Lebanon: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund
Publication Date:
09 Jun 2006
eISBN:
9781451822694
Language:
English
Keywords:
ISCR; CR; authority; debt ratio; debt; foreign exchange; GDP; Lebanese pound; exchange rate; broad money; real GDP; capital market
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Lebanon recovered from the financial shock triggered by Prime Minister Hariri’s assassination. Executive Directors supported the strategy of debt reduction through sustained fiscal adjustment. They welcomed the proactive stance of banking sector supervision and encouraged adoption of a strong securities regulator with adequate legal protection to enhance the stability of the stock market. They stressed the need to strengthen the environment for private sector activity by reducing red tape and corruption, reactivating the liberalization and privatization of the telecom sector, strengthening contract enforcement, and accelerating structural reforms.

Abstract

Lebanon recovered from the financial shock triggered by Prime Minister Hariri’s assassination. Executive Directors supported the strategy of debt reduction through sustained fiscal adjustment. They welcomed the proactive stance of banking sector supervision and encouraged adoption of a strong securities regulator with adequate legal protection to enhance the stability of the stock market. They stressed the need to strengthen the environment for private sector activity by reducing red tape and corruption, reactivating the liberalization and privatization of the telecom sector, strengthening contract enforcement, and accelerating structural reforms.

I. Introduction

1. Following the Paris II donor conference of November 2002, Fund staff intensified the frequency of surveillance at the behest of donors. The Paris II conference endorsed the authorities’ exit strategy out of the high debt overhang, based on a package of fiscal adjustment, privatization and structural reforms. However, implementation of the strategy suffered numerous setbacks, and advice provided in the context of Fund surveillance has had limited success in steering policies in the direction of faster adjustment and reform, mainly because of domestic political gridlock and instability. While Lebanon weathered successfully the confidence shock created by Mr. Hariri’s assassination in February 2005, the associated financial turmoil weakened what was an already fragile situation. The authorities see in the political transformation heralded by the June 2005 parliamentary elections an opportunity to relaunch a broad program of economic and institutional reform. Against this background, Article IV discussions focused on the macroeconomic risks ahead and a medium-term strategy to restore the financial health of the state and establish the foundations for strong economic growth.

II. Background and Recent Developments

2. Economic and financial developments since 2003 have been shaped by major changes in the political landscape. Policy initiatives were frozen during the political stalemate that prevailed prior to and following the extension of President Lahoud’s term in September 2004. Mr. Hariri’s assassination led to the resignation of the government and plunged the country into a period of political and financial turbulence. Despite continued political assassinations and bombings, market confidence was gradually restored following the withdrawal of Syrian troops from Lebanon and the June parliamentary elections. Upon taking office in July, Prime Minister Siniora announced that the government would seek the support of the international community for an ambitious economic reform and adjustment program to be introduced by end–2005. Renewed political tensions—over relations with Syria, the legitimacy of the president, and UN calls for the disarmament of Hezbollah (one of the coalition partners in the government)—have caused repeated delays in the adoption of these plans.

3. Economic growth slowed down considerably in 2005.1. A surge in tourism and construction activity, and strong exports contributed to GDP growth of 6 percent in 2004. However, in the wake of the political crisis, private and public demand contracted in 2005, though export growth remained strong. In the event, real GDP is estimated to have grown by 1 percent, and inflation declined to 0.3 percent in 2005.

4. Mr. Hariri’s assassination and subsequent political crisis triggered significant financial turmoil and pressures on international reserves. In the two months that followed the assassination, some $2 billion in deposits was withdrawn and another $5½ billion was converted into dollar deposits(Figure 1). The central bank absorbed some of the pressure through its international reserves(Figure 2), and also took action to counter financial pressures through: (i) swap operations, backed by higher interest rates and financial sweeteners, to lengthen the maturity of commercial banks’ claims on government and the central bank; and (ii) the issuance of 10–year dollar CDs yielding 10 percent interest to attract and lock in some of the foreign assets of the commercial banks. In order to avoid a downgrading of banks’ ratings and its possible impact on confidence, incentives provided to banks included upfront cash payments to shore up profits. A sharp rise in interest rates on Lebanese pound (LL) deposits eventually contributed to stabilize the situation, until the effects of the political crisis waned.

