Article 52 of the Income Tax Law No. 91 of 2005; this removed the obligation on leasing companies to limit their debit interest to maximum of four times capital. The Leasing Association was revived in 2005 as a GAFI initiative to provide greater voice to leasing companies’ concerns, to ensure dissemination of best practice, and to exchange important information. Moreover, the process for registering leasing contracts at GAFI was simplified in March 2005.25 SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 75

2. Main Challenges Facing the Leasing Industry

In spite of recent reforms, the development of the leasing industry in Egypt is still hampered by an unsupportive institutional environment. One of the major impediments is the difficulty of repossessing assets, related to the inadequate enforcement of ownership rights, as well as delays in the collection of overdue payments.26 Although ownership rights are clearly defined in the Leasing Law, lessors have great difficulty in achieving speedy repossession. According to the industry’s estimates, the average length of time the court takes in issuing a repossession order is around one month. Enforcement of any court order is a major issue, especially for movable assets, where the police often have difficulty tracking assets down and transferring them to the lessor. The legal and enforcement costs associated with repossessions are also very high. Due to these difficulties, for example, no significant secondary market for used machinery has developed. Moreover, it is difficult to sue a defaulted client for breach of contract, and the time to collect on a dishonored cheque is one to five years. As a result of problematic repossession and limited resale options, the leasing industry has moved towards “client-based leasing,” where the decision to make a leasing contract is based on the client’s creditworthiness, rather than relying on asset- based leasing. Another impediment for the leasing industry, as for the financial system at large, is the unavailability of credit information. Data at the Credit Registry Department of the central bank is only available to leasing companies that operate as bank subsidiaries, while independent lessors do not have access. This data is often inadequate and unreliable, since banks do not always report when clients default. Moreover, data does not include information on potential clients, which is a problem when dealing with client-based leasing. This limited information base inhibits growth, especially for non-bank leasing companies. The establishment of a private credit bureau will improve access to creditworthiness information for the financial leasing industry. Lack of long-term funding, and its relatively high cost when it is available, is another challenge. Leasing companies usually obtain most of their funding—often short-term—from their sponsor bank. However, leasing companies not affiliated to banks have problems accessing finance. Moreover, the relatively limited development of capital markets does not support the issuance of bonds to provide for long-term funding. As a result, the length of leasing contracts is short: on average three years. Another constraining factor is the rule imposed by GAFI in 2003 requiring at least 25 percent of the value of the assets to be financed from the capital of the leasing company for each contract. 76 Access to Finance and Economic Growth in Egypt

Another reason the leasing industry remains small is a lack of understanding of the sector. There is no department responsible for regulating and promoting the sector, since GAFI does not play a regulatory role. In addition, the limited scope and availability of ofﬁcial statistics decreases the industry’s visibility. Together with poor market conditions in Egypt, these factors have reduced the ability of leasing companies to reach out to clients, especially start- up clients. Although the leasing industry has been stagnant during the last few years, there is much scope for it to pick up, partially given the current reluctance of banks to extend loans, especially to small and medium ﬁrms. Importantly, as the Government proceeds with its leasing- reform agenda, the leasing industry has the opportunity to expand.

E. FACTORING

Another important source of finance in many countries is factoring— selling accounts receivable at a discount to a specialized collection company. It typically includes a package of services comprising working capital financing, credit risk protection, accounts receivables bookkeeping, and collection services. Factoring by banks and independent factoring firms is very important in developed financial markets. In Egypt, it is practically non-existent. As a result, enterprises finance their accounts receivables from their own sources, which increases their financing requirements, or through banks. Factoring’s growth should be strongly encouraged in Egypt, but extensive efforts are required to develop the industry. The Government acknowledges the importance of factoring and its value as a tool for encouraging Egyptian production, exports, and the development of SMEs, and has been adopting new regulations to foster the industry. Law 143 of 2006 amended the Stamp Duty Law 111 of 1980, which had imposed stamp duties on factoring companies, among other financial institutions.27 This new law is expected to contribute to the development of a more conducive environment for factoring. Further reforms to the legislative environment governing factoring will follow amendments to the Executive Regulations of the Investment Law 8 of 1997. These amendments include setting the main rules and regulations governing factoring activities, such as clearly defining factoring activities; licensing requirements, registration requirements and procedures; and surveillance that includes financial adequacy, credit risk protection, disclosure, accounts receivable bookkeeping, and collection services. To date, only the Egyptian Export Guarantee Company (EEGC) is authorized to operate as a factoring company. However, there are other companies ready to start operations, pending the issuance of the amendments. These amendments also assign GAFI as the responsible entity for setting further rules for factoring activity according to the best practices followed by international factoring groups, such as FCI and IFG. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 77

There are other impediments to the functioning of factoring companies, including the availability of credit information, enforcement of the legal rights of creditors, and resolution of default cases. Similar to other non-bank ﬁnancial institutions, factoring companies do not have access to potential clients’ creditworthiness information, and the legal mechanism for enforcing collection of receivables is inefﬁcient.

CONCLUDING REMARKS

Capital markets and non-bank financial institutions are not yet well developed in Egypt. Developed capital markets can provide external financing and help improve the risk and maturity profile of corporations’ external financing. In other countries, non-bank financial institutions are important forms of financing, especially for new and smaller firms. Affordable housing finance is important not only because it provides a much-needed social good, but because it can facilitate access to finance more generally by making an important asset available as collateral. The three main constraints to developing non-bank financial institutions in Egypt are similar to those impeding efficient intermediation by the banking system: the large role of the state in financial intermediation-through ownership and tightly prescribed (investment) regulations; the lack of well-functioning and efficient means of registering and enforcing property rights, especially on collateral; and limited and poorly available information on potential clients and borrowers. In addition, a number of specific regulations impede the development of the various non-bank financial services and institutions, and still others need to be put in place to facilitate it. Although progress is being made, further streamlining and more market-based measures are necessary.

Notes

1 Although there are more than 24 SME markets around the world, only a few are successful. These include AIM in the UK, TSX-venture in Canada, and KOSDAQ in Korea. The existence of a special market for SMEs is thus not a guarantee for access to equity finance for SMEs. 2 Calculations based on WFE annual report data (equity) and CMA data (corporate bonds). 3 The CASE 30 Index recorded the highest growth of 146 percent in 2005, following an increase of 135 percent and 122 percent during 2003 and 2004, respectively. 4 The costs for securities issuance include administrative costs for regulators, fees for listing and custodian services, fees for commercial intermediaries, and supporting service fees such as legal, public disclosure, and marketing. 5 While official schedules 1 and 2 are for high-quality shares of private- and public- sector companies, unofficial schedules 1 and 2 aim to accommodate local companies not fulfilling the listing requirements of official schedule 1, and foreign companies. 78 Access to Finance and Economic Growth in Egypt

Consequently, private firms can list their shares in four different markets according to their company characteristics: official 1, unofficial 1, unofficial 2, and OTC market. It is not clear why foreign companies are not eligible for official 1 regardless of quality of shares. 6 OTC’s trading accounts for 6 percent of total trading of all compounded securities on CASE, while listed market accounts for 94 percent.. 7 Government Debt Market Development Report, USAID, 2006. 8 Based on a comparison between the technical committee report and the emerging markets committee report on valuation and pricing of collective investment schemes, IOSCO, May 1999. 9 ROSC, 2002. 10 It should be noted that CASE has increasingly invested in educating the public and raising its awareness of the basics of investment in the stock market. CASE has conducted its annual Borsa Step by Step Event, which is a forum including CASE, CMA, Clearing Company, market participants, and the public at large. Furthermore, in 2005 and 2006 CASE has conducted various successful educational programs addressing aroud 5,000 students at key Egyptian universities, including Cairo University, Ain Shams University, Helwan University, Alexandria University, and Mansourah University, in addition to the German University in Cairo, Canadian International College, and the American University in Cairo; the programs cover the basics of investment in the capital market. Moreover, CASE encourages students from universities as well as schools to visit and tour its trading floor; around 2,000 students have visited CASE in the past two years. 11 See for example Impavido, Gregorio et al. (2001). 12 There is some evidence that they have been using overly competitive pricing to this end. This includes offering unsustainable guaranteed crediting rates on the back of accumulated reserves and their implicit government guarantee. 13 In addition there is evidence that local retention capacity is being under underused by the non-life sector and that mandatory motor insurance is severely underpriced. 14 Such as Misr Insurance, El Chark Insurance, Arab Contractors Pension Fund. 15 Mainly employer-sponsored plans with a strong concentration in the banking sector. 16 The latter two types of fund are not supervised, but should be. 17 For example, extending average terms from five to 15 years would augment average loan-to-value ratios from a current 25 to 30 percent range to about 45 to 50 percent, according to the estimated incomes of households and actual prices of supplied housing units (mostly targeted for middle-income urban households purchasing units in the price range of LE 100,000–LE 150,000). 18 The GSF may also undertake more market-oriented activities through its guarantee activities, while it should totally separate its other activities dedicated to channel and assess subsidies. On the guarantee side, priority consideration may be given to: (i) pre-titling guarantees for housing lenders, in order to cover the credit risk for a limited period until the mortgage lien is registered; and (ii) a mortgage-insurance program covering part of the mortgage debt for the lender (therefore sharing part of the credit risk, inducing lenders to ask for a lower downpayment and facilitating access to housing finance). 19 The state-owned banks may be able to issue bonds in their own name on favorable terms, should the market perceive them to be government-guaranteed; in this case the Government could, in turn, take on substantial market risks unintentionally. It would also tend to defeat the purposes of the Government’s financial-sector reform program. 20 The MFA has so far licensed 206 brokers, 69 appraisers and 15 agents. SOURCES FOR FINANCIAL SERVICES: NON-BANK FINANCIAL SERVICES 79

21 Leasing has the advantage over a secured loan in that, by retaining ownership of the leased asset, lessors’ ability to recover their outlay in the case of default is enhanced. 22 “Captive” leasing companies are wholly owned subsidiaries of a manufacturer established to support the sales of its parent’s products and services, with over 50 percent of its portfolio in the parent company’s products. These leasing companies are providers of operating leases. 23 These have been established for the purpose of one-time leasing deals with their parent firms to take advantage of the five-year tax holiday leasing enjoys. 24 The General Authority for Investments and Free Zones (GAFI) reports directly to the Prime Minister. However, with the Cabinet change in July 2004, and the establishment of the Ministry of Investment by the Presidential Decree 201 for 2004, GAFI (and accordingly the leasing sector), along with all non-bank financial institutions, is affiliated to the Ministry of Investment. 25 Previously, the requirement for each leasing contract to be registered by GAFI and checked for compliance with the law was a cumbersome procedure. This was exacerbated by changes made in the standard format of the registration contract in July 2003, which increased the time required from one week to three to six months. The delay is mainly attributed to three clauses that were added to the standard leasing contract to ensure lessor commitment to compliance with Egyptian Accounting Standards (EAS), adherence to anti-money-laundering and combating-terrorism financing (AML/CTF), and observance of the regulations imposed by GAFI regarding treasury, credit, and portfolio management (such as lending limits and client risk exposure). Moreover, this registration process is a mere formality that provides no real benefit to the industry (and charges a fee of LE 50 per contract), hindering its growth. One potential advantage that the CA could provide is to ensure that there are no multiple leases on the same equipment. However, in its current paper form, such information is difficult to obtain. 26 Due to difficulties of repossession and the poorly developed secondary market, leasing companies often resort to negotiations with customers and rescheduled lease. 27 Articles of Law 111 of 1980, which imposed stamp duties, include: Article 52 (a stamp duty of 0.3 percent with a minimum of LE 0.6 on bills and promissory notes and checks); and Paragraph 2 of Article 57 of the old law (a stamp duty of 0.3 percent with a minimum of LE 0.6 on assignment of financial rights). 80 Access to Finance and Economic Growth in Egypt INSTITUTIONAL ENVIRONMENT 81

CHAPTER 4

INSTITUTIONAL ENVIRONMENT

The structure and efficiency of a country’s banking and financial system is greatly shaped by the nature of its legal and regulatory framework and the supporting institutional infrastructure, which includes basic company, civil, and security laws; stock exchange and other financial markets regulations; information exchange setup; financial reporting; and accounting standards and supervision. Although in Egypt the legal and regulatory framework is coming into place, there are large gaps. Much of what is there remains untested and not all of it is conducive to easy access to financial services. However, a well-designed legal and regulatory framework is not enough for a sound and efficient financial system. It needs to be complemented with an adequate and supportive institutional infrastructure to ensure enforcement. Since the judicial system in Egypt has only recently started to come to grips with the move to a full market economy, further reforms are necessary.

A. LEGAL FRAMEWORK

In spite of recent legal changes, the prevailing framework in Egypt represents a constraint on the cost and terms of finance, and on the provision of finance in the first place. Some of the laws are poorly written, especially regarding secured transactions, bankruptcy, and settlement of disputes. Property-rights registration and titling issues make it difficult for firms, especially small and medium firms, to use land assets as collateral. Collateral legislation is poorly enforced. And even when collateral is registered, there is no information on its value. Banks lack an efficient judicial system to foreclose pledged collateral in case of default. There is no special court for debt recovery by banks and financial institutions. Loan-recovery procedures are slow and cumbersome, and often drag on for several years. The inadequate legal and judicial system makes banks reluctant to initiate bankruptcy and foreclosing procedures on defaulters. There are also no specialized judges with knowledge of financial markets or credit risk issues; this affects the quality and reliability of decisions. 82 Access to Finance and Economic Growth in Egypt

There are three areas that, individually and collectively, represent major constraints to accessing ﬁnance: (i) the law on secured transactions; (ii) bankruptcy procedures; and (iii) settlement of disputes before the court system. Although addressing all these legal constraints will take considerable time, policy-makers need to begin reform now.

1. Secured Transaction

An effective system for secured transactions reduces credit risk, which in turn increases the availability of financing and improves its terms. A bank that knows it has legally recognized rights to turn to a security in the event of a debtor’s default will assess the credit in a different way than in the case of an unsecured debt. The availability of such recourse may influence a bank’s decision to lend. Security is particularly important for new borrowers, including newly established firms and those recently privatized companies with no credit history.1 Egyptian law recognizes three major forms of security: mortgage, pledge, and business charge. ■ Mortgage is mainly governed by the Civil Code of 1948, under Articles 1030–1084 and 1096–1129. The actual practice of these rules over the past few decades has proven to have various shortcomings. First, the creation of a mortgage is both complex and costly. The formality requirement (evidencing the deed before a public notary) has added to the cost and time needed for the creation of a security. Second, the law adheres to theoretical principles that lack sound rationale and have a negative commercial impact. The application of the principle of mortgage specificity (a requirement to detail) to both the mortgaged property and the secured debt undermines the concept of general charges over present and future corporate assets. (It is not surprising that the principle of specificity has been dropped in many jurisdictions.) Meticulous identification is “often inconvenient, sometime impractical and

Figure 4.1: Legal Rights of Creditors in Egypt and Other Countries

200

150

100 Percent

0 Iran USA UAE India Syria Chile Brazil Egypt Benin China Belize Czech Bolivia Turkey Jordan Ireland Algeria Poland Mexico Bhutan Tunisia Croatia Estonia Belarus Bahrain Srilanka Bulgaria Armania Hungary Morocco Pakistan Thailand Australia Lebanon Malaysia Romania Lithuania Colombia Argentina Barbados Indonesia Botswana Cambodia Singapore Azerbaijan Philippines Macedonia El Salvador Bangladesh Korea, Rep. South Africa South

Source: Doing Business, 2006. INSTITUTIONAL ENVIRONMENT 83

always theoretical.”2 Lastly, the mortgage rules have some odd constructs, as both ships and aircrafts are deemed by law as immovable property. ■ Pledges are governed by Articles 1096 to 1129 of the Civil Code. The basic principle is that the pledged property is no longer possessed by the debtor who transfers it to either the creditor or a third party. There are two major drawbacks of the current drafting of the law: (i) the law only recognizes possessory pledges of movables, since non-possessory pledges of movables do not exist (as a result of the adherence to the doctrine of false wealth); and (ii) future assets cannot be pledged, since the pledged property must be adequately speciﬁed in the pledge agreement. ■ The third form of security, Law 11 for 1940 on fonds du commerce, provides for the only non-possessory charge over business. Here, the principle of speciﬁcity applies; hence the agreement must adequately identify the elements of the business and the charge agreement must be notarized. Except for inventory, no future assets can be charged. Moreover, immovable property under a business charge is subject to the rule on mortgage.

Egypt stands out internationally in its weaknesses in these areas. An index of the legal rights of creditors shows Egypt to be ranked among the lowest (Figure 4.1). The shortcomings of the law on secured transactions do not stop at the conceptual framework, but include how the rules on enforcement are drafted and practices occur: (i) the rules are complex by design and formalistic in the extreme; (ii) procedures for enforcement are very time-consuming (notiﬁcation, attachment, and sale by public auction); (iii) the process of sale is inefﬁcient, resulting in modest proceeds; and (iv) private sale and strict foreclosure are not permissible under law. Again, Egypt stands out internationally in this area. An index of the costs to create collateral shows Egypt to be ranked among the most costly (Figure 4.2).

