Lebanon: Selected Issues
Author: International Monetary Fund
Publication Date:
09 Jun 2006
eISBN:
9781451822687
ISBN:
9781451822687
Language:
English
Keywords:
ISCR; CR; debt sustainability assessment; interest rate determination; dollar deposit; position of the sovereign; maturity mismatch; liquidity position decline; net foreign exchange position; Commercial banks; Foreign currency exposure; Financial statements; Financial sector
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The Selected Issues paper of Lebanon provides an update of the vulnerability assessment based on the balance sheet approach. It explores the interest rate determination, the strength of the link to international interest rates, and exposure to international interest rate shocks, summarizes the methodology used to derive confidence intervals around the path of the debt ratio in the staff’s adjustment scenario, and provides an assessment of Lebanon’s competitiveness from a macroeconomic and microeconomic perspective, with a view to identify possible sources of competitiveness gains over the medium term.

Abstract

The Selected Issues paper of Lebanon provides an update of the vulnerability assessment based on the balance sheet approach. It explores the interest rate determination, the strength of the link to international interest rates, and exposure to international interest rate shocks, summarizes the methodology used to derive confidence intervals around the path of the debt ratio in the staff’s adjustment scenario, and provides an assessment of Lebanon’s competitiveness from a macroeconomic and microeconomic perspective, with a view to identify possible sources of competitiveness gains over the medium term.

II. Balance Sheet Analysis of Lebanon’s Vulnerabilities2

6. This paper uses the balance sheet approach to assess the recent evolution of Lebanon’s financial vulnerabilities. The analysis follows up on the work presented in the selected issues and statistical appendix paper of the 2004 Article IV consultation.

7. The balance sheet assessment of financial vulnerabilities is based on the construction of a matrix of intersectoral financial claims. This matrix is then used to assess the currency and maturity positions of each economic sector. The objective is to identify potential systemic risks, including foreign exchange, rollover, and interest-rate risks. For this purpose, the economy is divided into the following four sectors: the Government, the Banque du Liban (BdL), the Private Financial Sector (PFS), the Private Non-Financial Sector (NFS), and the Rest of the World (ROW).3 By construction, the sum of the domestic sectoral net positions (government, central bank, financial sector, plus non-financial sector) equals the country’s net position vis-à-vis the rest of the world.

8. The main conclusion from the analysis is that the principal vulnerabilities of the Lebanese economy are the solvency of the state, on the one hand, and the high mutual exposure between the government and the domestic banking system, on the other hand. This implies that distress in one of these sectors would rapidly be transmitted to the other. The analysis also shows that balance sheet vulnerabilities have generally increased since end-2003.

A. The Balance Sheet of The Public Sector

9. The size of Lebanon’s government debt raises solvency concerns (Figure II.1). The net debt of the government, at $34.8 billion or 158 percent of GDP in December 2005, remains on an ascending path. The gap between the primary surplus and the debt-stabilizing primary surplus has narrowed in recent years (Figure II.2), mostly on account of a decline in the interest bill, but this is likely to be reversed as zero-interest loans received in the context of Paris II mature in 2006.

Figure II.1.
Figure II.1.

Lebanon: Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Source: Lebanese authorities.1/ Gross government debt minus central government deposits.
Figure II.2.
Figure II.2.

Lebanon: Primary Fiscal Balance and Debt-Stabilizing Primary Fiscal Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Source: Lebanese authorities; and Fund staff estimates.1/ Estimated using the implicit interest rate prevailing in that year and a centered five-year moving average of growth and inflation.

10. A look at the distribution of debt by creditor highlights the high dependence of the government on domestic bank financing, as well as increased reliance on central bank financing since 2002 (Figure II.3). Out of total government liabilities of $38.5 billion at end-2005, $18.7 billion (48.5 percent of the total) were held by the private financial sector. This share has come down considerably since 2002, at the expense of greater central bank intermediation. The counterpart to the increase in central bank financing has been an even larger increase in commercial bank claims on the central bank, notably in the form of long-term certificates of deposit.

Figure II.3.
Figure II.3.

