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E ROLE OF THE STATE: THE CASE OF

Heba Handoussa

Working Paper 9404

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THE ROLE OF THE STATE: THE CASE OF EGYPT

Heba Handoussa

Working Paper 9404

Please address correspondence to: Heba Handoussa, Economic Research Forum, 7 Boulos Hanna St., Dokki, , Egypt, Fax: (202) 3616042. The Role of the State: The Case of Egypt

Heba Handoussa` Department of The American University in Cairo

An earlier version of this paper was presented to the Cairo Conference, Initiative For Promoting Economic Research in the

` I am deeply indebted to Sahar Tohami for providing me with much of the recent literature on the

New Institutional Economics and for her many useful comments on my research outline. I am also grateful to Ismail Shoukry, Dalia Khalifa and Ahmad Ghoneim. Ismail Shoukri was responsible for collecting the necessary detailed information on a large sample of public sector enterprises and for calculating measures of allocative efficiency for the group. Dalia Khalifa prepared a short appraisal of the public sector hotel and Ahmad Ghoneim made a thorough search of the local press for articles on the new public sector law and collected and adjusted data on . Abstract

This paper adopts a neoinstitutional approach to analyse the changing economic role of the state under liberalization, taking Egypt as a case study. Part I provides an analytical framework that establishes the boundaries of the state in a less developed . The conclusion is that state intervention should embrace - in addition to stabilization, regulation, correcting for failure and redistribution-the process of "catching up" by manipulating industrial policy and building up institutions that reduce uncertainty and promote the acquistion of knowledge. Part II tests four hypotheses concerning the weaknesses in Egypt's process of liberalization: (1) Under-regulation of product and factor markets has resulted in increased misallocation and behaviour; (2) Over-regulation of the institutional structure has raised transaction costs and created agency problems; (3) The persistence of centralized controls over public enterprises is responsible for deteriorating performance;(4) Divestiture is necessary for efficiency only if the state is unable to break the link between the bureaucracy and state-owned enterprises. The evidence is consistent with each hypothesis and highlights the importance of legislative reform as a necessary complement to comprehensive liberalization. Part III summarizes the achievements of the recent stabilization and liberalization programme and stresses the need for the state to play a new role in the context of alleviation and in the integration of the informal sector into the modern economy.

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This paper is concerned with a redefinition of the role of the state in a developing undergoing liberalization and , taking Egypt as a case study. In Egypt, after three decades characterized by central planning and regulation, the dominance of public enterprise activity in the productive and tradables sectors and the operation of an elaborate system of welfare, the scope and degree of state intervention is now being questioned. The problems of delineating the economic boundaries of the state and of analyzing the structure of incentives and organization with which it guides economic activity are common to many of those countries in the Middle East region which had opted since the 1960s for a similar configuration of policies and regulations to govern the process of and development and which have more recently begun to make the transition towards a .

Egypt represents a consistent model of development which has attempted to blend the neoclassical precepts of a market economy with those of a highly socialist orientation. This model was adopted to a considerable extent by many of its neighboring countries, with similar repercussions on performance. Halfway through the period under study, Egypt inaugurated its Open Door Policy (October 1973), with a partial liberalization of the incentive and institutional structure. However, the three underlying themes characterizing the Egyptian model have persisted throughout the period: an import substituting strategy imposed through central planning and macroeconomic policies; a dominant state-owned sector in key sectors of economic activity, itself dominated by a top-heavy bureaucratic structure; and an extensive institutionalized system of welfare transfers operating mostly via implicit and explicit subsidies and guaranteed employment.

An important distinction is made throughout this paper between the instruments wielded by the state in providing an optimal incentive structure for efficient performance of the economy and those used in providing an enabling institutional environment. The first concerns the package of macroeconomic policies and corrective measures that affect the operation of markets and resource allocation and the second addresses the system of laws and regulations which govern the operation of economic agents in the society. Together, these two sets of tools have to a large extent determined the pace and direction of economic growth. Yet neoclassical economics is mostly concerned with the manipulation of the incentive set of instruments, and tends to take for granted the institutional setting of the economy as 'given' and determined by the configuration of social and political circumstances over which the has little to say.

The analytical approach adopted here is therefore based on the neoinstitutional view of economic whereby the state and its institutions play a pivotal role in determining the performance of the economy. The standard neoclassical model - with its focus on market orientation as the essential ingredient to the efficient allocation of resources - ignores the major role which institutions play in reducing (raising) uncertainty and promoting (impeding) the acquisition of knowledge. Just as efficient institutions can provide an enabling environment which enhances competitive behavior and

1 an efficient growth path, inefficient institutions may persist over time because of the symbiotic relationship between them and the organizations that have evolved in response to their suboptimal structure. Organizations - firms, unions and other economic, political, social and educational bodies - come into being and develop to take advantage of the opportunity set as determined by institutions and by the standard constraints of economic choice theory. These organizations are therefore likely to maintain and reinforce an inefficient institutional system and can be seen as the major source of resistance to its evolution along a path that improves economic welfare.

The first part of this paper provides an analytical framework which links the nature of the state's intervention in the economy with the performance of that economy over time, based on the approach of the new institutional economics which recognizes both the theoretical framework of neoclassical economics as well as the limitations of its assumptions.' The main questions that we seek to answer are why the neoclassical model of growth has failed to explain the differential growth performance of developing countries and how the institutional approach can help remedy the weaknesses of the neoclassical model, and what are the boundaries of the state that are implied by the proposed theoretical framework.

In the second part of the paper, an attempt is made to apply the proposed framework of analysis to Egypt's development experience since the 1960s and identify the strengths and weaknesses of its interventionist model of the state. Four hypotheses are formulated which can be tested using the combined neoclassical/institutional apparatus of analysis. Evidence is brought to bear in testing each of these hypotheses. In some cases, the proposed hypothesis will need to be further tested against alternative hypotheses for support or rejection.

The third and concluding part of the paper presents a critical review of Egypt's current program of structural adjustment and institutional reform in order to appraise the consistency of the reform process against the declared objective of putting the economy back on a path of sustainable growth. The focus is on the future role of the state and the proposed methodology is again utilized in an attempt to highlight the major issues at stake.

I. Theoretical Framework

standard neoclassical analysis is based on the rational maximizing behavior of individuals and firms, with a focus on the functioning of markets to bring about equilibrium where all marginal conditions obtain. Simultaneous equilibrium in all markets leads to the static general equilibrium model which can then be aggregated to obtain a growth model.' The neoclassical growth model provides a neat and rigorous framework. Yet it is a historic, taking as its determinant the production function and using the highly stylized assumption that and organizational behavior is no more than that of well programmed calculating . The simple model cannot explain the differential performance of countries over time and especially that among developing countries, having (along with Keynesian theory) been formulated to deal with mature . Recent extensions of the

2 model have tried to incorporate such variables as structural change on the demand and supply sides, the pattern of industrialization and the internal and external policies which affect resource allocation. Another line of enquiry has focused on the nature of technical change and its correlation with firm size, research and .'

Whatever refinements are attempted, the neoclassical model is built on some fundamental assumptions which have long been criticized for their lack of realism. Foremost among these is the assumption of perfect information,' such that the only relevant costs are the costs of production. In fact, both transactions and information costs have been shown to constitute a major and growing share of total costs in a modern economy' and it is the nature of the state and its institutions (the system of property rights, the legal enforcement of contracts, access to knowledge and information) that determines the level of these transactions costs and hence the level of performance of the economy. A major contribution of the new institutional economics is to bring to center stage the cost of transactions as an explicit addition to the neoclassical model and to analyze the behavior of firms and organizations in the presence of transaction costs.' To the extent that the institutional framework has a direct and significant impact on performance via transactions costs, this important dimension is not captured in our standard growth and development models, however much these models decompose the sources of growth, integrate policy variables and use sophisticated techniques to analyze the growing of empirical data.

A second weakness of the standard neoclassical model has been the comparative static nature of the equilibrium growth path which makes it difficult to incorporate the all important process by which firms acquire knowledge and adapt to the ever changing circumstances of the global economy. Economists have thus been revisiting the notions of barriers to entry, comparative advantage and the role of social institutions in competition. In his seminal essay on "The Use of Knowledge in Society", Hayek claimed that "the various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process ".g Although Hayek was making a strong and convincing case against central planning (see section 2 of this paper), he recognized the important distinction between two kinds of knowledge: unorganized knowledge (of the particular circumstances of time and place) available to ordinary individuals in the market place and scientific knowledge in the possession of an authority made up of suitably chosen experts. It is now clear that whether that authority is the state's planning board, the research centers of large multinationals or the specialized consultancy houses of our day, both the availability of this knowledge and the efficiency of the process by which it is utilized will have a significant effect on economic performance.