Figure 4.2: Cost to Create Collateral in Egypt and Other Countries (percent of income per capita)

0 India Chile Brazil China Bolivia Turkey Ireland Jordan Algeria Poland Mexico Tunisia Srilanka Bulgaria Hungary Morocco Pakistan Thailand Lebanon Malaysia Romania Lithuania Colombia Argentina Indonesia Cambodia Singapore Philippines El Salvador Bangladesh Korea, Rep. South Africa South Yemen, Rep. Yemen, United States Taiwan, China Taiwan, Czech Republic United Kingdom Egypt,Arab Rep. Macedonia, FYR Hong Kong, China Syrian Arab Republic Syrian United Arab Emirates United Source: Doing Business, 2006. 84 Access to Finance and Economic Growth in Egypt

These shortcomings have negatively affected the lending environment. The lack of non-possessory charge over moveable property deprives both lenders and borrowers of important collateral. Enforcement of security is troublesome and the application of the enforcement rules under the Real Estate Finance Law 148 of 2001 (which apply only to banks as per recent amendments to the Banking Law) is yet to be tested. The Sale of Commercial Concerns Law of 1940 governing business charges fails to address the needs of those using the system. While these shortcomings are common to a classic Civil Law tradition, and not a deliberate choice by policy-makers, they do create large obstacles to the provision of ﬁnance.

2. Bankruptcy

The bankruptcy rules are embodied in the New Commercial Code of 1999 under Articles 550–772. These rules provide few conceptual changes to the Code for 1883, which it replaced. They adhere to historical perceptions of the bankrupt betraying the trust vested by the creditors, and focus on personal bankruptcy as opposed to corporate bankruptcy. Moreover, save for a solitary and ambiguous provision (Article 702), the rules focus on liquidation and fail to provide any regulation for reorganization. A review of the rules—more than 200 Articles—shows that the process is multi-layered, complex, and time-consuming. The court plays a very active role in supervising and approving all aspects of the process, leading to further delays. The eventual outcome of the process is the sale of the debtor’s assets via public auction, which results in only modest proceeds.

Figure 4.3: Bankruptcy Costs and Time in Egypt, MENA Region and OECD

70 Egypt

60 MNA Region

50 OECD

0 Time ( year ) Cost ( % of Recovery Rate estate ) Source: Doing Business. INSTITUTIONAL ENVIRONMENT 85

These shortcomings have resulted in the bankruptcy system failing to provide a ﬁnal avenue of debt collection. Existing processes, exclusively aimed at liquidation, are very slow, cumbersome, and costly. Egypt compares unfavorably in the time needed for debt collection (more than six years), the cost (more than 25 percent of the estate), and the recovery rate (less than 20 percent) (Figure 4.3). Altogether, Egypt is ranked 106th globally in these dimensions.

3. Court System

The importance of the court system cannot be overstated. Laws are seldom self-executing; a judiciary needs to ensure their correct application and enforcement, or at least support their implementation. The Egyptian court system, though well reputed for its impartiality and independence, suffers from several drawbacks that have resulted in it failing to provide an expeditious avenue for debt collection and resolution of other financial disputes. This is due to several reasons, the most important of which is delay that characterizes most procedures before the court. With an average civil and commercial case lasting for three to five years before a final and enforceable decision is reached, it is difficult to see how the system can provide a credible avenue for debt collection and other resolutions of financial claims. The long backlog before the Civil and Commercial Courts has resulted in loan-recovery procedures for bankruptcy and foreclosing on defaulters often dragging on for several years. Moreover, judges are not acquainted with complex banking transactions, a matter that in some instances results in inconsistencies between judgments. Finally, enforcing a final court judgment (after three to five years of proceedings) is complex and time-consuming. This has resulted in uncertainty and high cost, making banks reluctant to lend or choose for overcollateralizing of lending. Ninety- two percent of loan transactions require collateral (Figure 4.4).

Figure 4.4: Dominance of Collateral-Based Lending in Egypt

70 64.67 60.67 60

50 40 30 20 10 0 Land and Immoveable Moveable Other Personal Other buildings plant, machinery tangible assets machinery and assets equipment Source: Egypt ICA. 86 Access to Finance and Economic Growth in Egypt

Irrespective of firm or loan size, about 45 percent of firms were asked to collateralize both land and immovable machinery and plant. Banks require at least 60 percent of the loan amount in collateral, which hinders access to financial services, especially for SMEs and new firms.

B. INFORMATION INFRASTRUCTURE—CREDIT REGISTRY, CREDIT BUREAU AND OTHER SOURCES

Bankers and firms have difficulty making sound credit decisions and developing meaningful business plans, in large part due to lack of market and credit information, particularly information on clients’ creditworthiness and sector-related statistics. The only source of credit information is the Public Credit Registry at CBE. The recently established private credit bureau is not yet operating. Access to CBE’s credit registry has been limited to banks only. Moreover, bankers do not find the credit registry’s data sufficient or reliable. While mortgage and leasing companies are now allowed to access the registry, they have been slow not only in providing their credit data but also in conducting inquiry searches in the registry. Moreover, preventing other providers of finance from accessing clients’ creditworthiness information inhibits the development of non-bank financial institutions, an important source of financing, especially for small and medium firms. These limitations prevent the development of independent leasing and factoring companies, as well as mortgage finance. A strategy for expanding access to credit information and enhancing the information infrastructure is being implemented. In order to enhance access to financial services, the CBE has been strengthening its existing credit information department since early 2004. This has been coupled with regulatory, legal, and institutional changes, including amending Law 88 of 2003 in June 2005, which prohibits banks from releasing information on their customers. This amendment allows for the establishment of a private credit

Table 4.1: History of Public Credit Registry Database in Egypt

June 2004 December 2004 June 2005 December 2005 October 2006 Total Number of Files 356,374 529,254 599,755 643,137 705,585 Business files 25,630 - 46,977 49,717 52,162 Loans, credit cards, and mortgage files for 221,651 - 552,778 593,480 653,423 individuals Guarantors* 109,093 115,916 120,588 123,831 142,006 * not included in total files Source: CBE, Credit Registry Department. INSTITUTIONAL ENVIRONMENT 87 bureau and the sharing of credit information with non-bank financial institutions. Allowing non-bank financial intermediaries to access the credit-registry database is an important step, as it will improve enterprises’ access to finance, especially small and medium ones. It is equally important that non-bank financialintermediaries are required to provide client credit information. The amendment also allowed for the exchange of an individual’s credit information between banks and non-banks, subject to the individual’s signed consent. An agreement was reached to include all bank credits in the CBE Credit Registry, allowing banks to refine their credit adjudication processes by obtaining information on the payment habits of Egyptian credit applicants. As a first step, the bank reporting requirements has decreased from LE 40,000 to LE 30,000, and a further reduction to LE 20,000 is imminent; this will ease SMEs’ access to finance. The newly formed private credit registry “iScore” will obtain any remaining information directly from banks in 2007. Table 4.1 shows the growth of credits within the CBE Registry over the past two years. This additional information is now available to banks. When the registry expansion is completed, the number of individual files in the registry will have increased from 356,374 in June 2004 to almost 4.6 million in December 2007. The CBE credit registry is providing additional demographic and credit information to the banks. This includes a four-point rating of credit transactions, which will be further expanded to include monthly payment information along with borrowers’ pay-habit information. A negative database was created for credit-card balances under LE 30,000. This database was subsequently expanded to include all accounts 90 days or more past due within the Egyptian banking sector. The purpose of this database was to provide additional information to Egyptian banks for their credit-adjudication process. Table 4.2 reflects the number of credits reported in the negative database as of September 2005. A full-scale private credit bureau “iScore” was established in October 2005. “iScore” is majority owned by the banking sector— 27 banks, in addition to various financial leasing and mortgage

Table 4.2: Negative Databases of CBE Credit Registry

Negative database March 2005 March 2006 September 2006 account balances Greater than LE 30,000 494,000 2,709 1,213 LE 20,000–LE 29,999 709,000 2,286 2,305 LE 10,000–LE 19,999 2,825 6,304 6,489 Less than 10,000 33,446 46,317 47,089 TOTAL 37,474 57,616 57,096 Source: CBE, Credit Registry Department. 88 Access to Finance and Economic Growth in Egypt

Box 4.1: Current Status of the Private Credit Bureau in Egypt

With the establishment of a private-sector credit bureau, it was agreed that eventually either there will be a link with the CBE credit registry, or the information will be provided directly to the private credit bureau (once it begins operating). The link would allow the private credit bureau access to credit information housed in the CBE Credit Registry. Regulations to frame the private credit bureau industry, primarily for consumer protection, have been created and reflect international best practice. Licensing requirements have been established, resulting in the issuance of a license to “iScore”, the new private credit registry. “iScore” has commenced construction of its database and should be fully operational by the end of 2007. Creation of a Manner of Payment grading, necessary for effective credit granting, was agreed to. It is anticipated that this grading could be in place by early 2007. The CBE Registry is providing the banks with more comprehensive and detailed information on successful inquiries of the CBE Registry. Banks have indicated their appreciation for this additional information to assist the precision of the credit-granting process. The Registry’s access hours have been significantly increased, and an additional day has been added. An educational bro- chure was developed as the first step of a public awareness campaign that will educate consumers on the function of a credit registry as well as the rights and protections now for an individual’s personal credit information.

companies (Box 4.1). It is expected to decrease the cost of obtaining credit information, and therefore the overall costs of intermediation, and ultimately improve the quality, availability, and timeliness of data on borrowers’ creditworthiness. As an interim step, “iScore” will use existing CBE Registry data to populate the database it is currently constructing. Ultimately “iScore” will directly provide credit reports that include bank and non bank information to all qualified users in the marketplace. Imposing stricter penalties on misreporting and improving the enforcement of such penalties should be considered to prevent malpractice and ensure good-quality credit information. These steps are expected to resolve many information issues, but they should be implemented as soon as possible. It will also be important to foster various types of institutions that provide general and borrower-specific information. Data collections need to identify the manner of payment—the length of the outstanding loans, the history of loan balances and repayments, and whether there were any changes in the terms of the loan. These additional data will help to identify cases of rescheduling and rolling over of loans, which is a significant problem in Egypt. It is also important for creditors evaluating their potential clients to have information on individual loans—origination date, maturity, and type and value of collateral. Introducing a standard credit-report format and a unified credit-scoring methodology is necessary for financial intermediaries; currently each bank uses its own methodology, which they do not report to the registry department. Moreover, the central bank should introduce a charge for both successful and unsuccessful searches of the registry database. INSTITUTIONAL ENVIRONMENT 89

C. FINANCIAL REPORTING ENVIRONMENT

Another factor hampering access to finance in Egypt is the quality of financial reporting. The reliability of firms’ financial statements and related audit reports plays a major role in the decision of financial institutions to invest or lend (Box 4.2). Interviews and discussions with financial institutions make clear, however, that investors generally believe that information available in Egypt through published financial statements needs enhancement. External users of corporate financial information generally do not have enough confidence in the reliability of firms’ financial statements to make their decisions; rather, they rely on the company reputation, its major shareholders, and other qualitative factors, particularly in the case of smaller firms.

Box 4.2: The Importance of Good Financial Reporting for Firm Financing

In an efficient market, the supply side, represented by lending institutions and investors at large (corporate and individual), should be able to read, understand, and assess the quality of available financial statements, their disclosures and associated audit reports. Similarly, the demand side, represented by firms or individuals applying for finance, should be able to prepare reliable financial statements with adequate disclosures and audited by qualified and independent auditors. Moreover, the regulatory framework should be designed and implemented to support a reliable corporate- reporting environment. Enabling such an efficient market system can result in more informed investment decisions, better allocation of resources, lower cost of funds, and enhanced access to finance. On the supply side, confidence in and positive perception of the reliability of financial information are keys to any investment or lending decision. The flow of foreign direct and portfolio investment, domestic savings, and banks’ liquidity to finance firms’ activities is hindered by lack of a sound financial reporting infrastructure. Without a reliable financial reporting environment, non-performing loans may arise because of uninformed lending decisions based on misrepresented financial information. Similarly, financial-market crisis can occur because of misled investment decisions. Accordingly, the supply side, represented by lenders and investors, needs a transparent reporting environment and an effective regulatory framework that can provide some level of assurance and immunization against fraudulent or weak financial reporting. The reinforcement of credit and investment officers’ accounting skills is essential for sound assessment of financial statements as part of loan applications or equity valuations. Moreover, officers need a standard benchmark against which they can assess the quality of financial information. This is especially true for international or regional investors, who are unlikely to know enough about local accounting practices and are keen to have independent, reliable criteria to assess financial information and make investment decisions (the full adoption of International Accounting Standards can serve this purpose). Cash projections must be reliable, as they directly affect the financing decision. Although these projections are already often subject to some form of assurance by an auditor, the more the accounting profession is regulated, the more confidence investors have in financial information. On the demand side, the financial statements provided by applicant borrowers are directly affected by the skills of the accountants who prepare financial statements and the auditors who audit them. This is, in turn, affected by the quality of university education, licensing requirements, and continuous professional education practices. 90 Access to Finance and Economic Growth in Egypt

Althought the Egypt 2002 World Bank Report on Observance of Standards and Codes—Accounting and Auditing (ROSC-AA)3 identified some progress in setting accounting and auditing standards, the report— and the update of changes since it was issued—highlight the following deficiencies in Egypt’s current financial-reporting environment: ■ There are recurring incidents of divergence between accounting standards as designed and as practiced, especially in the areas of full disclosure on related-party transactions and assets pledged as securities, issuance of required statement of changes in equity, application of segment reporting requirements, tests on impairment of assets, presentation of foreign-currency exchange gains and losses, consolidated financial statements where appropriate, analysis of risk exposures and loan loss provisions, and proper classification of current assets and current liabilities. ■ Investors are concerned about the enforcement mechanisms and regulatory framework for the accounting and auditing practitioners upon which the investor community must rely. The corporate culture in general does not assign due attention to accounting and reporting issues, resulting in weaker financial reporting quality. ■ The level of users’ confidence is further eroded by the perception that university education gives insufficient emphasis on updating accounting curricula. Outdated curricula and lack of appropriate learning materials diminish students’ knowledge of modern accounting and auditing and do not improve critical thinking. ■ Small-size borrowers, especially, are overburdened with the high cost of maintaining appropriate accounting systems and of retaining qualified auditors. The resulting modest quality of corporate financial reporting leads to increased risks to lenders and investors, and higher cost of funds for borrowers.

Related to the quality of financial reporting are deficiencies in the accounting standards and auditing regulatory framework, and in its enforcement. The regulatory framework should help enhance the quality of financial reporting through monitoring the qualifications and performance of practicing accountants and auditors, enforcing mechanisms that regulate the preparation of financial statements and the conduct of audits, and applying a disciplinary system that can effectively deal with incidents of noncompliance. In Egypt there are still some noted weaknesses. ■ There is no requirement for a professional qualifying examination to practice auditing. A university graduate with an accounting major can join the public practice of an auditing firm just through completing a training period with a registered accountant and registering with the Registry for Accountants and Auditors maintained by the Ministry of Finance. ■ There are no applicable peer-review practices through which auditors can provide cross-examination to each other’s working papers, and no supervisory body to monitor the working practices of auditors and enforce disciplinary actions against those in violation. INSTITUTIONAL ENVIRONMENT 91

■ In addition, the profession is still personal: a company cannot appoint an audit firm, but rather appoints an individual partner of an audit firm, as a result of which audit firms cannot be held liable.

A new Accounting and Auditing Law is drafted to replace Law 133 of 1951. Although this new draft law includes many positive initiatives towards the development of the profession and the regulation of its practices, it has been in draft form since 2002 and is not yet approved by the Parliament. The Capital Market Law 92 of 1995 also introduced significant steps towards enhancing corporate financial reporting. The stock-exchange listing rules currently impose administrative sanctions on listed firms that fail to promptly disclose financial statements and information. The CBE also issued in 2005 some circulars to ensure the maintenance of auditors’ independence and the quality of auditors assigned with auditing firms that apply for credit facilities. (For example, the maximum auditing period for an individual bank’s auditor should not exceed five years, and the two auditors for the same bank cannot be from the same audit firm.) This is in addition to CBE guidelines to be met by auditors of firms applying for bank credit. In July 2006, the Minister of Investment issued updated Egyptian Accounting Standards to better align with International Financial Reporting Standards (IFRS). This was an initiative carried out by CMA and reviewed by a standards committee at the Ministry of Investment. All of these developments represent important interim arrangements. However, they will eventually need to be better integrated under a new accounting law that comprehensively regulates the profession.

D. FINANCIAL INFRASTRUCTURE

The institutional infrastructure needed for access includes the payments system and competition policy. In both areas improvements are possible.