Lebanon: Government Creditors

(In percent of total debt)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Sources: Lebanese authorities; and Fund staff estimates.

11. The high dependence on bank financing implies that rollover risk is linked as much to the stability of the deposit base as to the maturity structure of government debt. The share of short-term debt in total government debt stood at 28 percent (equivalent to 48 percent of GDP) at end-2005 (Figure II.4). With banks holding most of the market-held debt, rollover risk is linked closely to the rollover of the banks’ own liabilities (largely in the form of short-term deposit). Nonetheless, the decline in short-term debt has reduced the government’s exposure to interest rate risk.

Figure II.4.
Figure II.4.

Lebanon: Maturity Structure of Government Debt

(In percent of total governmnet debt)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Sources: Lebanese authorities; and Fund staff estimates.

12. The public sector’s (government and BdL) net foreign currency position grew increasingly negative in both 2004 and 2005 (see Table II.1)4. Financial pressures in the first half of 2005 caused net foreign currency liabilities to rise to $17.0 billion as of June 2005. These liabilities have since declined, but, at $15.2 billion at end-2005, they still stand substantially above the level of end-2003 ($86 billion). The deterioration of the public sector’s foreign exchange position reflects essentially the domestic non-financial sector’s increased preference for dollar assets, ie., dollar deposits.

Table II.1.

Lebanon: Foreign Currency Positions 1/

(In billions of U.S. dollars)

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

By construction, net positions sum to zero.

13. Although the public sector’s gross liquid foreign exchange reserves have increased since 2003, its net liquid foreign currency position has worsened (see Table II.2). From a comfortable long net liquidity position of $7.5 billion in December of 2003, the public sector has seen its net liquidity position decline to –$0.7 billion at end-2005. This weakening reflects both a bunching of government dollar maturities in 2006 (which increases U.S. dollar short-term debt at end-2005), and an increase in the short-term dollar liabilities of the central bank.

Table II.2.

Lebanon: Foreign Currency Liquidity 1/

(In billions of U.S. dollars)

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

Net foreign currency liquidity is defined as the difference between short-term foreign currency assets and short-term foreingn currency liabilities from Tables II.A.1 - II.A.4.

By construction, net positions sum to zero.

14. Increased deposit dollarization has been a source of risk for the public sector’s balance sheet. In periods of uncertainty, depositors tend to convert their Lebanese pound (LL) deposits into dollar deposits, putting pressure on banks to cover the resulting foreign exchange mismatch by liquidating government LL securities and acquiring dollar assets. Since the government cannot accommodate this changed currency preference instantaneously, the central bank typically intervenes by swapping LL government paper for U.S. dollar deposits at the central bank. This operation helps contain capital outflows by banks who would otherwise place U.S. dollar assets abroad. The net effect is a deterioration in the net foreign exchange position of the sovereign. Such was the experience, for instance, in the first half of 2005.

B. The Balance Sheet of the Private Financial Sector

15. The principal source of risk for the private financial sector stems from its high exposure to the sovereign (see (Figure II.5). Commercial banks display a high concentration of sovereign assets (government and central bank) in their portfolio. In December 2005, the total exposure of banks to the sovereign was 61.6 percent of total assets (28.4 percent in government debt and 33.1 percent in claims on the BdL, including certificates of deposits). Some market participants see exposure to the central bank as being less risky than exposure to the government: whereas claims on the government carry an outright risk of default, claims on the central bank in domestic currency can always be honored (albeit at the cost of inflation), and claims in foreign exchange are backed by the central bank’s own international reserves. In a systemic sense, however, the distinction between central bank risk and government risk is less clear. Particularly in a situation of stress, the government might exercise a claim on central bank international reserves ahead of the banks, and the central bank might resort to inflation to erode the value of government domestic currency liabilities to avoid an outright default. While the prominent role played by the banking sector in providing financing to the government (see above) creates vulnerabilities for banks, it also creates strong incentives for the banks to roll over government debt in order not to jeopardize the financial viability of their main debtor. In this sense, the risks of a government debt-cum-banking crisis are tightly interwoven.

Figure II.5.
Figure II.5.

