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Country Focus: Lebanon Navigates Difficult Waters

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
April 2007
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In early 2006, the Lebanese government outlined an ambitious reform program to reduce the country’s large debt and financial vulnerabilities. The timing was opportune because the economy looked poised for a strong recovery. However, the July 2006 conflict with Israel dashed hopes of high growth and forced the government to adapt its reform strategy to the postconflict environment. Donors endorsed the government’s revised agenda, presented at the Paris III conference on January 25, 2007, and on April 9, the IMF Executive Board approved a $77 million loan to Lebanon in the form of Emergency Post-Conflict Assistance, as part of a concerted international effort to assist the country.

The five-week conflict with Israel and the month-long blockade that followed inflicted a heavy human and economic toll on Lebanon. Housing and infrastructure suffered significant damage, many professionals left the country, and economic activity came to a near standstill, with tourism being particularly hard hit. As a result, real GDP in 2006 is estimated to have been flat. Financial markets weathered the crisis surprisingly well, owing to the central bank’s skillful management of pressures, the banking system’s strong liquidity position, and the timely deposit with the central bank of $1 billion by Saudi Arabia and $500 million by Kuwait. Cumulative deposit outflows of $3 billion during the conflict were recouped by year-end, but deposit dollarization and Eurobond spreads have remained larger than before the conflict.

The conflict has exacerbated Lebanon’s challenges in reducing its debt and financial vulnerabilities. The overall fiscal deficit widened in 2006, partly because of conflict-related revenue shortfalls and the need to accommodate relief and reconstruction spending. Donors committed $1.7 billion to help deal with the fiscal impact of the conflict, but government debt still increased to $40 billion (179 percent of GDP) by end-2006.

Reform strategy

Against this background, the Lebanese government is seeking to reduce its debt-to-GDP ratio by about 50 percentage points over five years. The reform program envisages fiscal adjustment to begin in 2008 with increases in gasoline excise taxes, the value-added tax rate, and the tax on interest income. In addition, the government plans to introduce a global income tax that will distribute the adjustment effort more evenly. On the expenditure side, the government intends to contain the wage bill and reform the social and energy sectors to limit open-ended transfers from the budget while protecting capital and social expenditures. Privatization of the telecom sector should also help reduce the debt.

The international community endorsed the government’s medium-term reform program at the Paris III conference in January. It pledged $7.6 billion in grants and loans to be disbursed during 2007-10. Of these pledges, $5 billion will go to the government in the form of budget support and project financing, and the remainder will support private sector development. Donors have indicated that their financial assistance will be conditional on steady implementation of reforms.

It is clear that 2007 will be a difficult transition year. Political tensions constrain the room for maneuver, paralyze legislative action, and adversely affect economic activity and financial markets. Still, the government has, under the IMF’s Emergency Post-Conflict Assistance, committed to containing the fiscal deficit, in part by setting a floor on gasoline excise taxes, while allowing for relief and reconstruction spending.

The financing strategy relies on the timely disbursement of donor assistance, which is also important to limit a further buildup of government debt. In addition, the government will undertake important structural reforms in 2007 to support the medium-term reform and debt reduction objectives. These include strengthening public financial management to better align spending with policy priorities and initiating reforms in the social security system and the energy sector.

Axel Schimmelpfennig

IMF Middle East and Central Asia Department

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