No economy is resting in a stationary state nor moving frictionlessly along a steady state. Circumstances on the global scene are changing at an accelerating pace and in order to adjust, enterprises are forced to either innovate, to specialize or to reorganize. Although inventions and have been responsible for the outward shift of production frontiers over time, there is growing evidence that a country can have a higher rate of growth and productivity than its trading

3 partners without necessarily being a leading innovator, as long as it has superior institutions which promote the best use of this new technology through efficient organization .9 In the context of developing countries this gives added strength to the argument that the role of the state should not simply be confined to the elimination of market distortions and ensuring a competitive environment (static efficiency) but should also encompass the promotion of innovation and change (dynamic efficiency) via its , science and industrial policies. Unless the state intervenes to permit the process of 'catching up', of structural transformation and of changing the 'inherited' comparative advantage,'() a risks stagnation (steady state solution) at a very low level of growth and diversification. On the one hand, experience shows that for many LDCs that have opted for nominal intervention with market forces successful growth performance has been elusive. On the other, a growing amount of the literature on successful newly industrialized economies points to the interventionist role of the government and the far from neutral trade policies it has pursued.1'

Another departure from the standard neoclassical approach that is deemed appropriate in analyzing the role of the state in countries is in the treatment of the notion of competition. In mature capitalist economies, neither domestic markets nor external markets can be described as fully competitive,12 a necessary assumption for equilibrium conditions to be Pareto optimal. For a typical less , the setting is even worse: markets are incomplete and highly segmented, and the mobility of factors of production a great deal lower than in mature economies. What is equally serious is that government intervention has more often than not aggravated the problem of market failure by superimposing a "modern" institutional structure which serves only one part of the economy, thereby accentuating the degree of dualism across public and private sectors, large and small scale, urban and rural, formal and informal. Although neoclassical theory admits of a role to be played by the state in overcoming the various forms of market failure, it is the approach of the new institutional economies which makes a valuable contribution in identifying those areas where externalities can be internalized (where the state should retreat in the provision of 'public' goods) and in exploring new areas where externalities are best addressed by a strong state.

The link between the role of institutions and externalities was first made by Demsetz when he showed that the primary function of property rights was in guiding incentives to achieve a greater internalization of externalities. "The reduction in negotiating cost that accompanies the private right to exclude others allows most externalities to be internalized at rather low cost"" except for those activities with externalities that affect so many people as to make the cost of the transaction exceed the gains from internalization. Very often, these costs are high not because of 'natural' difficulties (e.g. ) but because of legal constraints (e.g. on the formation and operation of various forms of private organization). In socialist oriented developing countries, the examples abound where property rights are altogether absent (the right to ownership including the right of sale) or where constraints on property rights result in the exclusion of the from particular activities (e.g. controls on rent, interest or formation of associations). In such cases, the problem of market failure is artificially created and the state has overstepped its boundaries in imposing limitations on

4 property rights.

In summarizing the reasons why the approach of the new institutional economics is considered an appropriate complement to the neoclassical framework in evaluating the role of the state in a developing country, the first is that it helps identify those aspects of the system of property rights which raise transaction costs and hinder the smooth functioning of market forces, and the evidence would seem to be that transactions costs and information costs are positively correlated with the degree of bureaucratic intervention in the economy, a common feature of developing countries." Both instances of under-regulation and over-regulation can be identified with the purpose of estimating the cost of inappropriate rules and understanding their continued persistence.

The second reason is that institutional analysis is interdisciplinary and seeks to incorporate the historical context in which growth takes place. As compared to the ahistoric treatment of growth by neoclassical economics, the institutional approach recognizes that social and political evolution is an integral part of ." This new approach is particularly relevant to the study of the role of the state in countries that are still in the process of reformulating their national identity, given their past experience in balancing internal and external political pressures as well as the interaction of traditional and modern social institutions. Rather than insist on one identical blueprint for the economic role of the state in all developing country, institutional analysis is sufficiently flexible to admit of country specific institutional structures that can serve to enhance the efficiency of the growth path.

A third justification for using institutional economics in the treatment of state intervention in developing countries is that it brings in more explicitly the question of and wealth distribution which is automatically ignored by standard welfare economics. Instead of relegating the income distribution role of government to second stage transfers via taxes and subsidies, the institutional model deals with property rights from the outset. The state can therefore play a pivotal role in the assignment or reassignment of property rights according to society's preferences for equity and justice. This role is particularly relevant to countries undergoing the transition from state to private ownership. Whereas "the market cannot create social justice; it is powerless to distinguish between good and evil; it has no moral role ... ",16 in contrast, "Eastern Europeans are essentially trying to start the market game fairly ... has no answer for how the game can be started fairly, since it was not started with a fair distribution of property rights "."

A fourth and final reason why it is useful to incorporate the institutional parameters into a discussion of the role of the state is that it avoids the trap of having to take a polarized position as between the extreme right and left ideologies. Although no economist can truly have a purely objective stand on the role of the state, should steer away from the extreme models of capitalism or socialism and use the pragmatic if eclectic approach of picking and choosing from both models those incentive and institutional instruments that together make a consistent formula

for state intervention. Figure 1 presents four alternative but extreme models of state intervention in

5 the economy, ranging from minimal intervention on the incentive and institutional fronts (the mature capitalist model) to maximal intervention (the mature socialist model).

Although experience shows that the majority of developing countries have opted for neither of the extreme models (Min/Min or Max/Max), one can distinguish among two main groups according to their choice between the High/High position (Extensive intervention with market forces combined with a heavy dose of bureaucratic intervention) and the Low/Low position (a selective degree of intervention with the system coupled with a minimum interference in the system of private property rights). Examples of the High/High model would include a large number of countries in Latin America," the Middle East (including Egypt), Africa and South Asia whereas the Low/Low model is a useful approximation of the successful Southeast Asian countries. An elaboration on the instruments used and their relationship with the functions of the state will show that the alternative models are in fact far more varied and complex than implied by the above figure.

Figure 1. Degrees of Intervention by the State in the Economy

Intervention via Institutional Instruments

Minimal High

Minimal Price mechanism rules Distorted price mechanism High Intervention Private property rights Highly bureaucratic system via Incentive Instruments Low Selective protection Central planning rules Maximal Private property rights Maximum state ownership

Low Maximal

In order to analyze the role and size of the state in a developing economy, it is now necessary to enumerate the set of functions which it should perform and then show whether the incentive (allocative) and institutional frameworks adopted in fact coincide with the efficient conduct of these functions. What is implied by our conceptual presentation is that the state intervenes in the economy in order to fulfil four major functions: stabilize the macroeconomy, correct for market failure, redistribute income and enhance the 'catching up' process. The first three functions are those that are conventionally accepted by neoclassical and Keynesian theory, the fourth follows from our reassessment of the competitive nature. of global markets, the dynamic implications of growth and the resulting importance we attach to the 'knowledge' and 'organizational' dimensions of development.19

Under the heading of market failure, we can again distinguish between three categories of functions undertaken by the state: regulation of economic activity, provision of public and merit goods,20 and the ownership of natural . As to the 'catching up' responsibility of the state, we can further subdivide it into planning & industrial policy and organizational development (including the creation of private or public enterprise in the tradables sectors of economic activity). We now have seven areas of intervention where the role of the state can be examined critically in order to identify the extent to which the tools and methods it has used have been optimal, assuming that the state is responding to the needs of society as a whole and not to any one group in that society.

6 It must be noted that in fulfilling the various functions of the state, there is a considerable degree of overlap in terms of the methods used as well as potential inconsistency among their objectives. The choice of an education policy has influence on both the provision of a merit good and the distribution of income (overlap), the conduct of a subsidy program will influence both equity and efficiency (conflict), and selective protection under industrial policy may conflict with the 'optimal' regulatory framework.

However, the potential inconsistency among functional objectives or methods of intervention is the key to our understanding the performance of the state in the economy and table 1 serves to illustrate the multitude of objectives and the variety of tools that can be manipulated by the state in a developing country. It can also be observed that the distinction between incentive and institutional tools is a real one not only conceptually but also in practical terms. The degree of openness of an economy as reflected under the incentives column may not necessarily translate into a corresponding degree of under the institutional column. Those tools and methods that are subsumed under the incentive framework are those that are more easily recognized by an economist trained in the mainstream tradition, they are all centered on the operation of the price mechanism and are designed to influence the allocation of resources in production, consumption and investment. Allocative efficiency can thus be used as the indicator of performance of state intervention in the market via the signaling mechanism.

Whereas much of the debate has revolved around the effectiveness of the chosen degree of market intervention by the state, particularly in and in planning, the institutional framework that governs the economy has long been taken for granted as part of the 'given' structure of the economy. It is only more recently that development economists have drawn attention to market failure that is caused by bureaucratic obstruction in the legal and administrative domains. The literature is especially rich in analyzing the difficulties faced by the traditional sectors of economic activity which hamper their integration into the modern economy and retard their growth potential." The debate over public ownership of enterprises in the tradables sector has also arisen over the past decade, and the arguments used in support of in the mature economy context are normally carried through to the developing country context.' Such unqualified support must be questioned in as much as the evidence for the superior performance of private over public ownership is far from conclusive, and because in most cases where state- owned firms have operated in the tradables sectors of developing countries, they have responded to a deliberately distorted set of incentives and institutional regulations. Reforms of the policy and control environments that surround the public sector are therefore much more likely to bring about the type of market response that is being called for than simply transferring their ownership rights to the private sector. Moreover, privatization will be especially risky in instances where the institutional and regulatory environments have not been suitably adjusted to avoid private sector monopoly behavior and agency problems.