Lebanon: Composition of Assets of Commercial Banks

(In Percent of Total Assets, End December 2005)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Sources: Lebanese authorities; and Fund staff estimates.

16. Since 2003, the financial sector has strengthened its net foreign currency position (see Table II.1). The sector’s net position improved from $1.1 billion in 2003 to $4.1 billion by December 2005, as the increase in foreign currency denominated assets (by $10.4 billion) outpaced the increase in foreign currency liabilities. Of this increase, $4.3 billion was in the form of higher deposits in correspondent banks abroad, while the rest was mostly accounted for by higher dollar claims on the government and the central bank. As a result, the share of claims on the sovereign in total foreign currency assets has increased from 21.3 percent of total foreign currency denominated assets in December 2003 to 23.9 percent in December 2005 (Figure II.6). The long foreign currency position of the financial sector reduces its direct exposure to exchange rate risk, but indirect exposure remains substantial in the form of credit risk to the unhedged domestic private sector which has borrowed heavily in foreign currency.

Figure II.6.
Figure II.6.

Lebanon: Banks’ Foreign-Currency Exposure to the Sovereign

(In Percent of Total Foreign-Currency Assets)

Citation: IMF Staff Country Reports 2006, 200; 10.5089/9781451822687.002.A002

Sources: Lebanese authorities; and Fund staff estimates.

17. The net liquid foreign currency position of the private financial sector has improved slightly, thus improving the sector’s foreign currency maturity mismatch5. Still, the existing maturity mismatch continues to represent a risk that could be transmitted to the public sector through contingent claims on reserves (Table II.2). Compared with 2003, the financial sector has reduced its maturity mismatch in foreign currency from a net position of –$21.1 billion in December of 2003 to –$18.3 billion in December 2005. The liquidity coverage of foreign exchange deposits, which at 58.3 percent is relatively high by international standards, constitutes a key element of confidence in the banking sector. Liquid foreign currency assets are held at the central bank ($9.9 billion) and in correspondent banks

abroad ($10.5 billion). Bank decisions as to whether to use foreign assets or central bank deposits as a first line of defense in the event of deposit withdrawals is an important determinant of the behavior of gross international reserves During the financial pressures of early 2005, banks initially reacted to deposit withdrawals by liquidating government paper, while continuing to increase (albeit marginally) their foreign exchange holdings abroad. Starting in April, banks moved a part of these foreign exchange holdings to the central bank to take advantage of higher rates of remuneration.

C. The Balance Sheet of the Private Non-Financial Sector

18. The foreign currency position of the private non-financial sector has improved since the end of 2003. Its long foreign currency position increased from $12.0 billion in 2003 to $18.7 billion in December 2005. Similarly, the short-term long position also widened, during the same period, from $27.7 billion to $32.7 billion.

19. Despite its overall long position in foreign exchange, subgroups of the private non-financial sector face large currency mismatches, the cost of which could be transmitted to the public sector in the event of a depreciation of the Lebanese pound. The heterogeneous nature of the sector means that foreign exchange assets and liabilities are distributed very unevenly across households and enterprises. The 2001 Financial System Stability Assessment indicated that individual borrowers, as well as sub-sectors that rely on local currency revenues, such as construction, trading, and services, face considerable exposure to exchange rate risk, and that a large depreciation could force some of these businesses and households into bankruptcy. The adverse impact on output would compound the problem. A large amount of corporate defaults, in turn, would weaken the balance sheet of banks and create pressures on the government for a financial bail-out.

D. Conclusions and Policy Implications

20. The analysis presented in this paper confirms that the main vulnerability for the Lebanese economy stems from the combination of two factors: first, the high level of public debt, which raises solvency concerns, and second, the high codependence between the government and the banking system. This, in turn, implies that a key source of vulnerability lies in the rollover (and continued growth) of the deposit base, which is largely unrelated to whether depositors are residents or non-residents.6

21. The funding base of the government is predominantly concentrated in the domestic banking system, which means that the government is ultimately exposed to the rollover risk of the deposit base. The government could reduce this risk by developing and pursuing alternative sources of financing. The development of well functioning secondary markets would be an important element of this strategy.

