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Pyramid capitalism: Cronyism, regulation, and firm productivity in Egypt

Abstract

We present novel evidence suggesting that cronyism had a negative effect on economic growth in Egypt, during a period when international organizations praised the country for its reforms of business regulation. We identify 385 politically connected firms under the Mubarak regime. This large database allows us to show that 4-digit sectors that experienced crony entry between 1996 and 2006 exhibited lower aggregate employment growth subsequently than those that did not. In manufacturing, labor productivity grew more slowly in sectors that experienced crony entry. Ample, though not definitive evidence suggests that this effect was causal. Crony entry skewed the distribution of employment toward smaller, less productive firms; crony firms do not appear to have entered sectors that would have also grown more slowly even in the absence of crony entry; and they enjoyed multiple regulatory and fiscal privileges that reduced competition and investments by non-crony firms, including trade protection and energy subsidies. These privileges account for the higher profits of politically connected firms.

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Notes

  1. It cut the minimum capital required to start a business, from 50,000 Egyptian pounds to 1000; reduced fees for registering property from 3% of the property value to a low, fixed amount; eased construction permitting.; launched new one-stop shops for traders at Egyptian ports; cut the time to import by seven days and the time to export by five; and it established a new private credit bureau (World Bank 2007).

  2. Kroszner and Stratmann (1998) show that political influence affects regulatory protection in the United States, but influential firms are far from “cronyistic”. Rather, legislators simply pay more attention to, and are more susceptible to lobbying by, economic sectors that are important in their districts.

  3. Chekir and Diwan (2015) also find that connected firms, despite lower profitability, exhibit higher stock market value. This could be consistent with the market value attached to the lower risk of predation and expropriation of connected firms.

  4. See also Parente and Prescott (2002).

  5. Innovation therefore allows firms to “escape competition,” at least temporarily. They argue that the “escape from competition” effect outweighs the traditional argument that perfect competition suppresses innovation by reducing the rents from innovative activity.

  6. Another outcome would have been possible if the privileges of connected firms were, in fact, not so large as to deter competition and thus investment by other firms in their sectors. If the privileges they enjoyed were less generous and did not reduce the expected profits from investments by other firms in their sectors, then sector growth could in fact have been faster in the presence of cronies. Contrary to this case, though, we find that the presence of connected firms suppresses sectoral growth.

  7. “Ex post” criteria include the use of lists of owners of confiscated assets after a regime change. The “ex post” approach may yield fewer false positives (the identification of cronies who, in fact, never exercised their proximity to the president for economic advantage). However, the approach may also yield false negatives to the extent that firms connected to the old regime also engaged in crony behavior subsequently, establishing close relationships with new leaders and avoiding asset confiscation.

  8. Many countries have conflict of interest laws that could force individuals to sell their businesses when they take high-ranking political office. In Egypt such a law was introduced only in 2012 and has not been enforced yet. No such law was in place during the period of our study.

  9. Faccio (2007) follows “ex ante” criteria similar to the ones we use, but also includes legislators within her universe of politically connected individuals. We assume that in an autocratic setting such as Egypt’s, members of parliament exercise little formal influence over policy.

  10. We also include Mr. Alaa Abd El Maksoud Arafa, a long-term friend of the Mubarak family who did not have a high political post during Mubarak’s rule. However, he has been a close business partner and co-owner of a holding company with Gamal Mubarak. The firms connected to him have been identified through this holding company and are thus also directly connected to Gamal Muabrak, satisfying criteria (ii).

  11. The names of major shareholders and managing directors of companies formerly listed on the Cairo stock exchange are publicly available. We identified these through online searches using financial portals such as Mubasher or Beltone. We applied a cut-off value for ownership by a connected businessman of 10%.

  12. We do not have information on firms owned by the military since ownership data of the military beyond anecdotes is not available. The military in Egypt does not need to disclose its budget details to the Egyptian government. Moreover, we do not identify private firms that were never listed or have never been partially owned by a stock market-listed company.

  13. The former Minister also faced accusations of subsidizing specific export industries while holding shares in companies operating in these industries and of an illegal selling of steel-manufacturing licenses while in office.