Figure 1.
Figure 1.

Lebanon: Monetary Impact of the 2005 Political Crisis

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Source: Banque du Liban.
Figure 2.
Figure 2.

Lebanon: Central Bank Gross International Reserves and Net Foreign Exchange Liquidity, 2005

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Sources: Banque du Liban; and Fund staff estimates.1/ Defined as: Gross international reserves minus principal and interest due over the next12 months on all foreign currency liabilities of the central bank to entities other than the government of Lebanon. Excludes long-term foreign exchange liabilities of the central bank.

5. By mid-year, the financial situation had stabilized. Deposit inflows resumed at a high pace, accompanied by gradual dedollarization. The $750 million Eurobond issue of October 2005 was heavily oversubscribed, notably by international investors; by mid-March 2006 Eurobond spreads had declined to a record low of 180 basis points, broadly in line with the global emerging market index (Figure 3). The stock market similarly picked up steam after the June parliamentary elections. Despite a sizeable correction in February 2006, by March the stock index was still 150 percent above its end-2004 level. Still, total capitalization remains small by emerging market standards (20 percent of GDP), with Solidere (the real estate holding company which owns much of downtown Beirut) accounting for over 60 percent of it, and banks for much of the rest.

Figure 3.
Figure 3.

Lebanon: Monetary and Financial Indicators

Financial market pressures, which increased markedly following Mr. Hariri’s assassination, have subsided.

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Sources: Banque du Liban, Bloomberg, and Reuters.

6. The economic slowdown as well as buoyant exports helped narrow the current account deficit to an estimated 12.7 percent of GDP in 2005, notwithstanding higher oil prices and losses in tourism. The negative shock to the capital account in the first half of the year was more than offset by the recovery of FDI and portfolio inflows in the second half, and by end–2005 gross international reserves were back at their end-2004 level. Owing to very low domestic inflation, the real effective exchange rate depreciated by 5 percent in 2005, despite the international appreciation of the dollar, to which the currency is pegged(Figure 4). Although labor costs tend to be higher than in neighboring countries, recent gains in export market shares do not suggest the presence of an immediate competitiveness problem. From 2000 to 2005, Lebanon’s global market share rose from 1.1 to 2.1 percent, and its regional (Middle East) market share grew from 18.4 to 36.1 percent.

Figure 4.
Figure 4.

Lebanon: Real and Nominal Effective Exchange Rate, 1995–2005

(1995=100)

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

7. In the absence of new policy initiatives to counter the adverse fiscal effects of rising oil prices and the economic slowdown, the primary surplus dipped to 2½ percent of GDP in 2005 from 3½ percent in 2004 (Figure 5). Since the 2005 budget was only approved (ex-post) in February 2006, most expenditure categories were effectively frozen in nominal terms. However, this form of fiscal austerity was not enough to offset: (i) a one-time transfer (0.3 percent of GDP) to cover losses in the social security funds; (ii) growing subsidies to the state electricity company (EdL), whose financial losses are estimated at 3.2 percent of GDP in 2005;2 and (iii) revenue shortfalls attributable in large part to the cap on gasoline prices introduced in May 2004.

Figure 5.
Figure 5.

Lebanon: Central Government Operations, 1995–2005

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Sources: Banque du Liban; Ministry of Finance; and Fund staff estimates.1/ Estimated using the implicit interest rate prevailing in that year (see footnote 2) and a centered five-year moving average of growth and inflation.2/ Ratio of interest payments to gross government debt at the end of the preceding year.3/ Cash basis.4/ Gross government debt minus central government deposits.