22. The banking system, in turn, is highly exposed to sovereign risk. Public debt represents a high share of banks’ total assets, and changes in public confidence in the government’s ability to repay (or even service) its debt could create problems for the banks. A reduction in the government’s borrowing requirement is a prerequisite to reducing this exposure, but the process will take time. The adoption of tighter prudential rules on sovereign exposure could also create incentives for greater diversification, and would help internalize the systemic costs of sovereign risk. As noted above, there might be a perception that banking sector vulnerabilities have been reduced by switching their asset composition from government paper to central bank CDs, but such a perception is not very meaningful in a systemic sense.

23. By most standards, the banking system maintains a high level of liquidity, which serves to enhance the confidence of depositors and the stability of the system. The main risk for the system lies in a large scale and rapid withdrawal of deposits. The relevant liquidity buffer against such a risk is the international reserve position of the entire banking sector, including the central bank. By this standard, vulnerability to a deposit shock has increased only slightly, with the ratio of banking sector foreign exchange reserves to total deposits going from 38.9 percent in 2003 to 35.5 percent in December 2005.

24. The severity of currency mismatches in the private sector cannot be appropriately assessed without more data, and efforts in this direction could improve monitoring of banking sector risks.

Table II.A.1.

Lebanon: Sectoral Balance Sheet Matrix, December 2003

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

Based on remaining maturity that only includes amortization.

Table II.A.2.

Lebanon: Sectoral Balance Sheet Matrix, December 2004

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

Based on remaining maturity that only includes amortization.

Table II.A.3.

Lebanon: Sectoral Balance Sheet Matrix, June 2005

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

Based on remaining maturity that only includes amortization.

Table II.A.4.

Lebanon: Sectoral Balance Sheet Matrix, December 2005

article image
Sources: Banque du Liban, Ministry of Finance; and Fund staff estimates.

Based on remaining maturity that only includes amortization.

2

Prepared by Juan Solé, Julian di Giovanni, and Edward Gardner.

3

The detailed matrix containing each sector’s assets and liabilities for December 2003, December 2004, June 2005, and December 2005 are presented in Tables II.A.1 through II.A.4 respectively.

4

A comprehensive pre-Paris II analysis is not possible due to the lack of comparable data. Nevertheless, the figures for December 2002 are largely indicative of the situation prior to the November 2002 Paris II conference, given that most of the external official financing disbursements took place in 2003.

5

The foreign currency maturity mismatch is measured by the net foreign currency liquidity position.

6

The residency concept is very loosely defined. Moreover, there does not appear to be much behavioral difference between these two groups.

Same Series

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Cover IMF Staff Country Reports
Lebanon: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2006: Issue 200
Publisher:
International Monetary Fund
ISBN:
9781451822687
ISSN:
1934-7685
Pages:
48
DOI:
https://doi.org/10.5089/9781451822687.002
  • View in gallery

    Lebanon: Government Debt

    (In percent of GDP)

  • View in gallery

    Lebanon: Primary Fiscal Balance and Debt-Stabilizing Primary Fiscal Balance

    (In percent of GDP)

  • View in gallery

    Lebanon: Government Creditors

    (In percent of total debt)

  • View in gallery

    Lebanon: Maturity Structure of Government Debt

    (In percent of total governmnet debt)

  • View in gallery

    Lebanon: Composition of Assets of Commercial Banks

    (In Percent of Total Assets, End December 2005)

  • View in gallery

    Lebanon: Banks’ Foreign-Currency Exposure to the Sovereign

    (In Percent of Total Foreign-Currency Assets)

Lebanon: Government Debt

(In percent of GDP)

Lebanon: Primary Fiscal Balance and Debt-Stabilizing Primary Fiscal Balance

(In percent of GDP)

Lebanon: Government Creditors

(In percent of total debt)

Lebanon: Maturity Structure of Government Debt

(In percent of total governmnet debt)

Lebanon: Composition of Assets of Commercial Banks

(In Percent of Total Assets, End December 2005)

Lebanon: Banks’ Foreign-Currency Exposure to the Sovereign

(In Percent of Total Foreign-Currency Assets)