By focusing on the institutional framework that governs economic activity and centers on property rights, on the enforcement and execution of the law and on the resulting transactions costs, the avenue is open for our study of the response of economic agents in terms of the organizational arrangements they chose and how these translate into an efficient or inefficient growth path. The evolution of the

7 Table (.Objectives and Instruments of State Intervention

Objectives Incentive Tools Institutional Tools 1.Stabilization Full employment Tax policy Tax & customs administration Price stability Expenditure policy Controls on trade and distribution Budget balance Monetary policy Banking & credit laws External balance Exchange rate policy Exchange controls 2.Regulation Promoting competition Antitrust Legislation Regulating monopoly Administered prices Protection of property rights Consumer protection Tariff levels Entry & exit rules: Invest. licensing Labor protection Non tariff barriers Consumer protection legislation Labor laws 3.Public and Merit Goods Defense & security No direct charge Government monopoly Population control No direct charge Government monopoly Environment protection No direct charge Zoning & pollution controls Legal structure No direct charge Independent judiciary Education & Research Free/vouchers/subsidies Public /private mix services Selective support Public/private mix Integrating informal sector Selective incentives Public/NGO mix Regional development Public/NGO mix 4.Natural Monopolies Providing and - Public monopoly utilities - Public monopoly 5.Redistribution Transfers to poor & vulnerable groups Taxes & subsidies Guaranteed employment Basic needs Social security Social contract (Same as merit goods) (Same as merit goods) 6.Planning Information & forecasting Information dissemination Indicative/Central Plan Industrial policy Selective protection Investment licensing 7.Organization Responding to global Autonomy, transparency & Discrimination in favor of national oligopolies and enhancing accountability of oligopolies (public or private) knowledge acquisition national oligopolies Institution building to promote information, education & technology institutional structure will determine total factor productivity change (our traditional black box) via the flow of knowledge it promotes and the economy with which knowledge is acquired by new organizational patterns. Total factor productivity (TFP) can therefore be considered as an indicator of the efficiency of the changing institutional structure as impacted on by state intervention and societal responses. In mature economies, a growing body of evidence would seem to indicate that neither size or expenditure on research can explain the differential TFP performance among firms in one country nor across countries, but rather the ability of firms to reorganize along both internalization and externalization directions." This evidence is also supported by the twin global trends whereby giant firms are still increasing their share of the market (internalizing economies accruing from the information revolution which reduces transaction costs) yet and are also increasing their level of specialization (shedding many of their production and service operations and relying on subcontracting and purchasing from smaller firms).'

8 Third World countries would seem to be in the precarious situation whereby the process of catching up becomes progressively more difficult. As the queen said to Alice in Through the Looking Glass: "Now here you see, it takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!" Yet three notes of optimism can still be voiced concerning the challenge ahead: one is that the information revolution is making knowledge a great deal cheaper to acquire (both in terms of the hardware and the skills needed to acquire it), the second is that structural change in world demand is making scarce capital a lot less important in the growth industries of the future, and thirdly, technical economies of scale have turned out to be much less important than judged by economists at mid century.25

This last digression would seem relevant to developing countries to the extent that it better situates the role of the state in providing an appropriate institutional framework for sustainable growth and development. What the future portends is that comparative advantage can no longer be sought in industries with cheap unskilled labor alone but in industries where labor is abundant and skilled. Skill intensive and knowledge intensive industries will be the leading sectors of the future and developing countries will find their niches only if they are willing to invest now in their . The state can play a crucial role in following an active industrial policy that carefully selects a number of leading sectors and promotes the correct choice of others by the private sector. The growth model of Southeast Asian countries depicts a deliberate interventionist state that has used four major tools to promote rapid structural change and productivity growth: selective protection for targeted subsectors at high levels but of limited duration (although the length of infant status would seem relatively long); a comprehensive assault on all institutional fronts in order to maximize the knowledge flow to all economic agents (market information, technology, education and training) and to minimize bureaucratic obstacles; a deliberate avoidance of foreign direct investment except in those fields where knowledge could only be obtained through that route; and a discriminate institutional policy favoring the creation and operation of giant conglomerates (at least in Japan and ).'

II. The Case of Egypt

Egypt's state system is considered the oldest in the history of mankind, long predating the year 3200 BC when King Mena united the two kingdoms of Upper and Lower Egypt. In fact, it is not known whether Egypt ever went through the 'tribal' and 'gentilic' stages and records show a strong civil organization since the start of the historical era. From the dawn of the historical period, the state administration recorded the annual level of the flood (the most important externality defining the need for a strong state) and took a census of the population. A complex and extensive marketing system existed, and so did foreign trade. Private ownership of is documented as far back as the Old Kingdom, and land leasing at least since the Ramesite period (1300 BC). The law gave equal rights to husband and wife and the practice of making a will was known. The state registered deeds of conveyance and guaranteed their execution such as in selling property. Associations such as trusts and pious foundation were given legal personality. The law was embodied in statutes and protected by courts 27

9 "But this law being a living thing, like the institutions it upheld, did not remain identically the same over the centuries. Human aspirations conditioned by new circumstances caused it to change, and it evolved between the pole of equality and liberty and that of inequality, the latter being determined above all by the system of land tenure .28

The pattern of the country's evolution over the most recent two centuries (Egypt's modern economic history begins with the reign of Muhammad Ali in 1805) engendered cycles of growth followed by stagnation, with two major attempts at structural transformation and growth, the first in the 1805-1845 period and the second following the 1952 revolution. Both attempts were made possible by the existence of a strong state capable of keeping foreign intervention at bay and of mobilizing domestic resources for development. In both cases, the state adopted highly centralized and administrative controls for the pursuit of an import substituting, closed economy model, but the second was especially concerned with the objective of an equitable distribution of income. The century long interval between the two experiments was marked by foreign domination, neglect of education, the absence of protective tariffs (until the 1930s) and the integration of Egypt into the as a primary exporter of raw which accounted for 80 percent of total exports until 1950. The growth path became unsustainable and per capita GDP which had been higher than Japan's (about $50) until 1913 grew negligibly thereafter.29 Meanwhile, the most damaging result of this lop-sided pattern of development was an irreversible change in the nation's resource equation, with population turning from shortage to surplus (10 million in 1900 to 52 million in 1990) and and cultivable land becoming effective constraints threatening the country's future economic viability and ecological balance.

Today and over the past forty years, the persistence of poverty reflects the most daunting challenge to Egypt's policy makers - how to harness the country's vast pool of human resources and turn it from burden to mainstay of consistent growth and rising living standards. The task has been all the more difficult because of the conflict between domestic and external demands made on the state's modest resources. Throughout the period since the late 1940s, the trade-off between defence and investment expenditures has been one of the most striking features impacting on the country's record of economic growth.30 Another has been the drastic shift in political alliances from the West to the East and back to the West in the space of less than twenty years. Between 1956 (the War) and 1973 (the October War), the country's institutional structure was twice traumatized, first with a series of radical socialist measures, handing over to the state the ownership of and control over a dominant share of non-agricultural activity, and second with the Open Door Policy (ODP) and the reinstatement of private ownership within a highly bureaucratized and inconsistent institutional framework.

It can be argued that throughout the socialist period and in spite of the far reaching of the 1960s, the 'incentive' framework was not as seriously disrupted as was the 'institutional' framework. Import restrictions rather than tariffs were the main tool providing protection for import substituting industries, relative prices continued to reflect world prices - subject to controls designed for the purpose of income redistribution and the mobilization of savings by the state - and central planning never effectively overstepped the boundary of allocating the bulk of the country's investment resources to projects selected and executed by the public sector, itself responsive

10 to the price mechanism. State intervention on the incentives front was thus high but not extreme, and the development of serious price distortions can in fact be shown to have started after the ODP began.31 The fact that the state refused to relinquish its control over prices despite the inauguration of the liberalization era in the mid reflects its persistent attitude towards the mode of delivery of income transfers, even though the net effect of artificially imposed prices was a substantial and growing loss to the state revenues, (contrary to the second objective of mobilizing savings). However, when - starting in 1986 - the state was forced to abandon price controls, the speed and smoothness with which the reform was accomplished can be considered "astounding", confirming the fact that the price mechanism was never even close to absent throughout the past thirty years.

In contrast, state intervention on the 'institutional' front as practiced in the 1960s has had a far more profound impact on economic, political and social relations by interrupting the normal development of domestic capitalist enterprise, preventing democratic participation in the decision making process and promoting negative attitudes towards individual initiative, risk taking and profits. The drastic reduction in property rights went hand in hand with a parallel exponential growth in the size of the bureaucracy which was to take over as the dominant power exercising control over the economy. The bureaucratic state, with its rigid and centralized rules and regulations, its lack of transparency and its internal inconsistencies became deeply entrenched and intractable.

Starting in the early 1970s, new legislation was enacted to encourage Arab, foreign and later Egyptian private sector investment and to allow the latter to engage in foreign trade.32 This legislation was added to the existing body of corporate, labor, foreign exchange, stock market and other laws governing property rights as modified during the socialist era with little if any amendment to these laws to suit the requirements and spirit of the declared Infitah. The result was a glaring contradiction across the laws, the proliferation of new bureaucratic agencies superimposed over the older ones to 'simplify' transactions for new investors and traders and the increased discretion of civil servants in interpreting and executing the ambiguous set of rules and their related procedures. By 1991, even foreign investors whose interests were given top priority in the formulation of the investment encouragement code (Law 1943 of 1974 and its two modifications in 1977 and 1989) and the creation of a specialized investment agency (the Authority for Foreign Investment and Free Zones) could still complain that two major impediments to an increased flow of foreign direct investment (FDI) were "a discretionary investment regime with an inappropriate incentive package and a lengthy screening and approval process; and an archaic bureaucracy ",33

In evaluating the role of the state since ODP, four hypotheses have been formulated which follow from our analytical framework and are designed to ascertain what are the major sources of weakness of the interventionist model currently applicable to Egypt. In some cases, further evidence must be sought and alternative hypotheses considered before accepting or rejecting the proposed hypothesis. The classification of the functions performed by the state - adopted in Part I of the paper (see table 1) - will be followed in our exposition. An examination of the first function - stabilization of the macroeconomy - is postponed to Part III which deals with an evaluation of the comprehensive stabilization and structural adjustment program currently under implementation.