  14. We exclude the following sectors, where firm dynamics in these sectors are driven by the government and not the private sector in Egypt: public administration, education, health, arts (4-digit ISIC Rev. 4 codes larger than 8400).

  15. Sectors vary also with respect to the number of politically connected firms. Fifty-seven sectors have exactly one firm with a politically connected owner, while one sector has 29 firms with connected owners; 60 sectors have exactly one politically connected firm of any type, while one sector has 30.

  16. These sources give the date of incorporation both for the mother company and for subsidiaries (establishments), as well as the years in which changes in firms’ ownership structures took place (crony businessmen acquiring or selling shares in companies) and mergers and acquisitions of previously unconnected firms by connected firms. All of these allow us to capture the entry of politically connected firms into new sectors.

  17. Tracking the firms of the connected businessmen over time, we found no cases of the exit of a crony firm between 1996 and 2011 (crony banks exited in the late 1980s, before our period of interest).

  18. Over a sufficiently long time period, sectors with higher productivity growth exhibit higher marginal products of labor and thus greater employment growth (see the reviews for empirical evidence from developing countries in Herrendorf et al. 2014; World Bank 2014; Vivarelli 2012).

  19. All politically connected firms had at least 20 employees in 2006. Overall, there were in total only 18,640 establishments with more than 20 employees according to the 2006 establishment census; 69% of all establishments in the census had fewer than 5 employees.

  20. Most of the prior research cited above, examining the performance of connected firms, has relied, as we do, on a combination of theory and empirical correlations to make causal inferences about the effects of political connections. Some prior research (e.g., Fisman) has exploited exogenous variations in political connectedness, such as announcements of leader illness, to make inferences about the causal effects of political connectedness on connected firms’ value. The longer time horizons needed to estimate impacts on aggregate growth make it difficult to rely on the methodologies in this latter research, however. In particular, the power of event studies is greatest when examining the effects of exogenous shocks on outcomes reported with high frequency. Changes in aggregate growth, though, can only be meaningfully measured over longer time periods.

  21. Most crony firm entry took place in the beginning of this period, leaving sufficient time for the impact of crony firm entry on sector market structures to materialize. In fact, 29 (24) out of the 35 crony firms entered previously unconnected sectors before 2001 (1999). Moreover, the results below are robust if we remove the five cases in which crony firms entered into unconnected sectors after 2001 from the estimation (results available from the authors).

  22. The 23 4-digit sectors within which we observe the entry of a politically connected firm is a large number in the context of the problem we are analyzing, but they are too few to also control for the unobserved sector characteristics of the 49 2-digit sectors to which the 23 sectors belong. In particular, at the 2-digit level, in some cases all of the 4-digit sectors are connected and therefore drop out when controlling for 2-digit sector dummies.

  23. In contrast, the signs of the other coefficients are ambiguous since the theory does not speak to growth differences between already-connected sectors and either already-connected sectors that experienced additional crony entry (βE), or unconnected sectors that did not experience crony entry (βN). For example, the effects of crony entry into already-connected sectors are ambiguous because these sectors may have already experienced the distortions associated with crony privilege.

  24. We cannot re-construct the figure for 1996 and 2012 since we only have access to the complete establishment census data in 1996 and 2006 but not in 2012. The complete census is needed to plot the distribution of employment across all establishments in Egypt. For 2012, we only have access to the total and average employment across firms by 4-digit sectors.

  25. We also find that the employment distribution in connected sectors is more right-skewed and exhibits a higher coefficient of variation (fatter tails) in employment. Likewise, the skewness and coefficient of variation in employment increased in crony sectors but declined in sectors that remained unconnected between 1996 and 2006 (we were able to obtain skewness statistics for always-unconnected firms, but not their full distribution). The results are available from the authors upon request.

  26. The World Bank database on NTMs provides either the year when an NTM was introduced or the latest year in which it was substantially revised. It does not distinguish the two.