8. The gradual lowering of the effective interest rate paid on government debt has contributed to a steady reduction in the overall fiscal deficit (to 8 percent in 2005). However, the maturing of the zero-interest loans received from banks in the context of Paris II and the scheduled repayment of below market financing from the central bank will tend to raise the effective interest rate in 2006. A near stabilization of the government debt ratio since 2002, was followed by another increase in 2005 owing to weak GDP growth, the settlement of arrears equivalent to 1.3 percent of GDP, and a new government prefinancing strategy.3

9. The central bank has increased markedly its intermediation role since 2002, but at the expense of its financial strength. Its balance sheet has grown from $13 billion at end–2002 to $29 billion by end-2005, reflecting (below market) financing of the government and parallel sterilization operations as well as efforts to replenish international reserves. The expansion of the balance sheet has been accompanied by growing losses that reflect these operations, as well as: (i) the transfer to the government of unrealized capital gains on gold holdings; (ii) the high cost of long-term dollar debt issued in the first half of 2005; and (iii) the favorable conditions accorded to commercial banks to protect their profitability in 2005. Central bank losses have not compromised monetary control.

10. The banking sector continues to record profits but remains vulnerable, with claims on government and the central bank accounting for over 50 percent of assets. The capital adequacy ratio was 22 percent as of mid–2005, although this high ratio reflects in large part the low risk weighting applied to government paper. Banks took advantage of abundant excess liquidity in the region in 2005 to raise capital. Profitability rose by about 13 percent in 2005, buttressed by the cash premium paid by the central bank to rollover maturing government paper. Still, on average, the return on equity is low by international standards—although higher for the larger banks. Banks remain highly liquid, with a net liquid to total asset ratio of 45 percent, and hold nearly $10½ billion in liquid assets abroad. Lending has stagnated, in part because of widespread over-leveraging in the private sector. The quality of the loan portfolio has stabilized at a ratio of non-performing loans to total loans of 10 percent (net of provisions).

11. Only moderate progress has been made on the structural reform agenda since 2004. Most public sector reforms have been of an administrative nature, with a number of legislative reforms pending in parliament (box 1). The EU Association Agreement will come into effect on April 1, 2006.

III. Outlook and Policy Discussions

12. Despite the recovery of confidence, the macroeconomic and financial picture is still one of high vulnerabilities. Underlying financial imbalances have grown.4 The government debt ratio has edged up again, and, with some of the financial benefits of Paris II coming to an end, the interest bill is expected to start rising. Moreover, the financial standing of the sovereign (central bank and government) has deteriorated at a much faster rate, owing to the fact that the central bank has absorbed in its balance sheet many of the fiscal costs of financial stabilization. On the positive side, liquidity conditions have improved markedly since mid–2005, in terms of international reserve coverage, commercial banks’ liquidity, and access to market financing. Although Lebanon is well placed to continue capturing some of the portfolio outflows from Gulf Cooperation Council countries (over $100 billion in 2005), delays in fiscal adjustment will cause the fiscal financing need to rise with possible new pressures on international reserves.

Lebanon: Structural Reform Initiatives in 2004–06

Public sector reforms

  • Reorganization of revenue administration. Large taxpayer’s office established in May 2005, although not yet fully operational.

  • VAT directorate. Law establishing a VAT directorate passed in August 2005.

  • Tax procedure code. Draft law establishing a modern tax procedure code (based on IMF technical assistance) to be sent to cabinet for approval.

  • Deduction at source of tax on salaries. Registration of all private sector employees virtually completed by May 2005.

  • Treasury single account (TSA). Draft law establishing a TSA pending in parliament.

  • Public debt. Draft law establishing an independent public debt directorate at the ministry of finance pending in parliament.

  • Public procurement. Draft law modernizing public procurement to be submitted to parliament.

  • Strengthening financial control of state-owned enterprises. An amendment to the 2001 budget law to be submitted to parliament in the near future, requiring annual external audits of all public institutions.