11 Hypotheses 1 & 2 on the Regulatory Role of the State

The state has not provided a regulatory framework which ensures competition, a major function it should perform in any modern economy:

1) Under-regulation has been a major feature of the partial Infitah implemented since the mid 1970s. Partial liberalization of the product and factor markets has only accentuated distortions and encouraged the growth of highly protected and often monopolistic private sector activities.

2) Over-regulation has continued to characterize the institutional structure in spite of the Open Door Policy. Reforms of the legislation and bureaucratic procedures have failed to significantly reduce transaction and production costs. Agency problems have now become a major source of resistance to reforms.

In dealing with these two hypotheses, it is useful to remember our distinction between incentive and institutional instruments available to the state in performing each of its functions. Our first hypothesis relates to the manipulation by the state (via the executive branch of government) of the package of policies that have a direct or indirect bearing on the system of relative prices guiding the allocative process. Both private and public economic agents are continuously responding and adjusting to these relative prices and the regulatory function of government is to ensure that this system of prices best reflects scarcity. In the case of Egypt, the transition from the socialist to the Infitah era was accompanied by only a partial liberalization of the incentive regime, with significant departure from the initial Second Best situation. Our second hypothesis deals with the legal and administrative rules that govern market entry and exit which were also only partially revised to allow more competition from the private sector. A partial liberalization of the incentive structure means that the market is under-regulated, making it possible for agents to behave monopolistically and for factors of production to be misallocated. In parallel, insufficient reform of the institutional structure means that agents are prevented from responding and adjusting to the changing market signals because of the institutional impediments: the institutional structure is over-regulated.

Our examination of the changing structure of relative prices since the Infitah is based on a review of indicators of effective protection, accounting ratios (the ratio of shadow to domestic market prices) and on the direction of real exchange rate, interest rate and wages in the economy. What the evidence shows is that over the period of the Infitah, the. three major tradables sectors, agriculture, and energy experienced a significant deterioration in the structure of relative commodity prices in their input/output relations as well as in the real cost of primary factors of production. The exchange rate became increasingly overvalued and the real rate of interest increasingly negative, while real wages in the flexible labor markets first shot up (until 1982) and then declined gradually to the present levels. The outcome was a significant departure of effective rates of protection from their initial levels in the late 1960s and early 1970s, with large numbers of subsectors now experiencing negative protection (agriculture and public sector manufacturing) and others experiencing extreme levels of positive protection (energy intensive and consumer durable industries)."

12 The link between the incentive structure and economic performance can be found in the indicators of allocative efficiency of the various sectors of economic activity and in the distribution of aggregate investment over time. The evidence shows that during the period 1975 to 1992, and as a result of the highly distorted structure of relative prices, sectoral performance - as measured by domestic resource cost and economic rates of return - has worsened, with significant waste in the use of capital resources, under-utilization of labor, and inefficient decisions on output mix;35 the allocation of investments going to various sectors has also been suboptimal.

The acceleration in the use of capital relative to labor in the formal private and public sector enterprises in manufacturing was one of the most striking results of a detailed analysis of their TFP performance over the Infitah. In real terms, after deflating the capital series, the capital/labor ratio was shown to have increased at an annual rate of 10 percent, at a time of rapid growth for the manufacturing sector as a whole.36 The slowdown in the absorption of labor in the manufacturing sector (annual labor growth of about 2 percent between 1970 and 1984 compared to 9.6 percent in the 1960-1965 and 3.7 percent in the 65/66 to 70/71 periods) is in contrast to the average annual growth in manufacturing GDP of about 7 percent over the Infitah.

As to the impact of the growing price distortions on product mix, the sector with the most significant supply response would seem to have been agriculture where the reallocation of land to various crops was unprecedented in terms of the departure of actual from optimal crop mix, with huge losses in opportunity cost to the economy (and to a lesser extent to the )." Moreover, the distorted price signals in the agricultural sector led to a wave of investments by large capitalists into what became known as ' Security Projects' in animal husbandry and dairy farms with negative real returns to the economy but huge profits to be made from access to highly subsidized loans and subsidized animal fodder.38

With regards the impact of the incentive structure on the overall allocation of aggregate investment over time, the evidence also confirms that the increasingly distorted price system that accompanied the partial opening of the economy was responsible for a lopsided distribution of private investment activity. While the unprecedented rate of (itself a function of poor stabilization policy) which rose from an average of 5 percent in the 1960s to 15 percent in the 1970s and 20 percent in the 1980s was partly responsible for the flow of savings into inflation hedges (mostly into property), it was the government's rigid system of administered prices on those activities it could control (the utilities, public enterprise output of intermediate goods and services, centrally marketed agricultural output) that created the most serious distortions in relative prices. The distribution of private investment between the periods shows the significant decline in the share of the commodity sectors (excepting ) and the unusual growth in the non productive services.39 Those subsectors characterized by excessive protection (due to tariffs or domestic subsidies) were those where large capitalists could reap abnormal profits by maintaining their monopoly position.

What we have shown is that under-regulation of an economy undergoing liberalization is likely to worsen the initial structure of relative prices unless liberalization is undertaken simultaneously on all fronts. The private sector is especially responsive to the price mechanism and its production, investment and consumption behavior will fast adjust to the new set of constraints and opportunities.

13 The resulting allocation is not only inefficient in terms of output losses to the economy but it also creates a new class of vested interests that will try to maintain this distorted price structure and the corresponding rents which it generates. In Egypt, this rentier class was created during the Infitah among importers and manufacturers of highly protected consumer and intermediate goods. The concentration of private sector operations in 'nonproductive' activities earned the Infitah a poor reputation among several prominent economists.40 Yet it is state imposed market failure that has been the cause of apparent private sector failure.

Our second hypothesis links the institutional structure with economic performance. Given the incomplete nature of the reforms concerning property rights, the bureaucracy has assumed new powers in interpreting the contradictory legislation and implementing it at its discretion, while the more powerful elements of the private capitalist class have exploited the inconsistencies in the legal system to their advantage. Agency problems have ensued, with strong shared interests between the new rentier class and the bureaucracy in maintaining the inherently monopolistic environment and resisting the necessary reforms. For those agents who are unable to capture the potential rents - the bulk of the capitalist class - transactions costs are prohibitive and they have refrained or been deliberately kept out of market entry. Competition is reduced and actual growth of the economy proceeds at a rate below its potential.

The evidence for how the nonrationalized structure of institutions that has persisted throughout the Infitah has worked to prevent the economy from achieving its potential growth can be found in the contradictory relationship between the various laws and the declared objectives of the policymakers. The two most prominent objectives that have been consistently pursued since ODP have been the growth in private sector investment and in exports. By examining just those segments of the institutional framework that pertain to the incorporation of a private firm and to export activity, we can identify a number of explicit and implicit constraints that have raised transactions costs and hampered market entry of potential producers and exporters. Explicitly, it took seven years from the start of ODP to introduce a new corporate law. The old law had been modified during the socialist era to provide for labor participation in management (equal share in Board membership) and in profits (25 percent share) and was only repealed in 1981 to make way for the new company law 159 which reduces worker participation to a 10 percent share in profits. Since its inception, the new company law has been competing with the twice amended law of 1974 for foreign investment (not defined by nationality of shareholders but by the currency in which equity is denominated) because of the irrational differentiation in the treatment of investors in such basic conditions as the price at which energy is sold to projects under each law (a differential ratio which reached 1:5) and the extent to which fiscal privileges can be obtained under each law." It is only now that legislators are considering to revise the separate laws and merge them into one.

Implicitly, the legislation discriminates in favor of large investors, partly on account of the centralized nature of the administrative departments which execute the two laws. Additional preferential treatment in income taxes, in customs and in access to land can be obtained for 'important' projects by negotiating with the various functionaries in the specialized investment departments as well as in local government and/or particular line ministries (special privileges have been granted to investors in remote areas and in sectors such as tourism and ). By 1984,

14 the extent of the bias against small firms obtaining law 43/203 status was so high that only 12 percent of projects in operation had capital of less than LE 0.5 million (50 projects) while 26 percent had capital in the over LE 10 million category. This contrasts with the representative case where more than 60 percent of formal manufacturing establishments are in the small size category.42 In terms of relief from customs payment, it was estimated that a potential 49 percent of tariff revenue (1986) was lost to privileged importers n In the case of potential exporters, the two most important sources of additional transaction costs are the restrictions imposed on foreign trading firms seeking to operate in Egypt and the monopoly status of a handful of state trading companies.44

Another major barrier to market entry for all potential competitors - public or private, large or small - is the discretionary nature of the investment licensing system which has lacked any transparency until 1991 when the negative list was first published. Up until then, the main criterion by which the relevant authorities (GAFI and GOFI) have judged the merits of a project - unless it is export oriented - is whether it fills a gap in existing production capacity, in glaring contradiction to the objective of promoting competition and spurring domestic firms to seek export markets. Another major form of discretionary power of the authorities has been in imposing import bans and then granting exemptions to individual importers. The coverage of import bans ('conditional imports') was as high as 37 percent of the value of agricultural and manufactured output as recently as early 1991,4s and yet actual imports of goods in the "banned" category accounted for a significant percentage of total imports, verifying that a substantial number of exemptions are normally granted. This gives the granting authorities significant discretionary power in responding to the requests of importers. In turn, the domestic producers who stand to gain/lose from the introduction/elimination of import bans are continuously putting pressure on the relevant authorities (not necessarily the same authorities) to maintain or increase the number of existing import bans.