1. Payments System4

Cash, cheques, and large-value inter-bank transfers are the basic means of making payments in Egypt, with cash the major instrument for individuals and cheques primarily used in commercial transactions and some government payments. The CBE operates the cheque- clearing system, and only one automated clearing house exists in Egypt.5 To enhance efﬁciency of clearing, the maximum settlement period has been reduced from ﬁveworking days to two at most, and new instruments like direct debit have been added. Payment cards were introduced recently, but the number of cards is still low.6 The use of cards is expected to increase substantially, mainly due to a Ministry of Finance program to automate government employee payroll and 92 Access to Finance and Economic Growth in Egypt

distribute payments through cards linked to bank accounts. Besides 1,862 ATM machines, there are some 24,000 POS devices (as of the end of 2005). Egypt Post plays an important role in payments, with more than 3,600 branches, many of them in remote areas. It provides low-cost savings and transaction account services for more than 14 million depositors with total deposits of LE 32 billion, supported by a centralized high-speed network linking main offices. To date, Egypt Post cannot exchange payments directly with other banks, but interoperability between its and some inter-bank networks is under preparation. Egypt Post has also an agreement with one large commercial bank where the bank places ATMs in post offices. Furthermore, Egypt Post is working on channeling payment of pensions through its savings accounts, direct depositing its own payroll (some 45,000 individuals), and issuing ATM cards. The CBE has led efforts to create a modernized payments-systems infrastructure covering systems operations, policies and regulations, and payment-system oversight. The new, automated interbank payments system has already improved arrangements, and processing times for interbank payments has been reduced. The CBE is also implementing a Real Time Gross Settlement (RTGS) system, which is being designed to comply with international standards and best practices Nevertheless, there are challenges, including improving the legal framework covering payments and securities settlement systems, and the development of the payments-system oversight function. Furthermore, although Egypt is one of the top five countries in terms of inflows of remittances, there are currently no particular measures in place to control the liquidity and credit risks of cross- border transactions, or regulations specifying minimum service levels or minimum transparency requirements for international remittances or other types of cross-border payments. International remittances are neither monitored nor regulated by an authority. Finally, there is no structured framework to improve the efficiency of remittance services.

2. Competition, Entry, and Exit Policy

A fundamental means to expand access is to promote increased competition in the provision of the full range of financial services. Competition not only benefits users by reducing the cost of financial services, but drives providers to seek new products and new client and geographic markets, resulting in expanded access. Competition also creates incentives for innovation in production and distribution of financial services, which contributes both to expanding access and reducing costs. For a market to be competitive there should not be any significant entry or exit barriers. The Egyptian banking system has suffered from the use of restrictive regulations such as special licenses and permits, which have prevented new entry and limited competition. There have been restrictions on domestic banks in terms of licensing INSTITUTIONAL ENVIRONMENT 93 and branching, as well as restrictions on foreign banks’ entry and types of activities. The main concerns used to justify restrictive entry regulations include: “cream skimming” by private and foreign banks; acquiring dominant positions in the domestic market; engaging in hit-and-run activities due to lack of commitment; the need to protect the interests of the existing banks, especially state-owned banks; and allocating most of domestically mobilized funds abroad. Banks in Egypt have not been allowed to fail. This has come about not because prudential policies or other measures have enhanced their efficiency and risk-management capacity, but rather through the support given by the central bank and the rest of the banking system to weak banks. Weak banks were left to operate, while adequate measures such as restructuring, merging, or liquidation were not applied early enough. To prevent financial instability, recapitalization was sometimes required, entailing fiscal cost. As a result, inefficient banks were encouraged to indulge in high-risk activities, while sound banks were forced to subsidize them. In recent years, and as part of the reform program, the Government has improved the rules and practices for entry and exit of banks and other financial institutions. The ongoing consolidation of the banking system and the expected increase in the number of foreign banks will increase the competitive landscape in Egypt. The restructuring of the insurance sector will lay the basis for a more competitive sector. But further reforms in other areas are necessary as well. In particular, access to information should not be restricted to incumbent banks only. In this context, it is important to assure that the new credit bureau is available to other types of financial institutions. Also, crucial institutional infrastructure, such as the payments system, should (subject to prudential concerns) be available to all financial institutions.

3. Regulation and Supervision

The groundwork for the banking-system regulatory and legal environment has been set by Law 88 of 2004, its executive regulations, and recent amendments.7 The decrees are, however, not equally access- friendly. Articles 19 to 25 specify requirements for taking, appraising, and reviewing collateral twice annually, and establishing collateral- evaluation assessors with speciﬁc responsibilities. These directives on collateral are a reaction to the “name lending” in the 1990s that led to large NPLs, but they raise transaction costs and lower access. With better corporate governance and risk-based regulation and supervision, these rules are no longer necessary. Moreover, while on-site supervision conducted every two years is moving to risk-management capability, off-site reporting requirements are still onerous, requiring 64 reports per month. Banks also collect data and report to not only the CBE but also to tax authorities, the Ministry of Finance (in the case of foreign- currency borrowing), and other entities. 94 Access to Finance and Economic Growth in Egypt

CONCLUDING REMARKS

Recent developments in strengthening the institutional framework are crucial for improving access to financial services. As part of its Financial Sector Reform Program (2004–2008), the Government is forging ahead with efforts to improve the infrastructure for the financial sector to enhance the efficiency of intermediation. Specific efforts include improving and strengthening the legal and regulatory framework, information infrastructure, and financial reporting; and the overall financial infrastructure, the payments system, entry and exit policies, and supervision. The institutional infrastructure in Egypt is coming into place for more efficient financial intermediation. Regulatory gaps are being filled, and new institutions are being created. The overall direction is promising, but the deeper institution-building, especially in the judicial area, is still ahead to facilitate to easy access to financial services.

Notes

1 For details see: Safavian, M. Fleisig, H., and Stienbuks, J. (2006), Unlocking Dead Capital: How Reforming Collateral Law Improves Access to Finance, Public Policy for Private Sector, World Bank, March 2006; and Fleisig, H. (1998), “Economic functions of Security in a Market Economy” (in: Morton J. and Andenas, M. (eds), Emerging Markets and Secured Transactions). 2 Wood, P. (1995), Comparative Law on Securities and Guarantees, p.5. 3 The ROSC-AA program was established to help countries implement international accounting and auditing standards to strengthen their ﬁnancial reporting architecture, and has proven a good diagnostic tool and a lever for policy change. For example, the ROSC reports have formed the analytical and diagnostic underpinnings for countries in South East and South Central Europe to enable accession to the European Union. 4 See World Bank Payments System Study “Payments and Securities Clearance and Settlement Systems in Egypt” (December 2005), carried out under the Arab Payments and Securities Settlement Initiative, for more detail. 5 The system processed some 9.9 million cheques in 2005, with an aggregate value of LE 267.3 billion, or an average value of LE 27,000 per cheque. In terms of inter-bank payments, in ﬁscal year 2005, the gross settlement system (“FIN Copy”) processed 404.8 thousands transactions with an aggregate value of LE 1,658.8 billion, or an average of LE 4.1 million per transaction. 6 There were 750,000 credit cards and around 2.1 million debit cards in use at the end of 2004 7 The executive regulations stipulate conditions for minimum capital, shareholding of banks, setting up new banks or branches of foreign banks, rules and regulations for the banks to comply with under the supervision of the CBE, establishment of a credit reporting system, and the establishment of internal audit and executive committees for the banks, as well as their functions. INSTITUTIONAL ENVIRONMENT 95

CHAPTER 5

EXPANDING ACCESS TO FINANCE

The speedy completion of the financial-sector reform program and the restructuring of state-owned financial institutions are essential to enhance access to financial services. Equally important is improving the quality of the institutional environment and corporate governance. Enhancing the role of banks that have a huge branch network, of the postal system, and of microfinance institutions is crucial for the access agenda. The securities issuance system; institutional investment deregulation; and Egypt’s regulatory capacity and policy framework should be reformed to enhance the primary markets. Ultimately, the combination of financial restructuring and institutional reform will make Egypt’s financial sector more developed and efficient, leading it to provide better-quality financial products and services, exhibiting a lower cost of financial intermediation, and being more competitive.

A. ENHANCING THE ROLE OF THE BANKING SECTOR IN FINANCIAL INTERMEDIATION

1. Bank Restructuring and the Role of State-Owned Banks in Enhancing Access

Restructuring the state-owned banks will be important, not only for stability and for reducing fiscal costs and contingent liabilities, but also for access. Once the state-owned banks have been restructured and privatization is solidly underway, incentives for sound financial intermediation will fall into place and a more competitive market structure will emerge. With a large and stable flow of savings into the banking system, increased competition has significant potential to increase access. As private banks identify their comparative advantage and competitive niches, and as margins are squeezed in traditional markets, access to financial services for small firms and households can be expected to increase and the quality and variety of financial services to be enhanced. However, lessons from other countries suggest that reaping these benefitsrequires a comprehensive approach and can take some time (Box 5.1). 96 Access to Finance and Economic Growth in Egypt

Box 5.1: Lessons on Bank Restructuring from Other Countries

Based on experiences in other countries, it is unlikely that access and the allocation of resources will improve dramatically before privatization and restructuring of the state-owned banks is well advanced. Experiences in Central and Eastern Europe and other countries have shown that even with rapid and deep bank restructuring the (resumption of) lending to the private sector can take some time. In these countries, following banking restructuring in the mid-1990s, bank lending resumed only with a lag. The recovery was typically over the three to four years after the completion of major parts of the bank restructuring involving large-scale foreign banks’ entry. In other words, banking reform takes time and needs deep changes, but does pay off. Quicker response might be possible in Egypt than that experienced in some of these other countries. While it is hard to generalize- much depends on who the new and existing owners are, on the state of lending technologies, on the macroeconomic climate, and on the political, and legal and judicial climate-experiences do show that a comprehensive approach is necessary.

Private Sector Credit-to-GDP

80%

60% Slow Reformer Slow Reformer 40% Fast Reformer * * * * * 20% * * * * * * Fast Reformer

0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Slow: Czech Slow: Slovak * Fast: Hungary Fast: Slovenia

In the meantime, it will be important that the Government exercise its rights as shareholder to ensure that state-owned banks contribute in a meaningful and commercially sustainable way to the Government’s access agenda. The state-owned banks collectively possess a large branch distribution network, an important asset in the context of expanding access. International evidence shows that access to finance can be a function of distribution networks (bank branches and the postal system), and that removing barriers to establishing branches and ATMs would significantly enhance access to finance. In Brazil, for example, access has involved, to some degree, wider branch networks for both public and private banks, and a good mix of domestic and foreign banks in the distribution of banking establishments. The appropriate time for the Government to guide banks in this direction is now, as the future strategy of the banks is being reassessed and debated as part of the ongoing restructuring program. Such guidance should be paralleled by efforts to upgrade corporate-governance EXPANDING ACCESS TO FINANCE 97 arrangements for the banks. Corporate governance should serve to both complement and reinforce the restructuring efforts, and provide a mechanism to ensure that the Government’s rights as owner are articulated and acted upon, without intervening in day-to-day operating decisions.

2. Improving Corporate Governance of State-owned Banks

For any corporation, sound corporate governance arrangements should clearly specify the respective responsibilities, authorities, and accountabilities of the owner, the board, and the executive management. They should imbed responsibilities, authorities, accountabilities, and information requirements (transparency and disclosure standards) in a well-defined legal and institutional infrastructure. Owner and board should have access to the information they need to fulfill their responsibilities. Recognizing the significant steps that are already being taken in Egypt, the principal measures in this regard are to consolidate ownership functions in an administrative unit of government outside CBE; to reconfigure the General Assembly so as to eliminate conflicts of interest; to take further action to strengthen, professionalize, and empower the board of directors; and to continue to strengthen the capacity of the executive management while ensuring that these executives do not dominate or bypass the board. The Government should consider consolidating the responsibility for exercising ownership functions in the state-owned banks within a single ministry. The designated minister would be responsible for functioning as the shareholder’s (Government’s) representative, and would report to and be held accountable to the Prime Minister and the Parliament for the conduct and performance of this function. The minister would be delegated the authority, subject to any relevant powers reserved for the Parliament, elect the banks’ boards of directors, appoint the chairpersons of the boards, determine board- member remuneration, chair the General Assembly meetings and vote the Government’s shares, and approve extraordinary transactions (mergers, divestitures, and major investments).1 The minister would be supported in his role of shareholder’s representative by professionals with relevant legal, financial, economic, and managerial expertise, and would have the resources and authority to hire outside expertise if required. The minister would have the authority to obtain from the banks any information required to assess the performance of the chairperson, the board, and the banks. 98 Access to Finance and Economic Growth in Egypt

A key responsibility of the minister is to ensure that the boards govern the banks in a professional and effective manner. Doing so requires the minister to communicate overall expectations, along with a long-term mission/mandate and overall board responsibilities and authorities, to the board. The mission/mandate should be supported by an articulation of high-level objectives and performance targets, which would be determined in consultation with the Prime Minister and the banks’ boards. Since the effectiveness of the board will depend on the performance of the chairman, the minister should define the chairman’s role. That role should include responsibility for direct contacts with the minister or his designees, for the efficient and effective operation of the board (including through use of specialized board committees, especially for audit, risk management, and remuneration), for working with the minister to determine the skills and experience the board should possess to ensure its effectiveness, and for ensuring that the performance of the CEO is formally appraised at least annually. Under these arrangements, the CBE’s engagement in ownership and board functions should gradually be reduced. Specifically, the CBE Governor would no longer serve as the head of the General Assembly, thereby avoiding possible conflict of interests between ownership and supervisory functions.2 So that the board, in practice, is able to exercise its responsibility to oversee and hold accountable the executive management on behalf of the owner, it is considered good practice that it has the authority to appoint and dismiss the CEO. In doing so, it should adopt transparent rules and procedures for nominating and appointing the CEO, based on professional criteria.

3. Limiting Government Intervention in Credit Allocation and Pricing

Government intervention in the credit-granting and pricing process undermines banks’ incentives to make good loans and borrowers’ incentives to pay back, and introduces other forms of market distortions. Regulations and policies to increase small firms’ access to finance, such as interest-rate ceilings, restrictions on lending, priority lending and credit subsidies, and other government interference can contribute to a distorted enabling environment for financial intermediation, hindering access. Most government-subsidized credit programs have proven costly failures because they undermine the commercial incentives for both banks and borrowers as well as introduce other distortions. Most government credit guarantee schemes have failed for similar reasons. Rigidity in chartering, high minimum-capital EXPANDING ACCESS TO FINANCE 99 adequacy requirements, limited degrees in funding structures, too- heavy regulations and supervision, too-strict accounting requirements, and high compliance costs can hinder financial institutions from operating efficiently. However, it is worth noting that tradeoffs arise as regulations serve other public-policy purposes. Governments should remove policies that either unnecessarily impede the ability of banks to design, price, and offer loan products, or undermine the commercial incentive structure for banks or borrowers. Moreover, banks that have recently penetrated the small- business finance market and have been active in the provision of microfinance should be careful in the selection of credit policies or procedures and in employing sufficiently skilled staff. Cross-country experience shows that many private banks employing poor credit policies or procedures, lacking skilled staff, or expanding too rapidly undermined the profitability of small-business lending and thereby reduced small businesses’ access to credit.

4. Enhancing the Role of Specialized State-Owned Banks

It is crucial to enhance the role of specialized state-owned banks in financial intermediation. Although analysis of the use of financial services by households suggests that, over the longer term, the most dramatic increases in access to financial services are likely to come from demand-side factors (such as those associated with improvements in human-capital development, education, and income), in the near term, actions can be taken on the supply side to improve access for households. Specifically, better use could be made of the existing branch networks of state-owned specialized banks to foster access. a. Re-evaluate the role of the specialized state-owned banks In principle, state-owned specialized banks could play an important role in achieving government’s access objectives. Yet serious questions have been raised not only about the effectiveness of the three specialized state-owned banks in Egypt in this regard, but more fundamentally, about their underlying financial and operational viability. Determining whether these banks have a long-run role in the Egyptian financial system is essential before restructuring them. A formal assessment of the banks’ future should re-examine their mandate in light of their current and prospective performance. It should consider whether any social and public-policy objectives that remain valid can be met more cost-effectively by other means (such as a government fund or an agency arrangement). This would also 100 Access to Finance and Economic Growth in Egypt

require these banks’ ﬁnancial and operational restructuring. An important context for such an assessment is a rethinking of the role of subsidized credit (Box 5.2).

Box 5.2: Subsidized Lending Schemes in Egypt

In promoting increased access to finance, the Government should de-emphasize subsidized lending schemes, such as those offered through the SFD. Rather, the Government should recognize the fundamental importance of promoting commercially sustainable expansion of access. Subsidized lending can undermine commercially sustainable expansion of access in several ways. Subsidized interest rates distort the overall lending interest-rate environment, putting financial institutions seeking to expand the reach of their lending at a competitive disadvantage, and deterring them from seeking to expand access. The association of subsidized schemes with government-sponsored programs, and the potential that a borrower might only receive a loan one time under a particular program, reduces repayment incentives for borrowers, and undermines repayment discipline in the market. The consequence again is to deter commercially oriented financial institutions from entering new markets or expanding the reach of existing services. Subsidized lending schemes also often undermine the commercial culture within the institution distributing the loans, and give rise to the potential for corruption in the allocation of subsidized funds. Empirical evidence supports these principles. A World Bank multi-country study, for example, looked at whether a long-term credit shortage exists and, if so, whether it has had an impact on investment, productivity, and growth, and what the role of the Government might be (Caprio and Demirguc-Kunt, 1998). The study found that although government-subsidized credit markets have increased the long-term indebtedness of firms, there was no evidence that these subsidies were associated with firms’ ability to grow faster. Indeed, in some cases subsidies were associated with lower productivity. Analysis by CGAP confirms these principles. CGAP’s Key Principles of Microfinance, for example, asserts that: (i) financial sustainability is necessary to reach significant numbers of poor people; (ii) microfinance is about building permanent local financial institutions; (iii) interest-rate ceilings can damage poor people’s access to financial services; (iv) the government’s role is as an enabler, not as a direct provider of financial services; and (v) donor subsidies should complement, not compete with, private sector capital.