Capital markets and bank mergers

  • Capital markets. Draft law on capital market development and the establishment of a regulatory commission with powers to oversee the Beirut Stock Exchange pending in parliament.

  • Securitization. Legislation allowing the securitization of financial assets passed in December 2005.

  • Collective investment schemes. Legislation giving legal status to investment funds passed in December 2005.

  • Insider trading. Draft legislation outlawing insider trading pending in parliament.

  • Insurance regulatory commission. Draft legislation establishing an insurance regulatory commission under review by government.

  • Bank mergers. Amendment to the law regulating the central bank’s role in facilitating bank mergers approved by parliament in February 2005.

Competition and domestic market reform

  • Anti-dumping. Draft anti-dumping legislation in line with WTO standards pending in parliament.

  • Streamlining import licensing procedures. Draft law on International Trade and Licensing in line with WTO agreements pending in parliament.

  • Consumer protection. Legislation increasing consumer protection passed in February 2005.

  • E-commerce. Set of laws enacted covering e-signature, e-contracts, e-payments, and protection of personal rights.

13. Discussions were organized around the four main pillars of the authorities’ program: (i) fiscal adjustment and debt management; (ii) monetary and exchange rate policies; (iii) the role of the financial sector; and (iv) the growth and social agendas. In the absence of a detailed government program, discussions were informed by an “unchanged policies” (baseline) scenario and an illustrative “adjustment” scenario developed by Fund staff. The latter draws from policy proposals discussed with the authorities since the last Article IV consultation

A. Medium-Term Scenarios and Debt Sustainability Analysis

14. The government’s solvency problem is illustrated in the staff’s baseline scenario, which shows that under unchanged policies the debt ratio would rise steadily to over 210 percent of GDP by 2011. (Figure 6). The scenario assumes a vicious circle of growing debt, rising interest rate spreads, and weak economic growth. It is difficult to predict where the breaking point lies, but it is clear that such growing financing needs cannot be filled indefinitely by ever increasing capital inflows.

Figure 6.
Figure 6.

Lebanon: Medium-Term Scenarios, 2005–11

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Source: Fund staff estimates and projections.

15. In the staff’s illustrative adjustment scenario, an ambitious fiscal effort and privatization reduce the debt ratio to 133 percent of GDP by 2011. on: (i) fiscal effort of about 7 percent of GDP (much of it front loaded in the first three years); and (ii) partial privatization of the telecom sector in 2006–07, yielding receipts of 19 percent of GDP.5 The scenario excludes exchange rate adjustment, debt restructuring and concessional financing.

16. The illustrative adjustment scenario is predicated on a mix of (mainly upfront) revenue and (phased) expenditure measures, as detailed in the table below. The revenue effort (4.3 percent of GDP) comes from an upfront increase in the VAT rate from 10 to 15 percent, reform of the income tax system (including an increase of interest income taxation), and a phased increase in gasoline excises back to their 2003 level. The expenditure compression is assumed to take place over time in line with structural reforms in the public pension system, civil service and wage policy, and the electricity sector. An expansion of capital spending, which has taken the brunt of the adjustment to date, is assumed to offset in part the above budgetary gains.

17. The authorities took a slightly more optimistic view of interest rate and growth prospects than the staff. The staff’s adjustment scenario assumes that interest rates would remain roughly unchanged from their present level, despite a projected increase in LIBOR. This further narrowing of spreads (by 110 basis points for LL deposits, and 60 basis points for dollar deposits) reflects confidence gains and a lesser financing need. The authorities were of the view that interest rates could decline further. As for GDP growth, the authorities expected a stronger rebound in 2006 than the 3 percent growth projected by staff.

Primary Fiscal Effort Between 2005 and 2011 in the Staff’s Adjustment Scenario 1/

(In percent of GDP)

article image
Source: IMF staff estimates and projections.

Figures may not add up due to rounding. Net gains refer to incremental changes.