The above description depicts only part of the formidable mass of legal and procedural entanglements that entrepreneurs must face in setting up or conducting their operation. It can be multiplied if account is taken of many additional transaction costs that a typical firm will encounter such as in dealing with the securities market, employment, taxation, purchasing 'quota' intermediates, and selling to government agencies.

Such a costly institutional environment makes it far more difficult for smaller firms to absorb fixed transactions costs which constitute an effective barrier to their entry and competition. In Egypt, micro enterprises (defined as establisments with less than 10 employees) account for 90 percent of total private sector employment outside of agriculture. They therefore face not only the usual problems of market failure that characterize underdeveloped markets for capital and labor but also those created by an inefficient and over centralized bureaucracy.'i6

We have now verified that under-regulation on the incentives vector and over-regulation on the institutional vector of state intervention in the economy have both been very high in Egypt since the introduction of ODP. We have also shown that the impact of these two dimensions on the growth of monopolistic private sector tendencies, of agency problems and of transaction costs has been positive and significant. As expected from our theoretical framework, these tendencies can only retard the growth process. Our two hypotheses are therefore consistent with the observed poor

15 performance of the economy and its relationship to a suboptimal regulatory framework imposed by the state. The policy implications of our results are clear: both sets of inconsistencies on the incentive and institutional fronts have reinforced one another over the past two decades, and neither partial nor complete reform of the one without the other can rid the economy of the significant burden that they impose. Rationalization of the institutional structure will prove to be the more difficult one to achieve, given the significant rents that accrue to some elements of the bureaucracy from its persistence.

Hypotheses 3 & 4 on the Role of the State as Owner and Producer

The state is in the process of reducing its role as owner and producer in the tradables sectors of economic activity. How much privatization should take place and in which subsectors should be based on an understanding of the strengths and weaknesses of public enterprise:

3) Centralization of the control structure over public enterprises in the face of partial liberalization has led to a where the state-owned organizations have not been allowed to respond to market signals. The deterioration in performance of the public sector is therefore directly related to the degree of centralization imposed by the state; the recent set of reforms in the legislation will only improve efficiency if the state is willing to enforce the spirit and letter of the law.

4) In the context of privatization, the extent to which the state should hold on to its role as a producer is intimately related to its willingness to break the link between the bureaucracy and public organizations. Managerial X efficiency is not significantly different between public and private firms in those activities where products are homogenous and processes are subject to a slow rate of technological change. On the other hand, those activities that require product differentiation, a high degree of flexibility and individual initiative should be turned over to the private sector.

In dealing with the question of state ownership outside the sectors of natural monopoly, the approach adopted here is to avoid altogether the ideological debate that has surrounded the issue and to accept as rational that a developing country may choose to use public or privately owned national oligopolies as dynamic agents that respond to the 'competitive' challenge of world markets in which giant corporations from the mature countries predominate. This objective has been subsumed under the 'catching up' function of the state as presented in the first part of this paper. Three conditions must obtain for public enterprises to fulfill the 'catching up' objective: they must enjoy full autonomy and flexibility to design and implement their individual strategic plans; they must abide by the regulatory rules that ensure that they cannot exploit their oligopoly advantage in monopolistic pricing or in preventing market entry; and they must be accountable for their performance via a transparent system of evaluation and penalty/reward. These three conditions also follow from our accepted analytical framework which assigns to the price mechanism the pivotal role in the allocation of resources.

In the case of Egypt and in spite of ODP, state-owned firms have until 1991 lacked autonomy in all key areas of decision-making including production plans, and price determination, hiring and promotion and investment and finance. The state has used and abused the public sector for income

16 distribution purposes, by persisting in its policies of administered prices, forced hiring practices and unified wage scales. These policies have imposed unsustainable costs on public enterprises, reflected in high rates of disguised , low productivity, falling real wages and increasing losses. They have also undermined the potential role of this vast sector to act as the engine for savings, dynamic growth and diversification. Moreover, the centralized and bureaucratic nature of the organizational structure governing public enterprises has stifled managerial initiative and inhibited its aggressive, market oriented behavior.47

All of the above constraints are institutional in character and are supposed to disappear now that the new law (Law 203 of 1991 and its attached executive decree) for the public business sector has been enacted and that a new organizational structure has been enforced (March 1993) which divorces the group of 17 Holding Companies and their affiliated enterprises from the supervision of line ministries and the ministry of planning. The new mandate for the Holding Companies is to maximize the present value of the state's portfolio of shares in each Holding's group of public enterprises and the Holding has the right to sell shares, assets or entire enterprises or to even liquidate them. Law 203 has guaranteed the freedom of affiliated firms to respond to market forces and has raised the level of transparency and accountability of their operating results.48 Whether the legislative (and incentive policy) reforms will allow Egypt's 309 state-owned enterprises to extricate themselves from the bureaucracy after 30 years of rigid subservience to it will depend on the state's willingness to enforce the new rules of the game and allow a true separation between the business and the administrative functions of the state.

Another major source of institutional constraint on the efficient performance of public enterprises has been the interventionist role of the state via the institution of the plan as conceived and implemented throughout the past three decades. Central planning in Egypt has been enforced so as to effectively replace market forces and enterprise decisions in the allocation of the bulk of public investment, often using a system of surrogate prices that contradicts the system of price relations dictated by opportunity cost. There are three essential ways in which the role of planning in a developing country can be supportive of efficient economic growth, based on our accepted analytical framework. The first is in tackling the information problem by using the sophisticated techniques available to expert individuals and specialized equipment in providing all agents in society with valuable predictions and forecasts. The second is in identifying sectors where market failure is important and designing alternative strategies for the long term solution to these problems including manpower and education plans as well as plans for regional development and for the protection of the environment. The third is in coordinating macro policies and public investment in the fields of public goods and natural monopolies so as to support an active industrial policy which selectively intervenes with market forces in the promotion of dynamic comparative advantage.

A central plan cannot efficiently perform the role of prices in a constantly changing environment, it cannot possess all the information dispersed among individual agents involved in decision making. As aptly put by Hayek, the price system provides the lowest cost option for communicating information and making one market out of countless individuals because each individual's field of vision sufficiently overlaps that of others: "the most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order

17 to be able to take the right action ".49 Since planning is the complex of interrelated decisions about the allocation of resources, all economic activity is planning, and the dispute is not about whether planning should be done but about whether it is to be done centrally, by one authority on behalf of the whole , or is to be divided among many individual agents. What this implies is that in conducting its planning functions, the planning authority should only interfere selectively with the price system and only out of conviction that prices matter and that the change brought about in the incentive structure is for the express purpose of bringing about an organizational and allocative response that satisfies the longer term objectives of dynamic efficiency.

The distinction between the role of government as a super-firm and autonomous enterprises organizing production, investment and transactions through the price mechanism can also be clarified by reference to Coase in his two articles analyzing 'the Nature of the Firm' and the 'Problem of Social Cost'. In the first he explains that the firm emerges in a specialized exchange economy because of the savings it achieves in costs attached to using the price mechanism -namely transaction costs - and that the size of the firm will be contained by the costs of organizing additional transactions. As firms get larger and "As more transactions are organized by an entrepreneur, it would appear that the transactions would tend to be either different in kind or in different places " and this can explain "why, if by organizing one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm?" In the second article, Coase reviews critically the concept of externalities and the compensation principle, arguing that one cannot ignore the reciprocal nature of the problem and that government regulation should only intervene in extreme cases where the market fails to bring about a negotiated solution between the parties that gain and lose from the externality. In such extreme cases, "the government is, in a sense, a super firm since it is able to influence the use of factors of production by administrative decision ... Such authoritarian methods save a lot of trouble (for those doing the organizing). Furthermore, the government has at its disposal the police and the other law enforcement agencies to make sure that its regulations are carried out ".50 What is implied is the need for a judicious choice of government intervention that minimizes the role of the state and allows organizations to make decisions in the light of a stable, coherent and transparent system of institutions.

In the case of Egypt, the current transition to indicative planning as expressed in the Third Five Year Plan document for 1992/93 to 1996/97 goes a long way towards reforming the institution of the Plan. Commodity balances are no longer the means to justify the implementation of projects that will fill the gap between projected domestic consumption and production (the long-lived import substitution criterion) and the entire public enterprise sector has in fact been excluded from the government's public investment budget. The public 'business' sector is now expected to make its own investment plans and to find its own sources of finance - on market terms - independently of any of the rigid controls it was subjected to over the past thirty years. The detailed observance of the plan's binding dictates on how much and where investments take place is no longer there, and enterprise profits - a major potential source of finance - are now subject to the same rules of distribution and tax liability as for the private sector. Moreover, the emphasis of public investments is on the provision of public goods (social services) and natural monopolies (infrastructure and utilities), with few large projects that have been chosen because of long term strategic considerations (e.g. land reclamation), while well

18 over half of targeted aggregate investment in the commodity sectors is projected to be undertaken by the private sector, especially in the critical activity of manufacturing. Nevertheless, the new plan's attempt to shift the focus of planning 'from the planning of projects to the planning of policies' can only bring about this forecasted acceleration in private sector activity if all of the institutional problems it suffers from are resolved, alongside the current reforms of the incentive structure which are being implemented as part of the program of structural adjustment.