  27. We convert the NTM data from the 6-digit (HS Rev. 2002) product classification to the 4-digit product group / industry (ISIC Rev. 4 classification) by using concordance tables from HS Rev. 2002 to ISIC Rev. 3 to ISIC Rev.3.1 to ISIC Rev. 4, respectively. Several firms operate in more than one 4-digit product group so that in total we have 230 product-firm observations in manufacturing or mining. Three politically connected firms are in two 4-digit ISIC Rev. 4 product groups, Casting of non-ferrous metals and Forging, pressing, stamping and roll-forming of metal, which we had to drop from the NTM analysis since they had no equivalent HS (Rev. 2002) product code.

  28. Some products in Egypt are also subject to sanitary measures (NTM Class A), mostly in the food sector, or price controls (NTM Class P), typically in addition to technical import barriers (NTM Class B).

  29. Observing the distribution of non-tariff technical barriers to import across all manufacturing or mining industries does not indicate that manufacturing or mining industries with more firms exhibit more barriers. If anything, more concentrated sectors benefitted disproportionally. 65% of all industries had some NTM protections, compared to only 56% of all firms.

  30. Large firms are defined as firms with at least 200 employees; there were 563 not politically connected manufacturing and mining firms in Egypt in 2006. We computed the number of large unconnected firms by subtracting the number of large politically connected firms, broad definition, from the total number of all large firms for each product group. We include large non-connected firms as an additional control group since these firms might have more similar characteristics (other than political connectedness) relative to connected firms, which are typically large firms.

  31. We cannot exclude the possibility that some large firms that we classify as unconnected were, actually, connected. However, it could also be the case that large connected firms coincidentally benefit from privileges that all large firms, connected and unconnected, receive.

  32. Note that almost all products are sold by at least one large firm and several smaller firms so that we cannot meaningfully separate product groups sold by primarily large unconnected or small unconnected firms.

  33. The results are available from the authors upon request. Note that we can only run such a probit regression at the (more aggregate) product but not the firm level since we cannot identify the individual politically connected firms in the establishment census data.

  34. See Table A2 in the Appendix for the UN classification of sector energy intensity. High energy-intensive industries account for 22% of all mining and manufacturing 4-digit industries, moderate energy-intensive industries for 37%, and low energy-intensive for 42%.

  35. Energy-intensive sectors tend to exhibit greater capital intensity. An alternative explanation for the findings in Table 7 is therefore that connected individuals simply have better access to capital markets. However, this interpretation is consistent with the evidence provided in this paper that cronyism suppresses growth by lowering the costs (of access to capital) of connected firms compared to other firms in the sector. Indeed, the next section shows that firms in sectors with connected firms are more likely to report having access to credit.

  36. The results are available from the authors upon request. Note that we can only run the probit regression at the industry but not the firm level since we cannot identify the individual politically connected firms in the establishment census data.

  37. We use ln(assets) instead of ln(employment) to measure firm size since many of the firms that report profit data do not report their (consolidated) number of employees in Orbis. Thus, we only observe employment and profits jointly for eleven politically connected manufacturing firms and 40 firms overall.

  38. Note that, in contrast to Table 9, we also control for firm size and age so that the coefficients differ somewhat.

  39. As in the literature more generally, not all politically connected firms in Egypt exhibit a higher return on assets (higher ln(profits/assets). Those that are not could be those where the government has extracted more costly favors in exchange for political privilege. This is an especially plausible interpretation in light of the fact that the same connected businessmen often own multiple firms. They can more than offset the costs of favors in one of their enterprises with the privileges in others.

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Acknowledgements

We are grateful for very helpful comments received by participants in seminars at the World Bank, the Harvard Kennedy School, the ERF Conference 2014 in Cairo, the World Bank ABCDE Conference in Washington D.C., the CSAE Conference 2014 at Oxford University, the IZA-World Bank Labor Conference 2015, and the LACEA Annual Meetings in Medellín 2016.

Disclaimer

The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent, nor of the Inter-American Development Bank, its Board of Directors, nor the countries that they represent.

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Diwan, I., Keefer, P. & Schiffbauer, M. Pyramid capitalism: Cronyism, regulation, and firm productivity in Egypt. Rev Int Organ 15, 211–246 (2020). https://doi.org/10.1007/s11558-018-9327-2

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Keywords

  • Cronyism
  • Growth
  • Political connections
  • Productivity
  • Regulation

JEL codes

  • D72
  • D24
  • O47