By Edmund Blair and Patrick Werr
CAIRO (Reuters) - Egypt's new Islamist president and his old military foes have come out swinging in a struggle for political power, but their countrymen need them to find a way to work together to avert economic chaos.
In the two weeks since his inauguration, President Mohamed Mursi of the Muslim Brotherhood has openly defied the entrenched military by summoning the Islamist-led parliament the generals dismissed on the eve of his election.
The political confrontation risks paralyzing the government, and the first casualty could be Egypt's fragile economy, fast heading towards a balance of payments and budget crisis.
The past year and a half of turmoil has frightened away tourists, sent investors packing and wrecked economic growth. Egyptians need their leaders to set aside their political quarrel fast.
"Both the military and the Brotherhood are here to stay for the foreseeable future and neither side is strong enough to defeat the other, so there has to be some compromise," said Shadi Hamid of the Brookings Doha Center.
The army, in power for six decades, moved to limit the power of the new civilian president even as voters were lining up to elect him. On the first day of a two-day run-off election last month, generals dissolved the parliament. On the second day, they issued a decree restricting the president's powers.
Mursi did not wait long to assert his own power either, issuing a decree summoning the disbanded parliament just days after he took office. The lawmakers met on Tuesday. Judges, seen as allies of the generals, responded by rebuking Mursi.
An economy in such straits will not long survive such confrontation, said economist Said Hirsh of Capital Economics: "Months, rather than years, they can hold on like this."
Mursi, whose Brotherhood was repressed under the rule of military men, wants to whittle away at the might of the Supreme Council of the Armed Forces (SCAF) and the sweeping economic interests they control.
But he must also address demands of an electorate desperate for jobs and security after exhausting uncertainty since Hosni Mubarak was toppled by street power in February last year.
"Confronting SCAF and improving the economy don't always go together. Sometimes you have to make a choice to prioritize one over the other," said Hamid.
The political crisis may have already cost Mursi valuable time to set the economy straight, and the tasks ahead are huge.
Egypt's foreign reserves have tumbled to $15.5 billion, well below half the level they were at when the anti-Mubarak uprising erupted in January 2011. Interest rates the government pays have rocketed to an unsustainable 16 percent for one-year treasury bills, their highest in a decade.
Investors will be watching closely as Mursi sets up a new government. Several names for a new prime minister are being bounced around - mostly technocrats with an economic background.
"The formation of a legitimate government - and evidence that that government is capable of making and implementing policy - is essential if investors who believe in Egypt's long term prospects are to be persuaded that they can begin to deploy capital now," said Simon Williams, HSBC economist in Dubai.
Mursi must convince the International Monetary Fund that he has enough control of government and broad political support to implement austerity measures the IMF is expected to demand to open the way for a loan facility, last put at $3.2 billion.
Mursi may win breathing space with donations. He visited wealthy Saudi Arabia this week in his first trip abroad since taking office. The West - fearful of instability in the first Arab state to make peace with Israel - also will not want to see Egypt fail.
But Saudi or American handouts will not earn much respite. Egypt needs to win over investors further afield, ranging from Western bond buyers to multi-national firms, which until Mubarak's overthrow poured in cash and delivered growth and jobs - even if Egyptians complained only the rich benefited.
"External aid will buy Egypt time, but Egypt needs reform, access to private capital and growth if it is to begin to reverse the losses of the last 18 months," said Williams.
A Western diplomat said Egypt is always likely to find a way to avert catastrophe, but that alone would not be enough to deliver on the hopes of people who expect a better future.
"They will always find a way to muddle through, but the prize is not to muddle through," the diplomat said. "The prize is to do something different."
In the years before the uprising, economic growth hit 7 percent, making Egypt a darling of emerging market investors. It now hobbles along below 2 percent, far below the level needed to create jobs for the youths who drove protests against Mubarak.
Egypt's pound has lost only 4 percent of its value against the dollar since the uprising, but even that seeming good news unsettles some foreign investors because they fear there is still room for a big devaluation ahead.
David Cowan, a Citibank economist, said he believed Egypt still had enough reserves to support its currency for another year and did not expect an IMF agreement until early 2013.
"My central scenario is more political confusion and just more policy muddle through for the rest of this year, whatever long-term damage this is doing to the economy," he said.
More political battles are on the way, including the fight to shape the new constitution. Earlier constitutional declarations and proposals by the army indicate the generals want to preserve their status and privileges from civilian oversight, which the Brotherhood is determined to impose.
"The big potential flare-up is the constitution," said the diplomat, pointing to a verdict that could come as early as next week from a court about whether an assembly appointed to write the new charter should be dissolved or not.
Yet, the disputes so far in Mursi's presidency may also yield a few reassuring signs. Though tensions rose, there was no descent into the kind of violence that often erupted last year.
The army did not physically prevent members of the disbanded parliament from gathering and even withdrew its troops that were stationed outside the building, handing over to police. Pro-Mursi demonstrations were peaceful.
Short of a full-scale military coup, which analysts think very unlikely, the army has less room to maneuver since it handed over executive power to Mursi. The president, meanwhile, may have emerged with some extra credibility.
"He had to demonstrate he was not going to be a pushover president, that he was going to be strong president with powers, and I think in that sense he has succeeded," said Hamid.
(Writing by Edmund Blair; Editing by Peter Graff)