Our second hypothesis concerning the public enterprise sector links its efficiency level to the incentive framework. If we are to assume that the institutional reforms are successful in breaking the hold of the bureaucracy over public organizations in the competitive sectors of activity, what factors will determine the level of x efficiency of these firms? What functions can still be performed by these firms now that they are neither instruments for income redistribution nor for fulfilling a centralized national plan? Hypothesis 4 asserts that there is no inherent difference in the managerial behavior of public as opposed to private enterprises in Egypt. The evidence for this statement can be found in two early studies of the operation of public enterprises, before they became subject to the totally inconsistent set of constraints that dictated inefficient behavior in response to distorted market signals. It can also be found in a detailed analysis conducted in 1981/82 on a large sample of private and public enterprises in Egypt's manufacturing sector which showed that there was no significant difference between the two sectors in measures of allocative efficiency.51 Moreover, TFP analysis of the comprehensive data set on formal public and private manufacturing firms over the 1970 to 1980 period shows no consistent superiority of private over public sector, and that in fact, in those branches of economic activity where they both really compete (e.g. textiles), the public sector rates of TFP growth were higher than those of the private sector.52

The performance of public enterprises in Egypt's manufacturing sector has thus been shown to be allocatively efficient for the majority of industries in which they operate and benefit from scale economies: most branches of textiles, food processing, basic metals, chemicals and engineering. Those enterprises that suffer from low rates of economic return (DRC ratio above 1) or negative domestic value added at international prices are few in number and fall into one of the following categories: the technology they utilize is either obsolete or is highly dependent on the acquisition of know how and capital equipment via a license agreement, which acts as a major constraint on innovation and technical progress; the project consists of low value added assembly operations that are only financially viable because of the high level of effective protection afforded to their products (which makes it attractive to multinational licensors to jump the tariff barrier and share with the licensee the equivalent import tariff which would have accrued to the state); the industry is highly energy intensive and can only survive because of the subsidized energy input.53 Moreover, it must be emphasized that public manufacturing enterprises created a comparative advantage for Egypt in a number of industries which they either pioneered or restructured in the 1960's including basic metals and metal processing, , paper, pharmaceuticals, railway rolling stock and some lines of electrical equipment and consumer durables. Their major strength has relied on the quality selection of their managers and technicians, the negotiating power they wield with multinationals, based on their oligopoly position in the domestic market, and the scale advantages they exploit either individually or by joining with other members of their group in such decisions as investment, production or importing of intermediates.

19 The type of support which the state has provided public enterprise and which allowed it to achieve dynamic economies is in no way peculiar to the socialist model of intervention nor does it only apply in practice to state-owned enterprises or to developing countries. In the case of one of the most socially oriented mature capitalist economies, industrial policy has sought to enhance the private sector's ability to exploit economies of scale, even at the expense of allowing firms to exploit market power. "... The attitude towards monopolies and "big business" has been quite different in Sweden as compared to, for example, the . Industrial policy has been a protrust policy rather than an antitrust policy with fiscal incentives (tax exemptions) for merging firms "54, and "Competition from abroad has been regarded as a substitute for competition policy ". ss This last condition is the crucial element of a rational industrial policy which provides for a strong national group of oligopolies but at the same time ensures that their market power will not allow them to engage in monopoly pricing and output. Not only do international prices matter, but market entry must also be ensured via a sensible investment licensing policy as discussed earlier.

In a developing country context, opportunity cost prices must be allowed to rule with the exception of limited protection for selected infant industries - in order for these prices to be reflected in the decision making process of autonomous public enterprises as well as in their operating results which can then serve as the basis for evaluating the performance of management. Egypt's unified accounting system for the public sector was instituted in the 1960s, and is based on sophisticated Western accounting conventions, with details that allow its automatic translation to national accounting flows. Public enterprises have since their inception been judged for their performance according to the profits or losses they generate, unlike establishments in Eastern European type economies.56 While the growth in price distortions of the 1970's and early 1980's made financial results of operations totally irrelevant to judging efficiency, the gradual price liberalization which began in 1986 ( and has been accelerated since 1991) will soon allow the profit and loss statements of enterprises to be reinstated as the tool whereby management can be held accountable for its results.

The essential hypothesis to be verified is that public enterprises have maintained their responsiveness to market forces in spite of all of the exogenous constraints imposed on their behavior via controls in their incentives and institutional frameworks. Measures of allocative efficiency were calculated for a sample of 31 enterprises affiliated to the Ministry of Industry representing the subsectors of manufacturing and accounting for more than half of capital employed in 1990/91. The results of our analysis57 show that industries which displayed comparative advantage ten years ago (1980/81) were still highly efficient(e.g. food processing, , , cables) except for the which would seem to have suffered from'the relative increase in international prices for extra long staple cotton.58 Another important result is that performance of some of those enterprises which suffered from low allocative efficiency in 1980/81 had significantly improved, either because they had altered their product mix (e.g. turning from passenger cars to buses), because the international price of energy inputs had decreased over the decade (e.g. aluminum and ceramics), or because they had benefitted from restructuring (e.g. the iron and steel complex). A third important result is that within each subsector, the variance in performance across firms is extremely high, a feature that has characterized Egypt's public sector throughout its history. These results are therefore consistent with the hypothesis that public enterprises are inherently responsive to the price mechanism but that the absence of a system of evaluation and enforcement of penalties for the chronically sick

20 firms means that those that should die (or be restructured) have instead been allowed to survive indefinitely. The challenge to the newly formed public holding companies is to use their mandate and move to rationalize their portfolios via all of the legal tools which have been instituted, including mergers, liquidation and privatization.

III. Structural Adjustment and the Future Role of the State

The legacy of four decades of heavy state involvement in the Egyptian economy has been more negative than positive, culminating in a set of unsustainable imbalances including the growth in the rate of unemployment, the food deficit, and the savings gap. Basic human needs are far from satisfied, is still too high and at least a quarter of Egypt's people are living below the poverty line.59 Starting with Infitah, the state's gradualist approach to liberalization has been responsible for an exorbitant cost in terms of the delayed response of economic agents to a reformed structure of incentives and in terms of the astronomical size of foreign which reached $ 50 billion by 1990-placing Egypt at the top of the world ranking in outstanding debt to GDP ratio. This piecemeal approach to reform has seriously aggravated the eventual social and political costs which the current comprehensive program of stabilization and structural adjustment is now imposing on the population. We have attempted to show that the partial nature of ODP meant that growth was dictated by an environment of excessive protection and distorted prices, leading to an anti-export and anti- labor bias and substantial investments in nontradables, low value-added activities and speculation. The positive potential of a generous package of investment incentives were neutralized by the persistence of import-substituting trade and investment regimes.

Our four hypotheses have also tried to bring the institutional dimension of state intervention more explicitly into our analysis and show how the incomplete nature of the legislative reforms and of the process of deregulation and decentralization have obstructed competition, raised transaction costs and retarded economic growth. The delayed or inadequate revision of property rights and especially the body of laws pertaining to financial markets, incorporation and employment have inhibited the flow of private investment into the productive sectors of economic activity. Moreover, the glaring inconsistencies between existing and new laws and regulations, the lack of transparency in many of the new provisions and the failure to reform the administrative apparatus of government and introduce strict but simple operating procedures have together encouraged the growth of agency problems, with mutual interests shared by the new class of powerful capitalists and elements of the bureaucracy that now wield new powers in interpreting the contradictory legislation and exploiting the high degree of discretion it provides. Although the structural adjustment program addresses a number of institutional issues, the state must pursue the many remaining issues, even though it is likely to face resistance from well entrenched interest groups.

In appraising Egypt's 1991 Economic Reform and Structural Adjustment Program (ERSAP), it is useful to distinguish between each function which the ERSAP is designed to address (refer to table 1). Stabilization policy60 (under IMF Standby) is designed to restore equilibrium in the government budget and external balance and to bring inflation under control. The measures that have been very successfully used are significant reductions in government expenditure including those on subsidies and on investment, as well as revenue raising measures, mostly indirect tax increases and increases

21 in the prices of public utilities and energy." The effects on economic growth are-as expected- highly negative. Yet such measures are being applied at a time when the economy has been suffering from six years of recession, in contrast to normal practice whereby expenditure reducing measures are used to stabilize an overheated economy. The restoration of GDP growth according to the IMF/ model is predicated on an upsurge in private sector investment in the medium term, a task made difficult when public investment is mostly of the "crowding in" type,62 and when a major element of the stabilization component of ERSAP has been to maintain a positive real rate of interest even at levels well above comparable international levels (the real interest rate reached 7 percent to 8 percent in 1993), in order to neutralize foreign capital flows.