Other measures include (i) eliminating the cap on domestic gasoline retail prices and gradually increasing gasoline excises to their pre-capping level; (ii) increasing the tax rate on interest income from 5 to 7 percent; (iii) introducing a global income tax; and (iv) eliminating various inefficient fees.

This category includes (i) an increase in capital expenditures (from the low 2005 base, as advised in the World Bank’s PER so as to adequately maintain the current capital stock and support the needed medium-term growth); and (ii) a nominal freeze in other current expenditures.

Mainly an exceptional transfer to the social security system.

18. The staff’s Debt Sustainability Analysis shows that the illustrative adjustment scenario is not without risks, and that, even if successful, the strategy would still leave Lebanon with a high debt ratio well into the medium term. Adverse growth and interest rate shocks can slow down the pace of debt reduction, as illustrated in the stochastic debt sustainability analysis presented inFigure 7a and7b, which show confidence intervals for the debt ratio under the adjustment scenario, based on the observed distribution of shocks to interest rates and GDP growth. The shocks to interest rates are cumulated from year to year in Figure 8a, and are not in Figure 8b.6 There are also significant risks that fiscal adjustment will fall short of target, due to political factors or the emergence of contingent fiscal liabilities, notably from the social security funds and the electricity sector. Even if the debt reduction target were to be achieved by 2011, at 133 percent of GDP, the debt ratio would still leave Lebanon exposed to the risk of liquidity shocks unraveling into a debt crisis.

Figure 7a.
Figure 7a.

Lebanon: Adjustment Scenario’s Debt-to-GDP Confidence Intervals: Permanent Shocks, 2006–11

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Figure 7b
Figure 7b

Lebanon: Adjustment Scenario’s Debt-to-GDP Confidence Intervals: Temporary Shocks, 2006–11

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

19. Concessional financial assistance from donors and domestic creditors, would accelerate convergence toward debt sustainability. By way of example, for every $1 billion of grant-equivalent assistance in 2006, the debt ratio would be reduced by an additional 5.6 percentage points of GDP by 2011. The authorities have approached the commercial banks for a voluntary contribution akin to that provided under Paris II, which came to $3.6 billion in loans at zero interest for three years.

B. Fiscal Policy and Debt Management Strategy

20. The authorities decided to postpone the 2006 budget in order to integrate it with their medium-term program, but in the meantime they have introduced a number of administrative measures to improve budgetary performance. The ministry of finance has put in place a cash management system to avoid overruns by line ministries and to strengthen fiscal reporting. Losses in the social security funds (NSSF), and the health fund in particular, constitute a large contingent liability for the budget, and the government has initiated an audit of the fund with a view to assessing the exposure of the state. The government has also launched an audit of arrears and begun to settle arrears to the private sector (mostly related to expropriations).

21. The authorities generally agreed with the overall size of the fiscal adjustment effort embedded in the staff’s adjustment scenario. However, in their view, the nature and timing of fiscal adjustment would need to be carefully calibrated to be supportive of the political and economic renewal of the country, avoid backlashes, and not forestall an incipient recovery in economic activity. The authorities concurred that the strategy would have to rely on an increase of the VAT rate—although possibly not of the magnitude suggested by staff for 2006—a reform of the income tax system, and a gradual increase of gasoline taxation back to its 2003 level. Plans for introduction of a Global Income Tax system to replace the current schedular system are under way, based on technical assistance provided by the IMF’s Fiscal Affairs Department (FAD). The authorities also saw scope for increasing the withholding tax on interest, presently at 5 percent.7 In the absence of any noticeable response to the introduction of this tax in 2003, the authorities felt that a modest increase in the rate would not have a significant effect on money demand.