Source: Gerard Caprio, Jr., and Ash Demirgüc-Kunt. 1998. The Role of Long-Term Finance: Theory and Evidence, World Bank Research Observer 13: 171-189; and CGAP, 2004, Key Principles of Microﬁnance, www.cgap.org, endorsed at the G8 June 2004 Summit in Sea Island, Georgia, USA.

b. Restructuring the state-owned specialized banks To the extent that it is necessary to maintain specialized state-owned banks, they would need substantial operational restructuring to make cost-effective contributions to the Government’s access objectives. An overall restructuring program focusing as well on institutional, operational, and ﬁnancial aspects is also needed. The Government needs to ensure that any new public capital contributions required to restore conformity with prudential ratios is done in conjunction with this overall restructuring program. In order to complement improved EXPANDING ACCESS TO FINANCE 101

financial disclosure, it is crucial to strengthen the roles and functions of the boards of directors, clarify their duties towards companies and shareholders, and increase their accountability. This should involve applying lessons learned in enhancing state-owned banks’ corporate governance; formulating quantifiableperformancemeasures;specifying how the costs associated with the provision of social/public services are to be covered; commissioning annual independent audits of the banks using commercial auditing principles; and making an ongoing assessment of costs versus outcomes. In the longer run, consideration could be given to consolidating the ownership function for specialized banks, as in the case of commercial state-owned banks. Lessons from other countries suggest that specialized banks can be reformed and privatized, but that it takes a sustained effort and strong policy commitments to make it happen. It would entail clarifying the mandates of the state-owned real-estate specialized banks and improving their governance, and leveraging their branch networks to improve access. The Government has already taken steps on that front, in terms of merging the state-owned specialized Egyptian Arab Land Bank with the private Housing & Development Bank, to create one large housing-finance bank. If there are no realistic prospects for significant and sustained progress in the restructuring of these banks, however, the Government should consider selling them to private investors who could make better use of those assets. Another alternative would be to transform them into funds, such as SFD, that might be more successful in addressing the social agenda.

B. EXPANDING THE POSTAL SYSTEM AND MICROFINANCE INSTITUTIONS

The large unmet demand for ﬁnancial services signals a role for the postal system to participate further in the provision of these services and for making the most of lessons from existing microﬁnance institutions in Egypt.

1. Enhancing the Role of Post Ofﬁces in Financial Intermediations

Egypt Post already offers savings, transfers of funds, and pension and bill-payment services. As in other developing countries, such as Brazil, China, and Morocco, the authorities can use the network of postal offices to expand access to additional financial services, by encouraging Egypt Post to diversify the range of services. Such diversification may entail distribution of credit provided it is regulated by CBE. For this to be possible, the postal financial services would need to be institutionally split from Egypt Post (which, as an industrialized and commercial entity, cannot apply for a banking license). Another option would be for Egypt Post to distribute credit 102 Access to Finance and Economic Growth in Egypt

on behalf of a commercial bank through an exclusive or non-exclusive strategic partnership, in which case a banking license would not be required. Hence different strategic options could be considered, involving different institutional and business models, and different levels of private-sector participation. Postal ﬁnancial services could be maintained within Egypt Post, or be externalized in a subsidiary, fully or partially owned by Egypt Post; the rest of the equity could possibly be distributed to private-sector players (commercial banks and insurance companies).

Box 5.3: Lessons from Successful Postal Financial Systems: Case Studies from Brazil and China

Brazil presents one of the most interesting cases in postal financial systems. With no historical legacy in postal financial services, Correios (Brazil’s Post Office) benefited from a strong government policy agenda that was seeking to improve access to finance, using direct and indirect incentives to attract new operators. The Government modified the regulatory framework to allow Correios to become a “correspondent” of a bank. Correios selected, through a transparent bidding process, a strategic partner (Bradesco, the most important retail bank in Brazil) and launched Banco Postal in 2002. Its range of services spans from traditional giro and savings accounts to payments and remittances, and has also included microfinance since 2003. Building effective and strong partnerships between state-owned postal operators and private financial institutions has proven to be a complex and cumbersome process. In the case of Brazil, seven years elapsed between the first feasibility study and the actual launch of postal financial services. Today, Banco Postal is a leading player in retail banking in Brazil. Its success arises from a clear strategic vision, a new regulatory framework reflecting government policy, a balanced contract with the strategic partner, and substantial investments in the network (particularly in information systems) to offer quality services.

China Post offers another success story of non-exclusive partnership. Since April 1984, China Post has been operating a Postal Savings Bureau (PSB), a key source of revenue for the postal service (44 percent). Postal savings are provided at nearly 35,000 post offices—approximately the same size as China’s entire bank-branch network (37,000 branches), and there are 260 million accounts for US$ 144 billion of deposits (9 percent of market share). PSB operates an ATM network and debit- card-linked accounts (“green cards”). It also provides 90 percent of private remittances in China (postal money orders), with 2,500 electronic remittance offices. Domestic remittances represented US$29 billion. China Post handles 15 percent of the total volume of cashless payment transactions in China. Since 2003, China Post has invested direct postal financial deposits in: (i) the interbank bond market (including T-bonds) and central-bank paper; and (ii) large-amount time deposits (negotiation deposits) in cooperation with commercial banks, rural credit communities, and other financial institutions.

China’s postal network also plays a role as an agent. It distributes insurance policies, utility bill payments, pension payments, social security, and medical insurance bund, in international remittances. It provides traditional international postal money orders, Eurogiro, and Western Union services. China Post has embarked on the development of innovative services such as life insurance, payroll services, mutual funds, and credit. In view of the fact that China Post does not have the required license to manage such products, it has sought partnerships with various ﬁnancial institutions. The competitive edge of China Posts rests on its large number of postal outlets, low charges, convenience, reliability, and long service hours. EXPANDING ACCESS TO FINANCE 103

In developing countries, strategic partnerships with one or more commercial banks have mostly prevailed, through partnerships that are exclusive (as in Brazil) or non-exclusive (as in China). The latter entail less risk but lower remunerations. The ability of Egypt Post to negotiate such partnerships and fair contracts is crucial for sustainability. An important aspect of a service-level agreement between the two partners is the way the network access fee is evaluated and charged to the partner by Egypt Post. Since Egypt Post has yet to develop cost-accounting tools and is only somewhat knowledgeable of its cost structure and cost factors, it is likely to set the network access fee either below the real cost (creating structural deficit) or above it and up to a point that the partner can contest. Such an ambitious diversification strategy entails some capacity- building in many fields, including cost accounting, negotiations, market-driven product development, and information technologies. The Government should promote the complete integration of all postal outlets into its online network to enhance postal payments and savings products, and consider using this distribution and IT infrastructure for credit extension, tapping relevant international expertise to promote successful expansion.

2. Applying the Lessons of Microﬁnance

Egypt appears relatively well advanced in its adoption of business and lending practices associated with the commercially sustainable provision of microfinance; this experience could be tapped to improve access to financial services, especially credit. These microfinance business practices, involving specialized lending techniques, incentive-based loan officer compensation policies, supporting managerial approaches, and supporting management information and information-technology capabilities, have broad application to the SME lending market. Some banks might therefore profitably apply microfinance policies and practices to the SME sector.3 There are several steps the authorities can take to apply this knowledge and experience base in microfinance. One is to ensure the Government’s own banks make full use of the opportunity, requiring better corporate governance. Another is to ensure that present bank regulatory and supervisory practices do not unnecessarily inhibit the broader adoption of practices proven successful elsewhere. There are constraints, for example, to wholesale lending by commercial banks to microfinance lenders that can be removed. Third, the Government can sponsor activities that continuously propagate relevant knowledge and experience to audiences outside the existing microfinance community in Egypt. 104 Access to Finance and Economic Growth in Egypt

Box 5.4: International Evidence on Institutional Policies to Enhance Access

International experiences increasingly show that catering to firms and households can be a valuable business proposition. Lessons on how to expand sustainable credit flows to creditworthy small businesses come from an increasing number of successful efforts around the world. These international best practices are grounded on two basic facts. The first is that many viable small businesses are creditworthy and willing and able to pay for reliable access to the bank credit that allow them to grow. The second is that reliable long-run access to credit requires stable and efficient financial institutions. The nexus of these two facts is a mutually agreed and advantageous commercial business relationship between lender and borrower that creates positive incentives for both parties. Managing financial institutions to achieve sustainable profitability, the prerequisite for stability and efficiency, provides strong incentives to price loans adequately, control the risk of loan defaults, and continue expanding a client base of borrowing customers. Since borrowers seek reliable, flexible, and timely access to credit and are willing to pay for it, they have strong incentives to repay previous loans and otherwise maintain a good business relationship with a reliable financial institution. In fact, the value of this relationship to both banks and borrowers derives not only from credit but also from other financial services such as deposits, payments, and risk-management products. Successful efforts to build institutional infrastructure also involve steps to improve the utility of collateral for banks and borrowers. While the primary source of loan repayment is the borrowers’ cash flow, the use of collateral improves incentives for borrowers and can reduce risks for lenders and facilitate the flow of credit to small businesses. Governments of various developing and developed economies are taking steps to expand the pool of assets that can be used efficiently as collateral. These steps include clarifying property rights, improving owners’ ability to document those rights, improving collateral registries and the availability of information regarding existing liens, improving the efficiency with which lenders can take possession of and sell assets serving as collateral, and promoting development of more-liquid markets for such assets so that the prospects for realizing their value is improved. Successful efforts commonly involve specialized policies and practices that enable banks to penetrate the small-business market on a commercially sustainable basis. Loans typically are granted on the basis of judgments regarding the cash flow, debt-service capacity, possession of collaterals, and character of borrowers. Since confidence regarding these judgments naturally increases as borrowers repay loans; default risk is often controlled in part by policies that “graduate” borrowers to larger, longer-term and sometimes less-expensive loans as their repayment performance is established. Policies requiring frequent payments (monthly, for example) serve to monitor cash flow and repayment performance and to minimize default risk. Policies and practices applicable to credit officers are important complements to this specialized approach to loan approval, monitoring, and collection. Credit officers are held accountable for most elements of the customer relationship. Moreover, the structure of compensation includes positive incentives for encouraging customers to repay their loans on time. Similarly, specialized management information systems play a vital complementary role in supporting implementation of these practices and in controlling and reducing costs. Steps to promote well-functioning credit-information registries are a key feature of successful efforts to improve the sustainable flow of credit to small businesses. Such information can improve banks’ ability to judge and price credit risks and reduce loan processing times and costs, and can offer similar benefits to potential trade creditors. Well-functioning credit registries create positive incentives for borrowers by enhancing the value of “reputation collateral” derived from timely repayment of bank and trade credit. Credit registries can facilitate the development of small- business credit-scoring systems, which have proven successful over the last 10 years in expanding access to credit in some countries. These tools often merge the personal credit history of business owners with data on their business to more accurately assess risks. EXPANDING ACCESS TO FINANCE 105

C. PROMOTING CAPITAL MARKETS IN THE ACCESS AGENDA

Cases of well-functioning primary securities markets are not numerous in developing countries. However, in Egypt the Government’s reform commitment remains strong, the securities industry is becoming more active, and foreign investors’ interest remains high. Reforms to enhance the primary markets should be carried out in the securities issuance system, the deregulation of institutional investment, and Egypt’s regulatory capacity and policy framework. Capital-market reforms in Egypt to date4 have mainly focused on secondary markets and not extended themselves to easing ﬁrms’ access to securities markets through new issuance. The Government should place a higher priority on primary market development. The reform measures to be taken involve improving securities-issuance regulation, developing the investor base, and creating an issuer- friendly policy and regulatory environment. Importantly, these government actions should be implemented within the context of a well-designed, overall capital market development strategy.

Policy actions to be taken in the short term include: 1. Reduce Issuance Costs

The Government should reduce issuance costs by improving and streamlining the legal procedures for securities issuance, completing the recent shift from a merit to a disclosure-based system, and streamlining any increased disclosure requirements and procedures. ■ Undertake various legal reforms in order to improve and streamline the securities issuance procedures. Law 92 of 1995 should be amended to elaborate on the regulations related to definition of securities, scope of “public” and different periods of effectiveness depending on the nature of securities. CMA should ensure the implementation of the recent shift from an approval (merit) system to a disclosure system in filing procedures. The governing body of bonds and other debt issues needs to change from an extraordinary general assembly to the board of directors. The Government should also introduce the notion of the institutional trustee, for example following the US Trustee Indenture Act of 1940, while alleviating or abolishing the administrative duties of issuers in maintaining the association system of bond holders.5 ■ Lower the transaction costs for new issuances through (i) seeking managerial efficiency, as well as reviewing fee structures of CMA and Misr Clearing, Settlement, and Central Depository (MCSD); (ii) introducing competition among underwriters, rating companies, and banks for intermediary services; and (iii) avoiding unnecessary regulation on securities issuance. CMA should monitor transaction costs in consultation with market participants and the business community. 106 Access to Finance and Economic Growth in Egypt

■ Simplify and streamline listing procedures. This means simplifying the listing schedules into a two-tiered system-one main board and one second board-rather than the current four boards. The Government should abolish the exemption of share dispersion for public-sector companies, but maintain the stringent delisting policy of CASE. Relevant laws and regulations need to be revised to require that ﬁnancial statements of all listed companies, ﬁnancial institutions, and large joint stock companies be prepared in accordance with accounting and auditing standards consistent with international best practice. ■ Improve transparency. There is scope to improve the transparency of government debt management and reduce the share of non- tradable government bonds. The Government should implement the proposed regulations allowing reverse repossessions, securities lending, and borrowing, and apply the mark-to-market principle to investment assets of banks and insurance companies.

2. Deepen the Investor Base

The Government should deepen the investor base by enhancing collective investment schemes regulations, developing retail programs for privatization IPOs, expediting the consolidation among brokers, and promoting competition. A series of measures can be undertaken to deepen and broaden the investor base, including: ■ Adopt a future price system in sales and redemptions of mutual funds. Abolish the 5 percent investment-maintenance rule for the sponsor banks and insurance companies for mutual funds. Prohibit sponsor banks from doing custodian business for the same mutual funds. To increase the transparency of markets, introduce for all financial institutions mark-to-market accounting of securities. ■ Develop retail programs to promote long-term holdings of privatization shares, including developing differentiated discount regimes for privatization IPOs based on holding periods, and mutual funds targeted at privatization IPOs. ■ Reduce the number of dormant brokerage firms through enforcing new net-capital requirements and strengthening CMA’s examinations. Strengthen the monitoring of the “Big Four” brokers. Strengthen the capital-market industry by liberalizing entry rules for financial institutions, promoting greater competition and improving supervision.

3. Create an Issuer-Friendly Regulatory Framework

The Government should create a more issuer-friendly regulatory framework through various measures including: (i) reinforcing the new Corporate Finance Division (CFD) at CMA with competent staff to champion direct corporate ﬁnancing through securities issuance; and redeﬁning the division of labor with SROs , such as CASE; (ii) improving the CMA statistical system to conform to the standards EXPANDING ACCESS TO FINANCE 107 of the World Federation of Exchanges (WFE), and strengthening its capacity in data and information dissemination; (iii) considering removing CMA approval of CASE board decisions and review the CASE ownership and governance structure; (iv) improving the information-disclosure system at CMA and CASE to enable investors to obtain more information on corporate governance structure and important corporate actions; and (v) creating a more reliable yield curve for private issuers through reducing non-tradable government bonds and implementing regulations regarding repurchase and securities lending and borrowing.

4. Develop a National Capital Market Development Strategy

This national strategy should be established in coordination with the government debt market and privatization policies, within the framework of the existing Financial Sector Reform Program. The National Capital Market Development Strategy should include four main pillars: (i) promoting the external ﬁnancing of Egyptian ﬁrms; (ii) fostering more (direct and indirect) securities holdings by households; (iii) enhancing the competitiveness of the capital-market industry; and (iv) accelerating the integration of the Egyptian capital market in the MENA region and the world at large.

5. Proceed with the Public Awareness Campaign

In order to increase public awareness of capital market instruments and develop a better understanding of the risks and returns involved in investing in these instruments, CMA should proceed with its public-awareness campaign, enhancing average retail investors’ basic knowledge and skills in the area of capital market investments. Raising awareness of use of new instruments, such as hybrid bonds with equity elements for corporate ﬁnance, is crucial. New equity markets for ventures and high-growth ﬁrms needs to be studied.