While reforms of the real side of the economy (structural reforms) are still in progress, the implementation of Egypt's ERSAP has been completed in the area of liberalization of the exchange rate, financial markets and capital accounts. This sequencing is quite different from that effected in most economies and has resulted in substantial reversal of capital flight and in the dedolarization of the economy. Against the positive impact which this has had on the balance of payments63 and on business confidence, the unexpectedly large inflows of capital have in turn led to an appreciation of the domestic currency which is contrary to the policy objective of maintaining a competitive exchange rate. The government's weekly auction of Treasury Bills was introduced since January 1991 and has since served as the determinant of the Central Bank discount rate.64 Only part of these sales have been used to finance the shrinking budget deficit, and the balance has served to neutralize the huge capital inflows which in turn maintains high interest rates. The interest cost to the budget of the cumulative stock of Treasury Bills (LE 25 billion by end of 1992) threatens to replace the interest cost of . It is therefore difficult to justify the neutralization policy which continues to encourage massive and volatile capital inflows in response to the interest rate premium achieved on Egyptian (as opposed) to foreign currency deposits over the past two years during which the unified and flexible exchange rate has been highly stable.

However, and in spite of these two criticisms, it would seem fair to judge the achievements under stabilization as highly successful in terms of the country restoring its creditworthinesss with the rest of the world, in terms of bringing inflation under control, and in terms of removing the many elements which have discriminated between public and private sector enterprises in the markets for finance and for foreign exchange. The impact of introducing the system of Treasury Bill sales as a new tool of government monetary policy is in itself another achievement, and so is the application of a unified exchange rate to all items in the government budget and to all public sector transactions, a reform which will enforce transparency and avoid inconsistency and distortions. The positive roles of low inflation and a stable exchange rate on the real economy are also significant since business expectations and confidence are highly sensitive to these.indicators.

The structural adjustment component of ERSAP (under the World Bank SAL agreement) aims at liberalization (the incentives framework) and deregulation (the institutional framework) of all sectors of the real economy.65 Reforms were in fact begun in 1986 with a "gradual" correction of relative prices. By end of 1990, price liberalization had been completed for more than half of public enterprise production, energy prices had increased by 43 percent, and the agricultural sector was entirely decontrolled except for cotton, sugar cane and rice. By mid 1992, cotton prices had been

22 raised to 66 percent of their world price equivalent, petroleum prices had reached 80 percent of world prices, electricity 69 percent of its long run marginal cost and the percentage of public sector output value subject to price control had been reduced to 22.4 percent. Another component of liberalization has been the trade and protection regime. Maximum and minimum tariffs have been revised so as to reduce effective nominal protection. The list of tariff exemptions was revised downward from 49 percent of their potential tariff revenue equivalent in 1986 to 17 percent in 1990. The import coverage of import bans was reduced from 52 percent in 1990 to 37 percent in 1991 and 10 percent in 1992. Deregulation has also proceeded swiftly with the dismantling of public sector monopolies in most of the foreign trade and agricultural distribution system, and with reforms of the investment licensing system.66 The reform of public sector legislation has provided for full autonomy of public enterprises and of the public holding companies they are attached to. Rationalization of the regulatory function of the state is thus well underway, and the completion of ERSAP will remove all of the remaining areas of state imposed monopolistic behavior, especially with the expected dismantling of the public sector export monopoly for raw cotton and the revival of the domestic cotton stock exchange in 1993/94.

Whereas discrimination between public and private enterprise is gradually disappearing, the dualistic structure of the economy between the large/modern and the small/traditional sectors has not been addressed by the state. On the one hand, the state has failed to correct for market failure and provide the micro enterprise sector with access to credit and to basic education and training, with a 60 percent rate of illiteracy among the urban self employed and 78 percent among the rural self employed. On the other hand, it has attempted to supplant traditional institutions with ineffective modern ones that are too costly to conform to a situation which impedes the gradual integration of the informal sector into the formal economy.67

As to the issue of equity, ERSAP has grave implications on income distribution, given that it substantially alters the system of intervention that the state has utilized to address poverty and unemployment since the 1960s.68 On the one hand, the, reduction in the budget deficit on current account has been focused on measures such as squeezing explicit and implicit subsidies and raising indirect taxes, all of which have a regressive impact on income distribution. On the other hand, the reduction in employment opportunities, particularly in the public sector, is bound to hit those segments of the population that rely more heavily on wage and salaries as their sole source of income. Egypt has no general system of social insurance nor does the state provide any form of unemployment benefits. What is happening in point of fact is that Egypt's 30 year old social safety net system is being dismantled, while no apparent substitute is emerging. The state has not addressed the need to design a new social contract in the absence of open-ended subsidies and publicly guaranteed employment for the educated entrants to the labor force and which meets with the minimum demands on the government to provide targeted support for the vulnerable groups in society. The component of ERSAP is an emergency tool to ease the social and political burden of structural adjustment and its design is such that it can only reach a very small number of beneficiaries from the labor force. Yet, in Egypt, poverty and unemployment are negatively correlated '61 as explained by the predominance of educated in open unemployment, while the very poor have little access to intermediate or higher education which entitles their children to a white collar job.70

23 Our analytical framework has given prominence to the role of the state in assigning property rights. The state enacted a series of land reforms starting in the year of the revolution, turning over a significant part of agricultural land to landless peasants." In the 1960s, it reassigned property rights from the capitalist class of industrialists and merchants to the state. Now that private enterprise is the order of the day, the state has the option to reassign some of its property rights to the poor and the unemployed. Poverty alleviation could thus be combined with promoting income generating activities and help relieve the problem of Egypt's 2 million unemployed as well as raise the of close to another 2 million working in the informal sector. The potential of this last sector as the engine of growth has been largely ignored by the state. Four decades of concerted effort at promoting Egypt's economic growth with equity have altogether bypassed the small scale traditional business segments of the economy because of policies and institutions which have discriminated in favor of the large, modem and unionized sectors of activity, especially in the form of tariff protection, fiscal incentives subsidized credit and access to subsidized land. There are much larger externalities to be reaped by government intervention that targets small business and provides it with access to education and training, to serviced land and to credit:

"So far, the government has tolerated existing informal activity to reduce open rates of unemployment. It has not used it to provide new incentives to stimulate a sluggish economy. Nor has it encouraged its integration into the political domain as a way ofpromoting political participation at the grass roots level. In fact, this mushrooming disenfranchised class is likely to seek its own solutions, unless the government finds ways of assimilating it into national life. The growing vacuum emerging from a redefinition of the role of state as required by structural adjustment necessitates the formulation of a new social contract whereby the small scale private sector is recognized and encouraged in its own right as a key agent for growth and development. The notion of private individuals willing to risk their meager capital and to allocate their labor towards providing a decent living for themselves and their families must replace that of the rich and all-powerful provider state"."

24 Notes

1. North, D. (1990). 2. "Mainstream" institutional economists include North, Olson, Pejovich and Williamson. Others such as Hodgson have altogether rejected the neoclassical model. See Hodgson G.M. 1988 and Hodgson G.M.(1993). For a review of the literature see Langlois, R. (1986) and Hodgson G.M. (1993). 3. The static general equilibrium model was first constructed by Walras and later refined by Hicks, Samuelson and Arrow- Debreu. Solow (1957) was responsible for formulating the first growth model. In the single commodity economy, output is determined by a production function and the rate of change in the capital stock, itself determined by an exogenous savings rate. Any residual growth over and above that accounted for by capital accumulation is explained by an exogenous rate of technical change. The model can be solved for its steady state, and comparative dynamics between steady states are feasible. 4. Examples are Chenery H. (1979), Dervis, K., de Melo, J. and Robinson, S. (1982), Chenery, H., Robinson, S. and Syrquin, M. (1986), Scherer, M. (1982). Also see Chenery, H., Lewis, J., De Melo, J. "Alternative Routes to Development in Syrquin, M., Taylor, L. and Westphal, L. eds. (1984). 5. In its weaker form, the assumption is that the objective probability distribution is known to everyone (rational expectations theory). 6. According to Wallis, J. and North, D. (1986), the share of transaction costs in the U.S economy has grown to more than 45 percent of GDP in the 1970s, up from about 25 percent a century earlier. For empirical purposes,Wallis and North have used national income accounts and defined transaction costs in the economy as the sum of value added by transactions activities (Finance; Insurance and Real Estate; Wholesale Trade; and Retail Trade) and the wages earned in transaction occupations in the nontransaction sectors (accountants, lawyers and judges, managers, clerks, salesworkers, inspectors, guards and police ...). 7. North, D. (1984) and (1990) and Williamson (1985). For theoretical purposes, North uses a broad definition of transaction costs which includes information costs while Williamson distinguishes between exante costs (costs of drafting, negotiating and safeguarding an agreement) and expost transaction costs (maladaptation costs, haggling costs, governance costs, binding costs). Although most transactions costs overlap with information costs, it is conceptually useful to maintain the distinction between the two, see Myhrman (1988). 8. Hayek F. (1945), p. 520. In a stationary or slow changing environment information costs are negligible because most events repeat themselves and it is not difficult to learn the structure of the economy over time. This situation may have approached reality in past centuries but is no longer applicable. 9. Reduced costs are not necessarily achieved by new investments but also by reorganization through subcontracting of production, zero inventory management, and new forms of marketing and distribution. 10. The traditional notion of comparative advantage has been shown to be obsolete as in Porter, M. (1990), Best, H. (1990) Thurow, L. (1992), and Zysman, J. (1983). 11. On the unsuccessful development experience of Laissez faire economies of Latin America, this has been well documented in the literature of the 1950s and 1960s. Also see Naya S. et at, eds. (1989). On the experience of Southeast Asian NICs, see Gangnes, B. and Naya, S. (1992), Bhattacharya, A. and Page, J. (1992). 12. The growing share of giant oligopolistic corporations in domestic and world markets is an accepted feature of the modern capitalist system which has replaced the traditional competitive market structure that earlier characterized mature economies. Thurow, L. (1992) reports that itself is also increasingly being managed by governments and that nontariff barriers are rising among developed countries. In the U.S. for example, the percentage of American imports that are subject to nontariff restrictions has doubled in the past decade to reach 25 percent, with a widening range of products from textiles (with the expansion of the multifibre agreement) to semiconductors (with the U.S./Japan deal) coming under coverage (also see Tyson L.D.(1992)). In successful Southeast Asian countries, a totally liberalized import regime has been deliberately avoided, protection being afforded to each targeted growth industry (electronics, computers, cars) until it has achieved a competitive status. Imports from low cost labor countries have also typically been restricted (textiles). 13. Demsetz H. (1967), p. 357. For several contributions to the literature on internalization see Cowan, T. (1992). 14. Evidence for the relatively higher costs of transactions and information in LDCs can be found in de Soto, H. (1989) Portes, A. et at (1989) and Chickering, A. and Salahdine, M. eds. (1991). 15. Institutional theory has in fact long been used as the framework of analysis for and political science. 16. Seabrook J. (1990), p. 188. 17. Thurow, L. (1992), p. 105. 18. The open economies of South America in the 1950s are perhaps best considered as Min/High. 19. For a similar classification of the first three functions of the state see Beckerman W. "How Large a Public Sector?" in Helm, D. ed. (1990). For a textbook elaboration of examples of the function of the state, refer to Hyman D.N. (1990) Public Finance 3rd edition Chicago: the Dryden Press. 20. The distinction between public and merit goods is based on the two principal characteristics that define a public good: nonexcludability and non rivalry. 21. de Soto, H. (1990), Portes, A., et at (1989), Chickering, A.L and Salahdine, M. eds. (1991), Hopkins, N.S. ed. (1992). 22. See Helm, D. ed. (1990), Galal, A. et at (1992). 23. For examples see Scherer, M. (1982), Scherer, M. (1986), Mansfield, E. (1988), and Griliches, Z. and Maitresse, J. (1990) "R & D and Productivity Growth: Comparing Japanese and U.S Manufacturing Firms" in Hulten, C. ed. (1990). 24. See Best, M. (1990).

