* Government faces daunting fiscal challenge
* Borrowing costs a quarter of state outgoings
* Lending may raise questions over c.bank independence
By Patrick Werr
CAIRO, July 25 (Reuters) - Egypt's cash-strapped government has been borrowing from the central bank on a large scale over the last 12 months, an unusual measure that indicates it may be running out of options to finance its persistently high budget deficit.
The borrowing has helped the army-backed interim cabinet to keep the economy running during the delicate transition to democracy, but shows the sheer scale of the task the new government will face as it tries to resolve Egypt's daunting financial problems.
"Central banks don't lend to the government on that kind of a scale, except when there's no choice," said an economist based outside of Egypt, who did not want to named because of the sensitivity of the issue.
A popular uprising last year hammered the economy by chasing away tourists and foreign investors and sparking a series of worker strikes for higher wages. Gross domestic product (GDP)growth slowed to around 2 percent in the 2011/12 financial year from 5 percent or more in previous years.
The military-backed government in June 2011 rejected a loan that the IMF had offered to help it over the crisis and instead turned to the local market to finance its deficit, now running at 8.2 percent of GDP.
This has pushed the lending ability of local banks to the limit and caused the government's cost of borrowing to soar. In June the interest rate on 364-day treasury bills surged to nearly 16 percent from only 10.44 percent immediately before the uprising that unseated Hosni Mubarak.
In October, Egypt's then Finance Minister Hazem el-Beblawi warned that the local market's ability to lend to the government had almost reached its limit.
But in a draft budget published on Sunday, for the fiscal year that began this month, the government said it expects the budget deficit to grow by 12.5 percent to 135.0 billion Egyptian pounds ($22.26 billion).
A quarter of state expenditure would go to pay the interest on debt, which will rise 26 percent.
Information about direct government borrowing from the central bank appears on the bank's website, which shows its "net claims on government" rising by 71.7 billion Egyptian pounds ($11.8 billion) to 186.4 billion pounds during the fiscal year that ended on June 30.
This is equivalent to well over half of last year's 120 billion pound budget deficit and to about 4.5 percent of total GDP. Over the previous five years the net claims on government figure had remained relatively unchanged.
"If the central bank didn't do it, interest rates would have gone through the roof," said an economist at an international lending agency.
This type of borrowing at such high levels is unsustainable in the long term. It also makes it tougher for the government to build political momentum to reduce its deficit and risks stoking more inflation, economists say.
The central bank did not reply to an email seeking comment.
Until now, the creation of Egyptian pounds caused by the central bank's lending has been balanced by a simultaneous decline in foreign reserves, which is the other side of money supply. But once Egypt depletes its reserves, any further lending to the government would be pure monetary creation.
"It's not sustainable in a non-inflationary way," said an analyst with a Cairo-based investment bank. "After they run out of net foreign assets then all you have is this growth in net domestic assets. This risks triggering stronger inflationary pressure."
The government has been selling its foreign reserves to support the Egyptian pound, partly out of concern that a more expensive dollar would increase the cost of imports and boost inflation already running at about 8 percent a year, fuelling more political discontent.
During the 2011/12 fiscal year, reserves fell by $11 billion, an amount roughly equal to the amount of money the central bank lent to the government. Of the remaining $15.5 billion in reserves, only about $8 billion is in liquid cash or negotiable securities, economists say.
The drain shows little sign of abating. Despite large one-off inflows of dollars in May and June, reserves barely increased.
During those two months, Egypt received at least $1.5 billion in loans from Saudi Arabia and $1.5 billion from the sale of dollar-denominated treasury bills.
It also gained $500 million from an annual revaluation of the central bank's holdings of gold and collected at least part of the proceeds from the $3.15 billion sale of shares in telecoms operator Mobinil to France Telecom.
The government's borrowing and its determination to keep the currency pegged to the dollar also raise questions as to how independent the central bank is and whether fiscal rather than inflationary concerns are driving its policy, economists say.
But a banker with knowledge of central bank thinking compared the operation to quantitative easing in the United States, and said the amounts were still small enough to be within the safety range of monetary creation. ($1 = 6.0630 Egyptian pounds) (Editing by Stephen Nisbet)