D. CONTRACTUAL SAVINGS INDUSTRY POTENTIALS FOR GROWTH

The development of contractual-savings institutions is associated with efficiency gains at the firm level, including increased availability of long-term finance, reduced costs of capital, and greater resilience in the private sector to external shocks. These benefits come about in more market-based economies through a decrease in firms’ leverage (at least in the formal sector); in more bank-based systems, insurance and contractual savings development leads to an increase in the maturity of debt. The development of insurance and contractual- savings institutions also enables governments to transfer common- 108 Access to Finance and Economic Growth in Egypt

good obligations-such as insurance against income loss, unforeseen natural events, adverse health, and old-age security-to markets, thus enabling governments to target their own expenditures more efficiently at those functions that cannot be served by markets. While international experience with insurance and contractual savings reform has shown mixed results, there are enough examples to point to key success factors. These include stable and enabling macroeconomic settings, an environment that enforces property rights, a reliable market infrastructure (exchanges and depositories), adequate levels of transparency and corporate governance, and market-oriented regulation and supervision backed by credible enforcement powers. Countries that have built some or all of the required institutions and infrastructure and have seen rapid growth of contractual savings include Chile, Slovakia, Singapore, South Korea, and some of the Gulf States. While adhering to these general principles, each has varied the model to suit local context and target markets, and to deal with local vested interests. The Egyptian contractual-savings industry has considerable potential for growth and efficiency gains, which would improve firms’ access to finance. This will require, besides general economic development, many specific reforms in both the near and long term. The near-term reform agenda entails the restructuring of existing institutions, developing a professional investment-management industry, encouraging better asset management, stimulating the supply of investment-grade schemes issued by the real sector, strengthening the regulatory and supervisory body, and adopting a pension-reform strategy. The medium-term agenda entails expediting the privatization and restructuring of state-owned insurers, outsourcing funded pension asset management on a competitive tender basis, easing investment limits for insurers and moving towards a prudent investor regime, and removing all direct taxes on savings and reviewing the final taxes on long-term savings. These recommendations are detailed below.

Policy actions to be taken in the short term include: 1. Maintain the Pace of Insurance-Sector Restructuring

A better-structured, properly priced, and more financially efficient non-life sector would almost certainly see a significant proportionate increase in funds available for investment. In particular, it would see a more aggressive attempt by the (new) players to expand overall penetration into the household and business sectors. The insurance sector is still dominated by state ownership, however, despite the rapid growth of foreign life-insurance companies. Restructuring will therefore entail enhancing the participation of the private sector in insurance ownership and management. This may include, if appropriate, transfer of portfolios before privatization for the three smaller state-owned insurers. EXPANDING ACCESS TO FINANCE 109

2. Improve Funds Management and Develop a Professional Investment Management Industry

To assure a proper role for institutional investors (especially insurance and pension funds), their portfolio allocations and quality, investment regime, corporate governance, and regulation and supervision need to be properly designed. The insurance-sector survey referred to in Table 3.66 showed a common pattern of constrained in-house investment, with listed equity holdings tending to be small. Although the state- owned insurers have substantial unlisted equity holdings, sometimes owning up to 20 percent of enterprises involved (usually in the tourist and property sectors), these are not actively managed or necessarily good financial investments. Although more than three-quarters of insurers hold some corporate bonds, altogether bank deposits and sovereign paper dominate in asset portfolios. There is also limited use of external custodians, with custodians in some cases associated with brokers employed (most use between one and three brokers). Those insurers using external funds managers are the rapidly growing foreign life offices, with a substantial proportion of single-premium hard-currency business in their sales. Since these inflexibilities are unlikely to be resolved in the short- term, alternative investment management approaches need to be adopted. These should include: (i) outsourcing the management7 of all pension funds below a certain size to professional asset managers, which would provide a better allocation of savings and allow the system to be viable sooner. This could take place as part of the reform of the pension sector, possibly involving the conversion of smaller Defined Benefits (DB) to Defined Contribution (DC) plans. Regardless of whether they are backing DB or DC plans, pension-fund assets should be segregated from other collective investment pools (although a managed pool could handle multiple small group DC funds or even individual accounts); and (ii) introducing professional asset management in the insurance industry, including the use of external investment managers. Specifically, until the state-owned insurers cease to be subject to civil-service rules, they should outsource up to 50 percent of asset management (subject to appropriate mandates and oversight). This would have an educational benefit and provide performance benchmarks.

3. Develop a More Active Local Asset Management Industry

The investment banks, securities houses, analysts, and professional fund managers that typically stand between institutional investors and the capital market are at an early stage of development in Egypt, and competition does not appear to be high. However, there are positive signs that this may change with the establishment of graduate selection and training programs and the beginnings of asset-backed 110 Access to Finance and Economic Growth in Egypt

security packaging and issuance. The ﬁrst of these (a mortgage- related offering by CIB) was initially offered to banks only, but it is understood that future issues will be offered to insurers as well.

4. Stimulate the Supply of Investment Grade Securities Issued by the Real Sector

In the interim, there is a need to stimulate the supply of investment- grade securities issued by the real sector suited to the liability proﬁles of institutional investors. Long-term corporate and sub-sovereign bonds and structured instruments such as mortgage-backed securities (MBS) in particular are ideal investments for institutional investors, as they enable them to achieve higher returns after controlling for risk (i.e., a higher alpha). All of this will encourage product innovation and allow more intermediation within Egypt’s borders. In addition, investment in foreign assets could be broadened in a controlled manner.

5. Strengthen the Supervisory and Regulatory Body—EISA

EISA is currently structured as an audit and control entity, reflecting the major role historically played by state-owned insurers. In addition, and in the absence of a risk-based capital regime, it controls asset risk through investment limits. Globally, the emerging model is to base capital requirements on risk levels (including asset risk), with the EU probably having such an approach within the next four years (North America already has risk-based capital, as do some Asian countries, including Indonesia). Risk-based capital is increasingly accompanied by a risk-based approach to supervision. EISA has adopted a medium-term plan to move to a modern supervisory approach; this will require considerable changes in its current mode of operation, including the injection of new skills. It will require phasing in a risk-based supervision model, applying fair-value accounting to insurance and pension assets, and adjusting liability valuation methodologies accordingly. In the interim, investment limits will need to be maintained. However, a move to a partial risk-based capital approach could be considered, together with more investment flexibility, once EISA is reformed and a greater choice of acceptable assets becomes available. In turn, this will provide investments in a broader class of assets, enhancing access to financing for the real sector.

6. State-Owned Insurers Compete on Product and Distribution Innovation

The state-owned insurers should be encouraged to compete on product and distribution innovation rather than price alone. This could include bancassurance arrangements between the major insurance companies and the major state-owned banks (if necessary with outside help) to help remove liquidity from the system8 and increase the supply of long-term funds. Bancassurance was pioneered in France and now EXPANDING ACCESS TO FINANCE 111 accounts for a signiﬁcant proportion (typically more than 30 percent) of life-insurance sales in Western Europe. The model is now being transplanted to East Asia with some success—the fastest-growing insurer in Indonesia is a joint venture between a French insurance group and Bank Mandiri, the largest bank (at the same time as a number of international agency-based insurers have exited). Indonesia has some commonalities with Egypt, and the fastest- growing life insurer in CIB is in fact using a bank distribution system. However, CIB is essentially selling a low-margin investment product, and the full contractual-savings approach has yet to be broadly adopted (although Allianz is exploring this approach while maintaining an agency system). The insurance survey showed that the sector as a whole largely relies on a narrow, agency-based distribution system, largely focused in Cairo and Alexandria.9 If a broader distribution of long-term savings vehicles is to be achieved, those channels that are already in place need to be tapped. In the case of the state- owned banks, this could also see a new source of fee-based income being generated, although the balance of proﬁt between insurer and distributor needs to be carefully managed if bancassurance is to succeed in the longer run as a genuine partnership.

7. Accelerate the Pension Reform Agenda

The Government should accelerate the pension reform agenda—as the net savings coming on stream are likely to be significant—and channel resources to the productive sector. Egypt is considering a major pension-reform program, primarily driven by fiscal and equity considerations. This could also offer a major source of long-term financing for the corporate and real sectors. One proposal would see a mandatory defined-contribution pillar being established, with a 5 percent contribution rate. Projections carried indicate that the resultant funds, together with the existing voluntary arrangement, could accumulate to approximately 10 percent of GDP within 15 years (Figure 5.1). Together with a more aggressive and innovative

Figure 5.1: Funds Build Up Under 5 Percent Mandatory Pillar Option

60.0%

50.0% Total 2nd Pillar and Occupational Schemes 40.0%

30.0% Mandatory 2nd Pillar 20.0% Occupational Schemes 10.0%

Reserve Accumulations as a % of GDP Reserve 0.0%

2007 2011 2015 2019 2023 2027 2031 2035 2039 2043 2047 2051 2055 2059 2063 2071 2075 Year Source: Improving the Welfare of Future Generations through Pension Reform: World Bank 112 Access to Finance and Economic Growth in Egypt

insurance sector, overall long-term funds could become some 15 percent of GDP in 10 years’ time. While this pales compared to more developed financial markets, where contractual savings institutions’ balance-sheet totals exceed 100 percent of GDP, it would provide a substantial source of new financing for the real sector. It could be sufficient to begin the healthy dynamic and iterative interaction between long-term savings institutions and securities markets that leads in turn to efficient supporting institutions, the development of required infrastructures, and ongoing financial innovation.

The Government should pursue mid- and long-term reforms in the following areas: 1. Continue to Expedite the Privatization and Restructuring of the State-Owned Insurers

Expediting the privatization and restructuring of state-owned insurers would accelerate the introduction of more entrepreneurial approaches, along with modern management, underwriting, and marketing skills. In the medium to longer term, the former state- controlled insurers would then compete on technical capacity as well as product, price, and distribution. This would involve increased use of Internet-based services, and enhanced services and consumer advice at the retail level. As in-house skill levels increase, investment management could also be brought back in (including through fund- management subsidiaries managing pension funds).

2. Require Outsourcing of all Funded Pension Asset Management on a Competitive Tendering Basis

Outsourcing all funded pension asset management on a competitive tendering basis, with clearly defined mandates reflecting liability structures, would almost certainly accompany the conversion of a large number of small DB plans to DC plans and a changed supervisory regime for supplementary pensions (including compulsory segregation of assets underlying funded pensions). An in-depth study of the appropriate medium- and longer-term structure of financial- sector supervision in Egypt should accompany any pension reform.

3. Gradually Ease Investment Limits for Insurers

The Government should ease investment limits for insurers and move towards a prudent investor regime as risk-based supervision (and capital) is introduced, actuarial capacity is improved, governance levels are raised, and capital-market depth and choices of ﬁnancial instruments improve. This will, importantly, allow for greater access to ﬁnancial services for the real sector. EXPANDING ACCESS TO FINANCE 113

4. Remove All Direct Taxes on Savings and Review Final Taxes on Long-Term Savings

Certain forms of savings are taxed—for example, life policyholders are effectively taxed at 3 percent on the savings component of their premiums. A desirable reform is to remove all direct taxes on savings and later review the ﬁnal taxation of long-term savings (subject to acceptable and appropriate accounting standards being in place). In the early stages, some countries have also instituted positive incentives for long-term savings, including supplements (e.g., Czech Republic) and tax allowances (Australia and New Zealand in the 1960s). While potentially useful, these need to be carefully designed to avoid distortions and be effective.

E. DEVELOPING THE MORTGAGE FINANCE MARKET

To improve access to housing finance, it is crucial to have a private- sector-led and funded mortgage-financesystem in a fair and consistent environment and market competition among primary lenders; longer-term market-based funding from institutional and private investors; and measures enabling primary lenders to alleviate and better manage the associated financial risks, particularly credit risk. Important reforms have gradually been put in place in order to set up the legal environment, but the short-term priority now consists in developing sizeable primary mortgage markets, which could be sound, low-risk, profitable, and accessible. This may also require significant reforms of the national housing policy, which go beyond the scope of financial-sector development. Despite recent progress, the market structure and infrastructure for a comprehensive, well-functioning mortgage finance system is not yet complete. Key required reforms in the short-term include:

1. Strengthening the Regulatory and Institutional Framework for the Mortgage Market

The judicial system has to recognize and be willing to enforce creditors’ mortgage liens on owner-occupied residential property. This would also require streamlining clear enforcement and foreclosure procedures. The market is not developed enough for the Government to provide insurance against default, without undue exposure to adverse selection and moral hazard issues, in case of fraud or underwriting.10 In terms of prudential regulations, prudential capital adequacy rules should differentiate low-risk loans collateralized by residential property. In the short or medium term, adjustable rate mortgages should be authorized to further reduce lender risks and reduce credit rates, by reinterpreting the Mortgage Law. 114 Access to Finance and Economic Growth in Egypt

2. Streamlining Property Registration Procedures

A reliable property-registration system is an essential element for any housing finance system. The ability to efficiently register property title and related mortgage deeds is a necessary foundation for collateralized, low-risk mortgage lending. Hence, it is crucial to alleviate existing constraints hindering reliable, easy, and quick registration and transfer of property titles and mortgage liens. This is vital in the new urban communities, and can be accomplished particularly by increasing registered ownership rights through systematic registration processes.11 The Government should continue the implementation of the National Property Registration Reform Program,12 including the recent reduction in property-registration fees to levels that are much more affordable to households desiring to register their properties, while also assuring financial sustainability of the registration and cadastre functions. It is essential to have a centralized, computerized registry that provides transparent and reliable information.

3. Develop EMRC

The Government should develop the recently incorporated EMRC into a well-functioning, financially sustainable, market-based institution. Experience in emerging mortgage-finance systems suggests that second-tier financial institutions should start with basic financial products and narrow mandates in order for them to better manage and control risks in relatively new and untested product markets, and that their operations should be regulated or overseen by an experienced financial-sector regulatory agency. The successes of similar companies were also owed to good financial and judicial fundamentals, extreme care in designing lending and borrowing mechanisms to avoid uncertainties in financial contracts and distortions in the sector, a fair, consistent, and competitive environment for primary lenders, conductive property registration and titling processes, and a reasonably efficient housing market. However, in the intermediate and long-term the Government needs to take the following measures:

4. Transforming the EMRC into a Securitization Company

The Government should transform the EMRC into a securitization company capable of purchasing mortgage loans without full recourse, which will help to further expand the scope and depth of the mortgage market; and/or it may be combined with a mechanism for partial credit insurance in order to help expand household access to mortgage ﬁnance from primary lenders while also providing credit enhancement for bond investors. EXPANDING ACCESS TO FINANCE 115

5. Develop Smarter and Targeted Housing Subsidies

The GSF intends to provide up to three monthly installments in cases of a borrower’s unemployment, but the usefulness of this product may be limited compared to broader guarantee products for future securitization activities. The GSF also needs to adjust and monitor a new program of credit-linked subsidies in order to favor the accessibility of underserved groups, according to housing markets and credit-affordability limits. In this respect, the GSF may require further institution-building and operational support in areas such as targeting, prioritization, distribution, monitoring, and financial structure. Other subsidy programs should be evaluated, including free land and discounted utilities provided to social housing developers, the legacies of former interest rate subsidies, and tax exemptions. Their fiscal impact should be kept under control and market distortions avoided. As subsidies should not distort market finance, the organizational and budgetary functions of the GSF should be separated between market guarantees and subsidies.

F. INCREASING THE FINANCIAL LEASING INDUSTRY’S CONTRIBUTIONS TO ACCESS

The leasing industry continues to face various challenges; however, various policy reforms can boost the leasing sector. Short-term measures include: ■ Ensure that leasing is treated from a regulatory point of view, but in particular from a tax point of view, equally to bank loans. In this context, it will be important to ensure that Leasing Law 95 of 1995 contains a clear, precise definition of leasing that easily allows the differentiation of leasing from any other forms of property hire or rent to prevent potential abuses of tax benefits, yet creates a separate legal notion for leasing. ■ Amend the Leasing Law 95 of 1995 to remove any differentiation based on the type of assets leased. Ensure that operational leasing, in addition to financial leasing, is possible. Remove the necessity in the law to provide for a definition of a leasing agreement in order to ensure a lease-back arrangement. ■ Amend the leasing law to allow leasing for non-commercial purposes; and allow banks to offer financial leasing products without having to establish separate entities. ■ Enhance institutional capacity by upgrading registry procedures for leased assets, while reducing (or eliminating) registration requirements for individual leasing contracts (since mandatory registration of all lease contracts is a burden and serves as a disincentive for parties to enter into leasing contracts). Increase the training of judges in leasing concepts and practices. ■ Encourage a more active role for leasing in firm financing and increase the voice of the leasing industry to the government 116 Access to Finance and Economic Growth in Egypt

authorities. A dedicated regulator and an active organization of leasing companies would allow the leasing industry to have more visibility and attract more clients.