25 25. Best, M. (1990), Thurow, L. (1992), Portes, A. et al (1989) and Madnick, S.E. "The Information Technology Platform" in Scott Morton, M.S. ed. (1991). 26. For the length of the infant protection period see Jacobsson, S. (1993). Also see Bohn-Young, K. (1982) and (1984) and Handoussa, H. (1986) for selectivity of investment and trade regimes of South Korea. 27. Harris J.R. ed. (1971), Handoussa, T. (1973), and Trigger, B.G. et al (1983). 28. Theodorides, A. "The Concept of Law in Ancient Egypt" in Harris, J.R. ed. (1971), p. 320. 29. See Issawy, C. (1990), Owen, E.R.J (1969), Mead, D.C. (1967), and Hansen, B. and Marzouk G. (1965). 30. See Handoussa, H. (1991) and Handoussa, H. and Shafik, N. (1991). 31. Evidence for the operation of a relatively undisturbed market mechanism throughout the socialist period (1960-1973) which witnessed Egypt's First Five Year Plan and the wave of nationalizations can be found in Hansen, B. and Nashashibi, K. (1975), Handoussa, H. (1979a), (1979b) and (1980). The argument is that public sector enterprises, in spite of the centralized organizational structure and of the price and employment constraints which governed them, were managed according to market rules and profit maximization was their objective function. 32. Fahmy, K.M. (1988). 33. Foreign Investment Directory Service (1991), p.i. The other two impediments are a poor macroeconomic framework and the predominance of public enterprise in the economy. 34. See World Bank (1983). 35. Ibid. 36. Handoussa, H. (1991) "Reform Policies for Egypt's Manufacturing Sector" in Handoussa, H. and Potter, G. eds. Mechanization has also accelerated in the agricultural sector over the 1970s as analyzed by Richards, A. (1991) "Agricultural Employment, Wages and Government Policy in Egypt during and after the Oil Boom" in Handoussa, H. and Potter, G. eds. 37. Moursi, T.A. (1980) and (1986). Also Kheir El Din H. and Clark, P. (1979) Economic Studies Unit, Ministry of Economy and Economic Cooperation. 38. Handoussa, H. and Kaldas, S. (1986) "Efficiency Issues in the Allocation of Loans for Food Security Project". Report prepared for Minister of Agriculture, February. 39. Handoussa, H. (1989b) and Handoussa, H. (1991). 40. Abdel Khalek, G. ed. (1982) and Biblawi, H. (1992). 41. Handoussa, H. (1989b). 42. Calculation from ibid for Law 43/230 projects, and from GOFI register for formal public and private manufacturing establishments in 1992 (formal is defined as having a minimum of LE 5000 of capital per establishment). 43. Handoussa, H. (1993b). 44. The standard example of a transaction cost is the cost of finding parties with whom to trade. The difficulty of contacting and communicating with foreign trading companies is thus a significant cost to Egyptian exporters. 45. World Bank (1991b) and GATT (1992). 46. See Integrated Development Consultants (1989) and Handoussa H. and Potter G. (1992). 47. Handoussa, H. (1991), "Reform Policies for Egypt's Manufacturing Sector" in Handoussa, H. and Potter, G. eds. In 1974, at the outset of ODP, and before the accelerated growth of price distortions, a total of only 4 out of the entire group of 116 public enterprises affiliated to the ministry of industry were making losses and no enterprise was receiving subsidies from the treasury. By 1984/85, the number of losing enterprises in the same group had climbed to 33 after receiving subsidy transfers of LE 339 million for that year. Handoussa, H. (1980) and Ministry of Industry (1990) and (1991). 48. See Table 1. in Handoussa (1989b) which compares the old public enterprise Law (Law 97 of 1983) with the new law (law 203 of 1991). 49. Hayek, F.A. (1945), p. 526. 50. Coase, R.H. (1937), p. 390-1 and p. 394 and Coase R.H. (1960), p. 17. 51. One study is Handoussa, H. (1974), The Economics of the Pharmaceutical Industry in Egypt. Unpublished Ph.D. dissertation, the University of London. Other evidence can be found in Handoussa, H. (1979a), Handoussa, H. (1980) and World Bank (1983). 52. Handoussa, H. (1991), "Reform Policies for Egypt's Manufacturing Sector", in Handoussa, H. and Potter, G. eds. The results were in fact very poor for both sectors with negative TFP growth in many of the manufacturing branches. 53. The prime examples in the first category are Egypt's Iron and Steel mill at (built in 1954 with West German Technology), the Abu Zaabal complex for basic pharmaceutical raw materials (built in 1961 with Soviet Technology) and the passenger car factory at Helwan (built in 1960 with Italian Technology), See Handoussa, H. (1979a). The second category includes the consumer which assembles foreign branded products and in which the public enterprises now compete with the new private firms for a large and lucrative domestic market. The two cases of highly energy intensive industries whose comparative advantage is totally dependent on the world price of energy are the Aluminum smelter and the Ferrosilicon plant in . 54. Hjalmarsson, L. "Competition Policy and Economic Efficiency: Efficiency Trade-offs in Industrial Policy" in Bourdet, I ed. (1992), p. 338. 55. Ibid, p. 337. 56. For Egypt's State control over the public sector see Wahba, M. (1986). For Eastern , See, Kornai, J. (1990), Schmid, A. (1992), Ferguson, P.R. (1992). 57. See Indicators of Allocative Efficiency in Egypt's Public Manufacturing Sector, 1990/91, prepared by Ismail Shoukry. The

26 sample is biased so as to represent all manufacturing subsectors and to include enterprises which were found to be the best and worst performers in the 1980/81 joint study between the Ministry of Industry and the World Bank. See World Bank (1983). 58. The results for the Textile Industry would seem to confirm those arrived at in 1986 by Kheir El Din, H. et. al. (1989). 59. See World Bank (1991a). 60. In a mature economy, stabilization refers to government intervention to dampen the cyclical upswings and downswings of the economy's growth path. The Keynesian model takes full employment as the equilibrium which the economy will return to with appropriate fiscal and monetary intervention. There are two reasons why the model does not seem appropriate to developing countries. One is that equilibrium in an LDC is normally at a level of significant , especially of labor, so that the government's fiscal policy should do much more than intervene to "stabilize". The other is that the living standard in an LDC is so close to subsistence that the hardship suffered as a result of stabilization policy under ERSAP cannot be compared to the belt tightening costs of stabilization in a mature economy. Again, the role and responsibility of the state cannot be compartmentalized as is implicit in IMF prescriptions that have little regard to the employment and poverty implications of stabilization programs. 61. See IMF (1992). 62. The bulk of public investment over the last Five Year Plan and the current (Third) Five Plan are in the infrastructural, utilities and land reclamation projects. See World Bank (1992b). 63. See IMF (1992). 64. Ibid. 65. Ibid. 66. With the publication and revision of the negative list for investment licensing, market entry rules have become transparent and market entry itself is in line with promoting competition. 67. See Handoussa, H. and Potter, G. (1992). 68. See Handoussa, H. (1989a). 69. Fergany, N. (1992) 70. See Handoussa, H. and Potter, G. (1992). 71. See Abdel Fadil, M. (1980). 72. Handoussa, H. and Potter, G. (1992), p. 23.

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