Long-term measures include: ■ Develop a supportive regulatory environment and strong judicial system, which is crucial for the development of the leasing industry. This includes clear rules for assigning property rights, strengthening the information infrastructure, enforcing of foreclosures, and ensuring easy repossession of assets in case of default. ■ Impose accounting standards in compliance with the IAS13 and adherence to AML/CTF standards. This should be done so as not to make the registration process of individual leases more cumbersome. Under a system of proper general regulation, oversight, and market-based monitoring of leasing companies, there is very little need, if any, for the registration of individual leases. ■ Provide leasing ﬁrms with better access to long-term funding sources. Developing the bond market and asset-backed securities market would help in providing long-term funds and extend the average maturity of leasing contracts. Effective implementation of the securitization law is expected to be useful to the sector in this respect. ■ Ensure the transparency and consistency of accounting rules. There is also a need to foster consolidation in the leasing industry and greater scale of operations.14 ■ Improve the dissemination of information on the leasing industry, for which it would be advisable for the Government to collect ofﬁcial statistics on the industry.

G. DEVELOPING THE FACTORING INDUSTRY

To enhance factoring in Egypt, there is a need to:

■ Include information on inter-enterprise credit in the Credit Registry Department at CBE. Since factoring involves the sale of (a portfolio of) receivables, where the credit information on inter- enterprise credit is a major basis for analyzing the creditworthiness of such an asset, it is crucial to give factoring ﬁrms accessibility to information on clients’ creditworthiness, and not just require them to provide such information. ■ Develop an adequate legal mechanism for enforcing the collection of receivables and the legal rights of creditors. While better enforcement is needed in general to enhance ﬁnancial intermediation, this recommendation applies particularly to factoring. EXPANDING ACCESS TO FINANCE 117

H. IMPROVING THE INSTITUTIONAL ENVIRONMENT

Fostering greater access to financial services requires improving the institutional environment that supports financial intermediation. Establishing an enabling institutional environment will allow the emergence of an efficient, increasingly private-led financial system that will provide more access and better serve Egypt’s development and growth objectives. Improving the legal framework, enhancing the credit information system, improving the financial reporting, and modernizing the payments system are crucial. The quality of property rights and their enforcement and the availability of information are especially important for SMEs’ access to financial services, and will increase external financing of small firms significantly more than for large firms.

1. Legal Reforms

Legal reforms to improve the lending environment relate not only to how laws are drafted but, importantly, to how they are being implemented. Legal reform is, therefore, a medium- to long-term process. Policy- makers have in the past often avoided legal reforms because they would only bear fruit after a few years. This has deprived Egypt of the benefits of reforms that, had they begun in the mid-1990s, would have changed the legal landscape of businesses’ experience today. It is paramount for Egypt to focus on such legal reforms now and avoid losing more time. These include legal reforms on secured transactions and bankruptcy and improving the court system. a. Legal reforms on secured transactions The starting point for reform of the law on secured transactions needs to be a full appreciation by policy-makers of the role of collateral in providing finance and the prevailing shortcomings that present major obstacles to access to finance. Such an exercise should entail revisiting the theoretical foundations of the law, its policy objectives, and the substantive and procedural provisions such a law should contain. Reform efforts in Egypt need to take guidance from the successful experiences of emerging economies facing similar legal and economic circumstances. In this regard, the Model Law on Secured Transactions prepared by the European Bank for Reconstruction and Development (as implemented by several Eastern European countries over the past few years) serves as a useful model for policy-makers to consider. The Model Law is not intended as detailed legislation for direct incorporation into local legal systems, and is only intended to form the basis for national legislation. The most interesting feature of the Model Law is that it has departed from most Civil Law concepts that represent a major impediment to taking security, and introduced Common Law concepts 118 Access to Finance and Economic Growth in Egypt

that can facilitate the taking of security, while still providing some safeguards that reﬂectCivil Law traditions. The Model Law introduces non-possessory charge over moveable property in a manner that is consistent with the Civil Law tradition and creates an automated public registry for such charges. It has also permitted taking security over future assets subject to certain registration requirements. The enterprise charge is a new concept introduced by the Model Law; it allows a pool of assets, constituting all or part of the assets of an enterprise to be charged. The enterprise charge allows the charger not only to possess and use the assets, but also to sell the charged assets free of the charge in the ordinary course of business to a purchaser in good faith. While the Model does not abolish public auctions, it permits private sales alongside them. It requires that any form of sale chosen must result in a “fair price”, indicating that the sale is subject to several procedural requirements set out by the Model Law. The Hungarian experience in adopting the Model Law represents a good starting point for reform efforts in Egypt. Reform needs to be comprehensive, though; while the Commercial Code of 1999 introduced some regulations on pledge over shares, it fell short of providing regulations allowing non-possessory charges over moveable property. Legal reforms would have to address the core of the problems facing lenders and aim to provide legal solutions that eliminates such difﬁculties. In so doing, policy-makers should opt for a comprehensive approach, avoiding the piecemeal solutions that have complicated and confused the legal system by creating a duality in applicable rules.

b. Legal reforms on bankruptcy The rules on bankruptcy should be changed to reflect new policy directions and economic developments. It is not merely that minor legislative changes are needed, but rather all bankruptcy rules should be re-conceptualized. The objectives of the law need to be clearly agreed upon among lawyers, economists, bankers and policy- makers. It needs to be clear that the role of bankruptcy provisions is: (i) to provide ailing firms with an orderly means of exit through the liquidation process; (ii) to help reallocate assets to better uses through rehabilitation; and (iii) to ensure a timely resolution of the problems of insolvent or financially distressed firms, and a socially efficient disposition of such firms’ assets. The first two objectives work together: the threat of exit spurs restructuring, and the possibility of restructuring makes exit easier. The process should provide the market with an assurance of a final method for debt collection in the form of a compulsory and collective forum in which the creditors can claim their entitlements. For the debtor the process should provide a route for a fresh start to be taken by viable firms. For the economy at large, the process should on the EXPANDING ACCESS TO FINANCE 119 one hand provide debtors with an incentive as well as a threat, and on the other hand give creditors a guarantee that money lent will be collected either because of the threat of collection or through the actual collection mechanism. Against this background, the existing rules on bankruptcy should be amended to ensure that: (i) there are adequate provisions on corporate bankruptcy; (ii) there is a comprehensive regulation for reorganization; (iii) the process is simplified; and (iv) there is a more proactive role for creditors. The experience of emerging markets in both Latin America and Eastern Europe could be beneficial to Egyptian policy-makers in their reforms. c. Improving the court system At the outset it is important to note that judicial reform is not only of importance to lenders and related to access to finance, but a matter that affects foreign and local investments in the country, as well as having an impact on the lives of the majority of Egyptian citizens. Reforming the judicial system to overcome its difficulties is a long- term process that requires the commitment and the long-term vision of policy-makers. In 1994 the Egyptian Ministry of Justice embarked on such a process by publishing a Report on the Recommended Solutions to Backlog and Delay in the Civil Courts. After a few years of work on the project and engagement in public debate, however, the process seems to have halted, although the backlog and delay remains as a serious problem as it was 12 years ago. While it has to be acknowledged that reform efforts have partially improved the lending environment, yet without comprehensive reforms it would be difficult to envisage real improvements in the legal environment affecting lending. Some specific policy changes to address judicial inefficiencies include: ■ The problem of backlog and delay in the court system cannot be solved without a substantial streamlining of the flow of cases (hundreds of thousands every year), to ensure that the courts entertain only genuine cases, not frivolous ones. Here, the introduction of the Common Law notion of “cost follows event“ can provide useful results, at least in commercial cases. The idea is that if the claimant loses its case (within certain parameters), it should be obliged to pay all the defendant’s actual costs, including the full attorney fee. ■ Moreover, appeal should cease to be “quasi-automatic“ as practiced today and a “leave to appeal” process should be considered. Additionally, judges’ training and rotation, whether as part of the Economic Courts under consideration today or as independents, should be given serious attention. 120 Access to Finance and Economic Growth in Egypt

2. Regulatory and Supervisory System Conductive to Efﬁcient Delivery of Financial Services

The regulatory and supervisory system in Egypt is relatively new and has only been tested in recent years as to its efficacy and efficiency. From the analysis of banking practices and the survey of most banks in Egypt, it is clear that there are a number of areas where the design of regulations and the way in which supervision is being conducted are not yet fully conducive to providing efficient financial services in ways that increase access. Areas where further improvements can be sought include: ■ To address legal uncertainty, the Government can issue a clear statement from the highest level that banks and loan officers will not be subject to criminal prosecution for loans that become non-performing due to non-criminal actions or other external circumstances. To enhance the quality of lending, the Government can issue on a regular basis a list of individuals with the largest NPLs. It can also make the Ministry of Justice’s list of defaulted promissory notes publicly available on request for a fee. ■ The removal of the stamp-duty tax is a very important improvement to lower the costs of financial intermediation, but the Government should also remove any remaining distortions impeding sound financial intermediation. The Government could specifically commission a review of regulatory and supervisory impediments to SME lending, and adopt a time-bound action plans to eliminate or mitigate those impediments. This could include a review of the Corporate Income Tax Law with a view to abolishing any leverage restrictions for interest expenses to be tax deductible. ■ There is a heavy emphasis in Egypt on compliance, rather than risk-based supervision, which is imposing a heavy burden on financial institutions. Furthermore, there are redundancies and inefficiencies in the way supervisory data are being requested and collected. The reporting requirements, especially those initiated during the foreign-currency shortage period, should be reviewed, and the reporting requirements for tax compliance, foreign currency obligation tracking, and other non-banking purposes should be streamlined. Moreover, efforts to collect on-site and off- site supervision reports need to be further streamlined. ■ Banks are experiencing large capacity gaps, with limited qualified bankers and consequently a significant need for training. The Government could further facilitate the build-up of expertise through the enhancement of training programs of, among others, the Egyptian Bankers Association. ■ There is scope to realize the potential for electronic payments to substantially reduce transaction costs and support higher volumes of low-value transactions. This will require ensuring that access objectives are fully considered in ongoing payments-system reforms, including ensuring effective interfaces between payments systems and credit-reporting operators. EXPANDING ACCESS TO FINANCE 121

3. Credit Information System

In order to enhance access to finance, it is essential to improve the quality and credibility of the credit-information system. In that respect it is crucial to move forward with a private credit bureau. It is important to encourage this private credit bureau to set up its own credit-information database of bank and non-bank financial institutions, as well as to combine the data of the public and private credit bureau. This combined database would be available to qualified users, both banks and non-bank financial institutions. This would mean a copy of the public credit registry information would be privatized as part of the consolidation of the two databases. As an alternative there could be an interface that would link the public credit registry and private credit bureau. The public credit registry would continue to exist to meet its legal mandate. When the private credit bureau is close to operational, a decision would be made as to whether the public credit-registry information would be combined with the private credit bureau or an interface built to link private credit bureau with the central bank’s public credit registry database. It is essential to continue the expansion of the public credit registry at CBE, as the current credit marketplace is focused on aggressive growth in the retail credit sector and needs additional credit information to support this growth. Were the CBE to wait for the newly established private credit bureau to be fully operational, and continue to delay adding credits to the public credit registry database, which they have done since August 2005, there would be a further one-year gap where significant credit and demographic data would not be available to banks as they entertain retail credit applications. There is no reason for this to occur given that the CBE’s credit registry has the capacity, expertise, links and ability to handle the expansion that immediately serves the banking sector and would underpin this growth. In terms of the amount, quality, and reliability of the information provided, data collections need to identify the manner of payment— the length of the outstanding loans, the history of loan balances and repayments, and any changes in the terms of the loan. These additional data will help to identify cases of rescheduling and rolling over of loans, which is a significant problem in Egypt. It is also important for creditors in evaluating their potential clients to have the information on individual loans—the origination date, maturity, type, and value of collateral. Introducing a standard credit-report format, along with a unified credit-scoring methodology by the credit registry, is necessary for financial intermediaries; currently each bank uses its own methodology, which they do not report to the registry department. Moreover, it was recommended to the central bank that they should introduce charges for both successful and unsuccessful searches of the registry database, as reflection of best practice. In July 2005, they chose not to charge for either type of search. It was recommended to impose stricter penalties on misreporting and improving the enforcement of such penalties to prevent malpractice 122 Access to Finance and Economic Growth in Egypt

and ensure good-quality credit information. This recommendation has been accepted and should be implemented in early 2007. It will also be important to foster more types of institutions providing general and borrower-speciﬁc information.

4. Financial Reporting Environment15

Recommended key strategic government policies center on the drafting and phasing-in of the legal and regulatory framework, strengthening the institutional design, issuing the relevant operating procedures, and focusing on education and training. They can be summarized as follows: ■ Advance the new draft accountancy profession law to strengthen the regulatory framework and restore users’ confidence. This would require the introduction of professional qualifying examinations for accountants, the recognition of accounting firms as providers of statutory audit services, and the establishment of an oversight body (higher council for accounting and auditing). Other elements to be incorporated in the law include mandating continuous professional education, ensuring independence of the proposed accounting and auditing oversight body, setting the rules of confidentiality of information between the auditor and the oversight body, and defining the oversight body’s power and authority with regards to enforcement and disciplinary actions.16 ■ Ensure that the Egyptian Accounting and Auditing Standards are in consistent alignment with the International Standards to ensure local and international recognition of the reliability of financial statements. A permanent committee should be entrusted with updating the Egyptian standards on a regular basis, and keeping pace with the issuance of new and revised international standards. Investment in the update of the standards and their dissemination and enforcement is also crucial if their application is to be secured and maintained.17 ■ Enforce the tools available to strengthen the audit profession and ensure auditors’ empowerment, independence, and professionalism. This can be achieved through corporate governance mechanisms, such as audit committees, to improve auditors’ empowerment and independence and to protect auditors against possible management abuse of power. The recommended oversight body should enforce independent practice reviews to ensure auditors’ compliance with quality-control requirements, and should also have the authority to investigate possible violations and impose sanctions. ■ Modernize the university accounting education curricula to graduate accountants with better exposure to International Accounting Standards and International Standards on Auditing. Also encourage investment in continuous professional training in order to keep abreast of changes and developments in the field of accounting and auditing. EXPANDING ACCESS TO FINANCE 123

5. The Payments System

In order to enhance the security, integrity, and efﬁciency of the payments system, the CBE has already embarked on an ambitious National Payments System Reform Program.18 This program includes improvements in the legal framework, the full integration of all systems, the introduction of new payment instruments, and the establishment of an oversight function for payments and securities settlement systems. As part of this program, expanded access, lower production and distribution costs, reduced risks, and market innovations can be promoted and facilitated by ensuring a fully electronic payment-instrument capability nationwide for all types of transactions, including via Egypt Post. This would involve migrating from current paper-based instruments, ensuring widespread availability of new instruments (such as credit transfers and direct debits), and ensuring the full interoperability of payment-card and ATM networks. It also involves ensuring effective interrelations between payment systems and operators of credit-reporting systems. This would enable, for example, the inclusion in the credit information infrastructure of so-called “positive credit/payment information” such as utilities payments via direct debit, enabling potential borrowers to build up reputational collateral.

Speciﬁc actions to achieve increased access and efﬁciency include:

■ Enhancing the efficiency and soundness of retail payments systems, and supporting the offering of a wide range of payments instruments and services. The CBE should continue to play a leading role in retail systems, with the overall objective of providing the Egyptian economy, either as operator or acting as catalyst for change, a broad range of safe and efficient payment services. Examples include plans by the CBE to offer ACH-like payment and collection services to banks, the Treasury and others, and its January 1, 2006 launch of a direct credit service. Infrastructure and services in this area will have to be designed in such a manner that the use of cheques is reduced, contributing to a move to fully electronic credit instruments. ■ Integrating government collections and disbursements with the National Payments System (NPS), and supporting the system’s smooth functioning. As demonstrated by experiences in many countries, significant efficiency gains and reductions in costs of government payments and collections can be obtained by payments system reforms, and investment costs can be recovered in a very short time. The current system for government payments and collections in Egypt should be reformed and upgraded to ensure that benefits of payments reform accrue to all segments in the country. The CBE should take advantage of the initiatives of the 124 Access to Finance and Economic Growth in Egypt

Ministry of Finance and other governmental bodies to distribute employee payrolls and other benefits through bank accounts and payment cards, and to automate the payment of other government services. In particular, the CBE should make sure that an appropriate system to handle a large number of transactions of relatively small value seamlessly is in place to further enlarge the impact of these initiatives on overall system efficiency. The CBE should also continue to work with the Ministry of Finance so that relevant projects in this area-such as the Treasury Single Account-materialize as quickly as possible. ■ Rapidly and conveniently distributing remittances and other cross-border payments within Egypt, and ensuring efficiency from the perspective of the cost for users at both ends. International remittances and cross-border payments of corporations are increasingly relevant for Egypt due to net migration outflows and commercial and financial integration with other countries in the region. The CBE, considering the generally poor performance of payment-services providers in international remittances, should address this issue as part of its payments-system oversight activities. A major goal would be to promote the most efficient use of the current infrastructure in the country, including that of banking and non-banking financial institutions. The CBE should strive for the regulatory perspective to be widened from the traditional issues of balance of payments and money laundering to include payments-system issues, particularly issues related to efficiency, transparency, and risks. Eventually, in coordination with other authorities, it should decide on whether new regulations are necessary. In particular, the CBE should implement the framework defined by the CPSS-World Bank General Principles for International Remittance Services. ■ Clearly defining the payments system oversight framework, ensuring that the CBE is able to exercise effectively its oversight authority. The CBE should promote competition in the payment- services market and the protection of consumer interests in coordination with other regulators. The CBE should pay attention to both systemically important and retail systems, since the latter are especially important in supporting economic activity and the public trust in money. ■ It is crucial that CBE develop a long-term strategy for the payments system and to discuss it with all stakeholders.19 The strategy should have the following sequencing: (i) diagnostic, stocktaking, situational analysis; (ii) vision development; (iii) conceptual design and implementation planning; (iv) user requirement specifications; and (v) acquisition, procurement development, testing, and implementation. Furthermore, important issues to be decided when launching a payments (and securities) settlement reform are scope, approach, degree of sophistication and selection of innovative products and technology, number of systems, system operator, ownership of the system, and timeframe. Coordination EXPANDING ACCESS TO FINANCE 125

with stakeholders on the scope and objectives of the reform effort is essential, as has been recently formalized with the re- establishment of the National Payments Council, and the high- level Supreme Committee of the National Payments Council.20 It is also important for CBE to put in place an effective organizational arrangement, which includes the strengthening of a Payments System Department with appropriate resources and powers to perform the role of payments-system operator and overseer.

6. Promoting Competition in the Financial Sector

The authorities should continue to promote competition in the financial sector. The impact of enhancing competition in financial systems can be observed in several dimensions. In terms of development and efficiency, competition leads to lower margins and lower costs of financial intermediation-lower cost of capital for borrowers and higher rates of return on investment for lenders, spurring growth. Competition not only leads to improved efficiency and lower cost, but provides incentives for institutions and markets to innovate. In terms of market development, competition can be beneficial for liquidity and help develop sustainable local markets. On the institutional side, competition can lead to better- quality local rules and greater enforcement. A basic foundation for competition is proper entry and exit policies to ensure contestable markets.21 There should not be unreasonable barriers to those who have the capital and expertise to enter the financial services business in Egypt. Cross-country evidence suggests that foreign bank ownership is the most consistent factor associated with improved banking-system competitiveness, with positive effects on costs and on the quality of financial intermediation.22 For Egypt, entry of foreign banks-starting with the privatization of Bank of Alexandria-can also lead to more access, indirectly by driving local banks to provide more access and directly by enabling foreign banks to provide credit. Entry of foreign banks can also result in the emergence of new and more diverse products, greater use of technologies, and spillovers of expertise. It also puts pressure on the authorities to improve regulation and supervision and increase transparency.23 In terms of exit, the Government should evaluate carefully the position of the state-owned banks. As new competitors enter the market or existing private commercial banks decide to compete more aggressively, the franchise value of existing banks will diminish, creating risks. The Government should also continue the institutional restructuring of the state-owned banks and non-bank financial institutions that are likely to remain in public hands for some time to support a competitive market. Furthermore, the authorities need to evaluate the current very high minimum capital requirements for obtaining a banking (deposit-taking) license. The current requirements may well preclude specialized niche players from entering the market. Such niche players can be important sources of innovation, making vital 126 Access to Finance and Economic Growth in Egypt

contributions to increasing competition. This could be particularly relevant to high-quality microfinance institutions operating in Egypt today. The authorities should be amenable to the conversion of these lenders to regulated deposit-takers. This would require either reducing the minimum capital requirement for banks or creating a separate regime.24 Barriers to entry can further arise due to lack of access to essential services, such as payments systems, credit information arrangements, and a telecommunications regulatory and legal framework; ensuring that all these services are available should be incorporated into reforms. A second basic foundation is to ensure a fair, consistent, and competitive environment for each financial service and between similar types of financial services across all type of providers. Ensuring a level playing field among public, private, and foreign banks is crucial. This entails avoiding differences in the regulatory treatment of similar types of financial services. While it is sometimes difficult to ensure a such an environment-especially in terms of capital requirement for branches of foreign banks versus local banks, tax treatments between pension and dividend-on-return saving deposits, and information disclosure requirements for the capital market versus the insurance sector-this should nevertheless be the goal. This includes adopting policies and procedures to identify evidence of price-fixing or manipulation in any segment of the financial services industry, and for taking action to remedy it. It could also include allowing partnerships among banks and non-banks to promote, for example, alternative distribution platforms, including commercial bank wholesale lending to NGOs, and ensuring there are no unreasonable legal, regulatory or supervisory impediments.25

CONCLUDING REMARKS

The institutional infrastructure in Egypt is coming into place for more efficient financial intermediation. Regulatory gaps are being filled, and new institutions are being created. The overall direction is promising, but deeper institution-building, especially in the judicial area, is still ahead; it will take much more time to facilitate easy access to financial services. The speedy completion of the Financial Sector Reform Program and the restructuring of state-owned financial institutions are essential to enhance access to financial services. Equally important is improving the quality of the institutional environment. Ultimately, the combination of financial restructuring and institutional reform will make Egypt’s financial sector more developed and efficient, leading it to provide better- quality financial products and services, exhibiting a lower cost of financial intermediation, and being more competitive. EXPANDING ACCESS TO FINANCE 127

Notes

1 With respect to election of board members, enhancements to the arrangements suggested here would be to adopt a formal process for the skills-based selection of board members, and even perhaps to form an independent, professional commission that identifies and screens board members of state banks. New Zealand offers an example, where a Cabinet-approved process must be used for the appointment of all directors of SOEs, and where the semi-independent Crown Company Monitoring Advisory Unit (CCMAU) functions as a contracted advisor to Ministers responsible for SOEs. Key CCMAU tasks include: identification and pre-screening of potential candidates; assessing (in collaboration with company chairs and responsible Ministers) future skill requirements for board vacancies and preparing a position specification; matching candidates with skill requirements; and submitting qualified candidates to the Ministers. Once Ministers identify their preferred candidate, CCMAU and the chair undertake a due-diligence process that further assesses the candidate’s suitability and identifies and evaluates any conflicts of interests. The Ministers make the final decision, either selecting the preferred candidate or requesting that other candidates be identified. By convention, the Ministers’ selection is reviewed by the Cabinet prior to final decision. Ministers are required to certify that they have followed the Cabinet- approved appointment process and have appointed the best-qualified candidate, and that there are no unmanageable conflict-of-interest issues in the appointment. 2 In addition, the General Assemblies of public banks would no longer include representatives of private banks. As noted, several members the General Assemblies currently serve as chairmen of other banks, and thus have conflicts of interest in their capacity as representatives of the Government in the governance of the public banks. 3 Some banks, such as NDB, have already begun to do so. 4 The Egyptian Government has accelerated its reform efforts in the capital market since early 2005. The main thrusts include: (i) establishing the investment protection fund; (ii) launching training programs for the code of corporate governance in the Institute of Directors; (iii) training securities-industry and CMA staff; (iv) revising law 92 of 1995 for securitization; and (v) broadcasting investor education programs on national television. 5 Although the US Trust Indenture Act does not require the association of bondholders, eventual substitution for the bondholder association system should be made at the time its legal feasibility is fully reviewed in parallel with the implementation of the unified company act. 6 The survey was completed by 20 insurers, effectively representing 100 percent of the sector. 7 A project to determine required legislative changes could be required. 8 At the time of writing, the banking system was running a substantial liquidity surplus approaching US$80 million; some of this could be profitably diverted to longer- term intermediation. 9 The three largest insurers had 1,203 accredited agents in Cairo, 217 in Alexandria, and 718 in the rest of Egypt. The other agency-based insurers, with the exception of Suez Canal and Delta, are largely confined to the Cairo/ Alexandria axis. CIL and Allianz have 186 bank-based representatives, almost all of whom are in Cairo and Alexandria. 10 Direct insurance against non-enforcement of the contract faces similar problems. Setting up large government-sponsored institutions would not be advisable because the adverse selection problems could be huge if there is lack of data and experience. Moreover, the capacity to regulate such institutions is limited. 128 Access to Finance and Economic Growth in Egypt

11 In order to simplify, streamline, and expedite the processes of residential property registration in the new urban communities, the Government needs to put in place policies and procedures to: (i) enable titles to houses and apartments to be registered without first requiring the registration of title to the underlying land; (ii) treat land plots in apartment development projects as subdivided property units, title to which can be registered regardless of the status of other land plots in the project; (iii) enable titles to be delivered to home buyers with associated land parcels subject either to a mortgage securing payment of the land purchase price, or else in exchange for a guarantee of payment or performance from a financial institution; and (iv) place a contractual burden on apartment developers to assure that titles to apartments can be delivered to purchasers upon completion of a building. 12 This should be done through systematic title adjudication, survey and registration processes, and changing the property registration system in urban areas from a deeds- recordation system to a more efficient title-registration system. The reform program includes a major focus on the new urban communities, which are expected to be an important source of demand for mortgage finance. 13 Previously the accounting treatment of financial leases was not in line with IAS, which allowed lessees to keep the leased asset off-balance sheet and therefore get the benefit of depreciation allowance and improve their performance ratios, underestimating the extent of their liabilities. 14 Before the 2001 legislation, there was no limitation on entry to the leasing industry: any company could register to obtain a leasing license. Although the executive regulation imposed a limit of LE 500,000, it should be raised further to reduce the number of “one-contract” companies, and prevent new ones from entering the market. Leasing companies that are not active should be closed after two years of inactivity. 15 These recommendations are based on analysis of the current status and the developments since the conference on Enhancing Financial Reporting in Egypt that was held in Cairo on April 2005; this conference discussed some action steps for improving the financial-reporting regime. 16 Detailed World Bank comments on the draft law were shared with the Ministry of Investment and the Ministry of Finance in January 2006. 17 As a temporary arrangement, until an oversight body is established under the new draft accounting law, CMA has undertaken the role of preparation and update of the Egyptian Accounting Standards and is planning to do the same for the auditing standards. The World Bank has provided some feedback to CMA on the completeness of the initiative; the need to ensure that differences from International Standards are clearly disclosed; and the importance of the consistent update of the published standards. An option could be to later reinstate the current standards committee under the proposed oversight body. 18 For details see the World Bank documents Payments and Securities Clearance and Settlement Systems in Egypt, Vision of the Future National Payments System for Egypt, and Implementation Plan for Reforming the National Payments Systems in Egypt. 19 The World Bank Payments System Team has already delivered (in April 2006) a draft vision document on the National Payments System in Egypt to the CBE. 20 Stakeholders include the central bank, the securities regulator, the Ministry of Finance, the Egyptian Bankers’ Association, commercial banks, non-bank financial institutions, clearinghouses and payment service providers, the stock exchange, the Central Securities Depository(s), broker/dealers, end-users, and other regulators. EXPANDING ACCESS TO FINANCE 129

21 In Egypt’s current circumstances, an important objective in this regard is that SOE arrearages be cleared on a fair and equal basis among all banks. 22 Claessens and Leaven (2004). 23 Although entry of foreign banks has a positive impact on stability, there are various risks associated with it; for example, the risk of introducing new technologies and new financial instruments prematurely, and the risk of capital flight by banks that have access to international financialmarkets. Achievingmaximum gains from entry requires harmonization of regulations and legal and other institutional infrastructure. 24 This would require an assessment of the pros and cons of adopting an additional lower minimum capital, deposit-taking license regime. 25 Some market participants indicate that a revision of NGO Law 84 is required in this regard. 130 Access to Finance and Economic Growth in Egypt

ANNEXES

ANNEX 1: INDICATORS FOR ASSESSING THE SOUNDNESS AND PERFORMANCE OF THE BANKING SYSTEM

Table A1.1: Banking System Credit and Deposits (LE billion)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Total Credit 107 129 152 179 204 227 241 260 284 303 316 324 Government 17 18 16 13 12 12 13 14 13 18 21 21 Public Enterprises 25 28 32 29 31 32 29 32 30 38 42 33 Private Enterprises 50 65 83 105 132 151 165 178 190 207 205 214 Households 13 16 20 30 26 29 31 32 32 39 46 53

Total Deposits 157 175 201 216 237 260 290 319 403 494 540 569 Government 21 27 29 32 32 38 42 46 67 84 83 77 Public Enterprises 17 18 20 17 16 15 16 15 17 19 23 26 Private Enterprises 20 23 32 36 43 45 46 48 55 63 64 81 Households 96 105 118 129 144 161 186 198 264 319 353 380 Source: CBE, Annual Reports (various issues).

Table A1.2: Ownership Structure of the Banking System

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Number of Banks Public Commercial Banks 4 4 4 4 4 4 4 4 4 4 4 4 Specialized Public Banks 4 4 4 4 4 4 3 3 3 3 3 3 Established Banks within the framework of the investment - - - - - 35 35 35 35 34 30 29 law or special laws Branches of Foreign Banks 21 21 21 20 20 20 12 11 10 10 8 7 Number of Branches Public Commercial Banks 851 866 883 908 918 913 921 919 918 924 942 975 Specialized Public Banks 993 1,002 1,012 1,031 1,043 1,069 208 208 209 211 211 211 Established Banks within the framework of the investment - - - - - 452 495 514 536 574 614 674 law or special laws Branches of Foreign Banks 38 41 42 42 45 47 41 47 48 49 45 48 Source: CBE, Annual Reports (various issues).

Table A1.3: Banking System Distribution of Assets, Loans and Deposits (in percent) ASSETS 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 57.83 56.69 55.71 54.04 52.78 61.37 60.34 60.47 59.52 59.96 60.81 58.48 Private Banks* 36.32 37.75 38.43 39.93 40.75 38.63 39.66 39.53 40.48 40.04 39.19 41.52 LOANS Public Commercial Banks 50.57 53.23 53.07 50.04 46.99 56.58 54.47 51.58 47.85 45.14 43.21 44.38 Private Banks 38.44 36.73 37.12 39.66 42.47 56.34 54.21 51.54 46.85 43.27 40.57 39.97 DEPOSITS Public Commercial Banks 67.47 65.31 63.51 62.16 60.08 67.19 66.98 68.48 69.44 71.47 71.76 76.32 Private Banks 30.05 31.82 33.14 34.57 35.98 67.15 66.93 69.45 73.01 73.99 72.39 72.40 * Private banks include commercial banks, joint ventures, and branches of foreign banks. IntroductionAnnexes 131

Table A1.4: Number of Banking Units and Density for Selected Years per Governorate

End of June 1990 End of June 1995 End of June 2003 No. of No. of No. of Population Banking Population Banking Population Banking Governorate banking banking banking (million) density** (million) density (million) density units* units units Cairo 6.4 285 0.45 7.2 373 0.52 7.4 439 0.59 Alexandria 3.2 115 0.36 3.7 137 0.37 3.6 155 0.43 Port-Said 0.5 26 0.52 0.5 32 0.64 0.5 35 0.70 Suez 0.4 17 0.43 0.4 22 0.55 0.4 20 0.50 Ismailia 0.6 29 0.48 0.6 34 0.57 0.8 46 0.58 Beheira 3.6 124 0.34 4.1 122 0.30 4.4 126 0.29 Damietta 0.8 34 0.43 1.8 42 0.23 1.0 49 0.49 Kafr El Sheikh 2.0 79 0.40 2.1 83 0.40 2.4 91 0.38 Gharbieh 3.1 107 0.35 3.6 112 0.31 3.7 114 0.31 Dakahlia 3.8 123 0.32 4.3 132 0.31 4.6 141 0.31 El Sharkia 3.8 139 0.37 4.3 150 0.35 4.7 165 0.35 El Monouﬁah 2.4 74 0.31 2.6 82 0.32 3.0 89 0.30 Qaliubiya 2.9 76 0.26 3.2 83 0.26 3.6 85 0.24 Giza 4.3 115 0.27 4.6 159 0.35 5.2 203 0.39 Fayoum 1.7 51 0.30 1.8 63 0.35 2.2 67 0.30 Beni Souef 1.6 53 0.33 1.7 56 0.33 2.1 62 0.30 Menia 2.9 109 0.38 3.4 116 0.34 3.6 119 0.33 Assiout 2.4 82 0.34 2.9 86 0.30 3.1 103 0.33 Sohag 2.7 96 0.36 3.1 98 0.32 3.4 105 0.31 Kena 2.5 88 0.35 3.0 104 0.35 3.1 109 0.35 Aswan 0.9 38 0.42 0.9 48 0.53 1.1 53 0.48 Red Sea 0.1 10 1.00 0.1 22 2.20 0.2 25 1.25 El Wadi El Gedid 0.1 14 1.40 0.1 16 1.60 0.1 8 0.80 Matrouh 0.2 7 0.35 0.2 6 0.30 0.2 7 0.35 North & South 0.2 35 1.75 0.3 45 1.50 0.3 48 1.60 Sinai Total 53.1 1,926 0.36 59.5 2,223 0.37 64.6 2,464 0.38 * Including the head ofﬁce and branches. ** Ten thousand individual per banking unit. Source : Compiled by the author from Central Bank of Egypt, Economic Bulletin, and Central Agency for Public Mobilization and Statistical (CAPMAS), Yearbooks, (various issues).

Table A1.5: Equity-to-Assets Ratio (non-risk weighted) (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 3.36 3.22 2.94 3.75 3.94 3.91 3.63 3.47 4.53 4.31 3.85 4.00 Private Banks 6.38 6.33 6.48 6.97 7.00 7.26 6.70 6.71 6.00 5.97 6.77 7.36 Banking System - - - - - 5.20 4.85 4.75 5.12 4.98 5.00 5.39

Table A1.6: Private Sector Loans-to-Loans (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 14.24 17.31 19.51 24.87 32.52 34.9 32.2 36.40 36.70 35.50 36.30 34.70 Private Banks 32.08 36.83 40.8 44.01 46.60 33.00 36.40 32.60 33.10 30.80 31.60 31.50 Banking System - - - - - 67.90 68.60 69.00 69.80 65.30 67.90 66.20 132 Access to Finance and Economic Growth in Egypt

Table A1.7: Household Sector Loans-to-Assets (in percent) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 3.08 3.58 3.66 4.00 4.79 5.40 4.80 4.70 4.00 4.00 4.20 4.80 Private Banks 4.77 4.62 5.19 10.90 5.15 2.00 1.90 1.90 1.40 1.70 1.90 2.20 Banking System - - - - - 7.40 6.70 6.60 5.40 5.70 6.10 7.00

Table A1.8: Government Sector Loans-to-Loans (in percent) 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 4.00 4.10 3.80 3.00 4.20 5.80 5.50 Private Banks 1.40 1.50 1.50 1.40 1.40 1.10 1.00 Banking System 5.40 5.60 5.30 4.60 5.60 6.90 6.50

Table A1.9: State-Owned Enterprises Loans-to-Loans (in percent) 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 18.28 18.03 18.08 18.35 18.58 19.24 15.23 Private Banks 3.58 3.25 3.28 3.37 3.18 3.06 2.01 Banking System 12.62 12.18 12.23 12.36 12.57 13.14 10.07

Table A1.10: Indicators of Public Enterprises Financial Performance (In billion of Egyptian pounds, unless otherwise speciﬁed)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Operating revenues 55.45 55.08 58.94 46.57 33.84 32.98 32.64 29.61 34.35 39.91 43.3 Other revenues 7.48 4.3 NA NA NA NA 5.19 3.85 3.4 1.6 NA Wages and salaries 5.79 6.07 6.03 4.13 4.89 NA NA NA 4.68 5.16 NA Earnings before interest & tax 9.06 9.8 6.7 5.69 7.15 4.57 2.5 2.9 2.44 3.6 NA Interest 4.07 4.14 4.13 NA NA NA 2.95 2.6 3.2 3.4 3.8 Profits of profitable companies* 3.56 3.94 4.34 3.73 3.68 3.15 2.34 2.23 2.32 2.76 3.7 Losses of losing companies -2.45 -3.29 -2.51 -2.08 -1.6 -1.9 -2.7 -2.3 -3.59 -2.76 -2.7 Net profits 1.11 0.65 1.55 1.66 3.54 NA NA NA -1.27 0.9 1 Net profit margin (%) 2.1 1.2 4.3 5.4 8.1 NA NA NA NA NA NA Return on investment (%) 1.26 0.72 1.63 3.09 3.29 NA NA NA NA NA NA No. of profitable companies 202 184 180 165 168 150 116 117 113 118 106 No. of losing companies 88 92 82 59 41 50 62 62 61 57 64 No. of Co. left under Law 203 290 276 262 224 209 200 178 179 174 175 170 Carried loss balances** -9.76 -12 -13.28 -15.36 -10.28 NA NA NA -19.8 -22.03 NA Net assets 88.28 90.27 94.86 53.57 63.1 62.1 60.4 62.5 56.07 66.83 67.6 Total debt 70.4 74.88 74.37 NA NA NA 27.92 24.94 29.52 28.65 NA Net equity 10.14 8.59 12.02 NA NA NA NA NA -1.2 -2.2 -4.08 * Profitable companies are those which achieve a return on sales of 10 percent or more. ** It should be noted that even in cases where a profitable company has an outstanding historical balance of carried losses, and is at present making profits it tends to allocate only a very small percentage of its profit to reducing its loss balance. Source: Compiled by the author from the Public Enterprise Office. It should be noted that these are figures for companies under Law 203 and that this base number is decreasing with time, and hence comparing figures may be somewhat misleading. IntroductionAnnexes 133

Table A1.11: Loans-to-Assets Ratio (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 42.30 47.00 46.66 46.58 53.10 56.58 54.47 51.58 47.85 45.14 43.21 44.38 Private Banks 43.84 47.66 50.04 60.08 59.09 56.34 54.21 51.54 46.85 43.27 40.57 39.97 Banking System 42.68 46.61 47.52 51.25 54.25 56.49 54.36 51.57 47.44 44.39 42.17 42.55

Table A1.12: Loans-to-Equity Ratios (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 1258 1461 1586 1241 1347 1446 1500 1484 1057 1046 1121 1110 Private Banks 608 630 613 911 782 776 809 768 781 724 599 543 Banking System 1297 1441 1594 1189 1268 1085 1121 1085 926 892 844 789

Table A1.13: Number of Projects Approved and Cases of Bankruptcy

1995 1996 1997 1998 1999 2000 2001 2002 2003 No. of Bankrupt Co. 17 18 21 25 27 47 27 22 26 No. of Newly Approved Co. 1,416 1,835 3,027 4,156 3,893 3,258 2,772 2,286 2150 Source: General Authority for Investment (GAFI).

Table A1.14: Liquidity Ratio (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Sector Banks 48.28 44.18 44.89 44.15 37.42 28.21 30.86 34.18 40.48 42.24 42.08 45.42 Private Banks 47.08 43.69 41.79 37.07 32.59 35.81 36.95 40.18 44.87 48.21 48.73 47.43 Banking System 47.83 43.99 43.65 41.26 35.42 31.15 33.27 36.56 42.26 44.63 44.68 46.25 * Liquidity Ratio is the ratio of liquid assets (cash, Inter Bank claims of any maturity, government bonds & treasury bills) to total assets.

Table A1.15: Loans-to-Deposits Ratio (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Public Commercial Banks 55.51 61.58 61.08 62.29 70.03 84.22 81.32 75.32 68.90 63.16 60.22 58.15 Private Banks 78.6 82.5 87.0 103.6 96.4 83.91 80.99 74.21 64.17 58.48 56.03 55.20 Banking System 66.2 71.3 73.5 79.9 82.4 84.10 81.19 74.88 66.93 61.25 58.57 56.97 134 Access to Finance and Economic Growth in Egypt

Table A1.16: Rate of Growth of Deposits (in percent) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Public Commercial Banks 8.85 8.62 12.26 4.32 5.77 8.55 12.79 12.09 18.34 15.14 11.85 3.86

Private Banks 30.82 22.34 23.91 19.40 18.57 20.59 17.76 13.14 27.62 11.32 5.22 7.54

Banking System 21.2 21.21 17.86 18.67 13.94 12.07 14.71 12.51 22.04 13.55 9.14 5.31

Table A1.17: Rate of Growth of Loans (in percent)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Public Commercial Banks 16.41 20.49 11.36 6.40 18.90 16.29 6.02 9.36 7.34 6.42 6.98 Private Banks 27.55 22.08 26.20 33.69 6.67 5.44 6.18 11.47 6.43 1.44 0.82 Branches of Foreign Banks - - - - - 4.83 13.63 -0.70 19.63 7.65 -15.19 Banking System 20.85 20.82 18.12 18.2 13.49 6.53 10.74 3.77 9.08 3.91 4.37

Table A1.18: Central Bank Credit to Banks-to-Liabilities (in percent)

2000 2001 2002 2003 2004 2005 2006

Public Commercial Banks 2.28 2.12 1.82 1.54 1.27 1.57 1.29

Private Banks 3.15 2.57 2.25 1.80 1.55 3.61 1.47

Branches of Foreign Banks 2.64 2.30 1.99 1.64 1.38 1.37 1.36

Table A1.19: Banks’ Liabilities to Foreign Correspondents-to-Total Liabilities (in percent)

2000 2001 2002 2003 2004 2005

Public Commercial Banks 2.4 2.8 2.7 2.4 1.5 1

Private Banks 2.5 2.3 1.7 1.5 1.7 2

Branches of Foreign Banks 10.8 7.9 5.6 4.6 5.5 4.3 IntroductionAnnexes 135

ANNEX 2: INDICATORS FOR ASSESSING THE CAPITAL MARKET

Table A2.1: Capital Market Jan-Aug Ofﬁcial list 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 No. of companies 521 112 107 124 139 141 147 153 101 129 139 142 Nominal value (LE billion) 3.0 3.9 4.5 8.1 8.9 10.6 11.0 NA 46.74 50.27 53.23 60.74 Market capitalization (LE billion) 73.8 77.9 57.5 38.0 31.5 24.0 20.3 NA 95.18 163.95 318 378.89 Value traded (LE billion) 2.1 6.1 13.6 9.0 10.0 8.8 4.8 NA 14.44 29.27 83.62 168.95 Turnover % (end-year) 2.8 7.8 23.7 23.7 31.7 36.7 23.6 NA 15.17 17.85 26.32 44.59 Others No. of companies 225 530 543 710 881 935 963 971 877 666 622 499 Nominal value (LE billion) 7.4 9.8 13.8 22.5 38.2 65.2 72.0 NA 51.99 50.04 51.64 50.60 Market capitalization (LE billion) 53.8 101.3 311.4 298.1 245.4 94.9 64.1 NA 76.75 69.95 77 82.55 Value traded (LE billion) 1.4 2.3 5.7 7.9 20.9 31.1 11.8 NA 5.29 4.03 17.81 9.01 Turnover % (end-year) 2.6 2.3 1.8 2.7 8.5 32.8 28.4 NA 6.89 5.76 23.23 10.91 Total equities No. of companies 746 642 650 834 1020 1076 1110 1151 978 795 744 641 Nominal value (LE billion) 10.4 13.7 18.3 30.6 47.1 75.8 83.0 92.08 98.73 100.31 105.34 111.34 Market capitalization (LE billion) 127.6 179.2 368.9 336.1 276.9 118.9 112.3 122.4 171.92 233.9 456.27 461.44 Value traded (LE billion) 3.5 8.4 19.3 16.9 30.9 39.9 16.6 11.5 19.72 33.3 138.15 177.96 Turnover % (end-year) 2.7 4.9 5.2 5.0 11.2 33.6 21.97 21.14 11.47 14.24 30.27 38.56

Table A2.2: Traded Bonds

Government bonds 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 No. of bonds - - - 23.0 25.0 27.0 28.0 26.0 26.0 31.0 35.0 39.0 Nominal value (LE billion) 3.5 3.8 8.0 8.2 11.1 13.1 13.1 13.1 9.1 22.1 43.6 58.1 Market capitalization (LE billion) - - - 8.6 10.5 13.2 13.6 14.4 10.6 23.7 45.92 60.23 Value traded (LE billion) 0.1 0.3 0.2 0.7 2.1 2.8 7.9 13.52 3.04 2.79 8.69 7.86 Turnover % (end-year) - - - 8.2 20.0 21.2 53.7 93.9 28.7 11.8 18.9 13.0 Development bonds No. of bonds - - - 94.0 89.0 102.0 108.0 107.0 107.0 102.0 98.0 97.0 Nominal value (LE billion) 0.0 0.4 1.8 1.0 1.0 1.2 1.10 1.09 1.44 1.36 0.74 0.52 Market capitalization (LE billion) - - - 0.9 1.0 1.1 1.3 NA 0.05 0.04 0.03 NA Value traded (LE billion) 0.02 0.01 0.01 0.00 0.00 0.002 0.36 0.05 0.00 0.00 0.00 0.00 Turnover % (end-year) - - - 0.1 0.01 1.82 3.0 NA 0.04 0.19 0.00 0.00 Corporate bonds No. of bonds - - - 19.0 27.0 32.0 29.0 28.0 26.0 25.0 23.0 21.0 Nominal value (LE billion) 0.0 0.1 0.1 2.3 1.9 5.2 5.1 5.68 5.52 5.28 7.35 6.77 Market capitalization (LE billion) - - - 2.5 3.9 4.8 4.6 5.6 5.4 5.3 6.47 5.84 Value traded (LE billion) 0.00 0.05 0.13 0.4 0.2 0.3 0.4 0.65 0.23 0.05 0.16 0.18 Turnover % (end-year) - - - 4.1 5.1 6.3 8.7 11.6 4.3 0.94 2.47 3.08 Total bonds No. of bonds - - - 136.0 141.0 161.0 165.0 161.0 159.0 158.0 159.0 157.0 Nominal value (LE billion) 3.5 4.3 9.9 11.5 14.0 19.5 19.3 19.9 16.1 28.7 51.7 65.4 Market capitalization (LE billion) - - - 12.07 15.4 19.2 19.7 NA 16.05 29.04 46.23 Value traded (LE billion) 0.09 0.38 0.33 1.10 2.30 3.10 8.06 14.22 3.27 2.84 8.85 8.04 Turnover % (end-year) - - - 9.11 15.0 16.2 44.7 NA 20.33 9.78 17.19 Source: CASE. Data for equities refers to end-year and (for value traded) calendar year. 136 Access to Finance and Economic Growth in Egypt

ANNEX 3: INDICATORS FOR ASSESSING THE INSURANCE AND CONTRACTUAL SAVINGS SECTOR

Table A3.1: Insurance and Pension Funds (in LE billion unless otherwise speciﬁed)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Insurance Number of entities 11 11 12 13 13 15 16 17 20 21 21 of which: private 7 7 8 9 9 11 12 13 16 17 17 Premium income 1.64 1.69 1.72 1.83 1.96 2.04 2.10 2.28 2.88 3.8 4.29 Life 0.33 0.36 0.40 0.47 0.56 0.62 0.66 0.72 0.95 1.34 1.52 Non-life 1.31 1.33 1.32 1.37 1.40 1.42 1.46 1.56 1.95 2.46 2.77 Investment funds 7.21 8.37 9.65 10.32 11.31 12.43 12.81 12.84 14.05 15.55 16.81 Private Pension Funds Number of entities 535 544 554 577 591 595 600 607 617 618 620 Premium income 0.6 0.7 0.8 0.9 1.1 1.3 1.4 1.4 1.6 1.9 2.1 Investment funds 3.2 3.7 4.5 5.3 6.2 7.0 8.1 9.8 12.4 14.4 16 Source: MFT Quarterly Economic Digest, (various issues).

Table A3.2: Investments of Insurance and Pension Funds

Value Share of Total Investment Insurance (LE million) (in percent) 1997 1998 1999 2000 2001 2002 2003 2004 1997 1998 1999 2000 2001 2002 2003 2004 Government bonds 1,877 2,301 2,658 2,708 2,822 3,521 3,811 3,820 19.6 22.0 23.5 22.5 22.1 26.0 25.9 23.5 Securities and shares 2,782 3,277 3,823 4,160 4,444 4,333 4,685 5,312 29.0 31.3 33.8 34.5 34.8 32.0 31.9 32.6 Real estate 522 536 544 583 622 612 581 664 5.4 5.1 4.8 4.8 4.9 4.5 4 4.1 Mortgage 1 16 14 18 11 13 7 6 0.0 0.2 0.1 0.1 0.1 0.1 0 0 Loans to policyholders 45 52 67 83 98 116 122 143 0.5 0.5 0.6 0.7 0.8 0.9 0.8 0.9 Other loans 101 83 78 65 67 122 122 93 1.1 0.8 0.7 0.5 0.5 0.9 0.8 0.6 Fixed deposits 4,271 4,208 4,128 4,425 4,702 4,842 5,361 6,236 44.5 40.2 36.5 36.7 36.8 35.7 36.5 38.3 TOTAL 9,599 10,473 11,312 12,042 12,766 13,548 14,689 16,274 100 100 100 100 100 100 100 100 Pension Funds Government bonds 2,520 3,069 3,685 4,268 4,837 6,109 8,172 9,745 55.8 57.7 59.6 61.0 60.0 61.4 65.9 67.4 Securities and shares 237 336 282 358 390 407 375 365 5.2 6.3 4.6 5.1 4.8 4.1 3 2.5 Real estate 185 185 124 140 145 166 173 118 4.1 3.5 2.0 2.0 1.8 1.7 1.4 0.8 Loans to members 123 101 116 141 138 185 141 142 2.7 1.9 1.9 2.0 1.7 1.9 1.1 1 Fixed deposits 1,383 1,544 1,915 1,996 2,492 2,913 3,518 4,007 30.6 29.0 30.9 28.5 30.9 29.3 28.4 27.7 Other investments 71 81 66 89 62 173 28 72 1.6 1.5 1.1 1.3 0.8 1.7 0.2 0.5 TOTAL 4,519 5,316 6,188 6,992 8,064 9,954 12,407 14,449 100 100 100 100 100 100 100 100 Source: EISA, Annual Report (various issues). Introduction 137

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