22. There was broad agreement that the sustainability of the adjustment effort depends critically on expenditure reforms, the elimination of open-ended subsidies, and measures to protect the budget from contingent liabilities. On pension reforms, the government is working in collaboration with the World Bank to establish a financially-sustainable and more equitable system, notably by consolidating the private and public pension systems. The healthcare system managed by the NSSF is another source of fiscal strain which the government plans to address mainly by strengthening financial management. The authorities planned to maintain the nominal wage freeze and to rely on attrition to reduce the size of the civil service, but also acknowledged that these measures would need to be replaced by a proper civil service reform.

23. Addressing EdL’s losses is seen as key to fiscal sustainability, although a reform plan has yet to be finalized. EdL has long been beset by organizational inefficiencies, governance problems (there are no audited accounts since 2001),8 high technical losses, and widespread theft and non-payment. Plans to reduce costs by switching to gas imported from Syria have not come to fruition. There has been a marked reduction in non-technical losses (from 29 percent in 2001 to 17 percent in 2005), backed by other measures to improve collection and lower the cost structure, such as improved fuel procurement practices. However, the breakeven price of oil in electricity production is still around $25 dollars per barrel. The menu of measures being considered include governance reforms, a partial privatization of EdL (to realize efficiency gains), increases in tariffs (unchanged since 1996), and investments to reduce operational inefficiencies.

24. The authorities recognized that fiscal adjustment would need to be backed by stronger budgetary and expenditure management to minimize leakages and overruns. Public financial management remains relatively weak in Lebanon: hard budget constraints are not always applied, and cash rationing remains the only effective constraint on spending. The authorities have been developing a detailed action plan to address these shortcomings, with assistance from FAD and are considering the introduction of a Fiscal Accountability Law. The ministry of finance is also in the process of reorganizing its activities to move towards a more modern function-based administrative structure.

25. The authorities emphasized the importance of proactive debt management to reduce interest costs and rollover risk. In line with this approach, they have built up a significant liquidity buffer in the central bank. In addition to setting up a Public Debt Directorate, the ministry of finance is also keen to expand the range of financing instruments to attract longer-term investors, both domestic and international, as a way of reducing rollover risk.

C. Monetary and Exchange Rate Policies

26. In the authorities’ view, the exchange rate peg remains key to the stability of the financial system. In the absence of a clear need for an exchange rate adjustment, and given the high level of dollarization, the authorities considered that the risks from exchange rate movements (in terms of balance sheet exposures) significantly outweigh any potential benefits (in terms of adjustment to external shocks). This belief was reinforced by the events of 2005 and the important role played by the peg in preserving confidence.

27. Based on the strength of capital inflows and the recovery of international reserves, the authorities did not see a need to match recent increases in international interest rates. Capital inflows have remained strong, even as interest rate spreads have narrowed.9 Gross international reserves (GIR) are the indicator followed most closely by the market. Differences of views between the ministry of finance and the central bank on the international reserve target have, at times, led to poor policy coordination and tensions over interest rate policy. This time, staff found a convergence of views between the two institutions that GIR is presently at an appropriate level. Even though the reserve coverage of short-term foreign currency liabilities remains low by emerging market standards, based on the experience of 2005—the worst financial shock suffered since the end of the civil war—the authorities felt that the present reserve buffer would be sufficient to withstand a similar large shock until fiscal and other measures can be taken.

28. Coordination between the central bank and the ministry of finance has improved markedly. At the root of this are the recent convergence of views on the level of reserves, a commitment by the ministry not to resort to central bank financing (and to repay maturing loans), and an agreement to coordinate the bunching of central bank and government maturities coming due in 2006. To some extent, improved collaboration also reflects the current benign economic environment.

29. The central bank recognized the need to eliminate central bank losses over time. It noted, however, that the losses it has incurred until now have had no monetary impact, since the associated liquidity injection has been absorbed by growing money demand, or mopped up by the issuance of long-term central bank paper. The authorities indicated that loss-making operations had been entered into as a matter of necessity rather than choice, and that they hoped to unwind them as the financial situation settled down. Based on existing obligations, central bank (cash) losses should decline rapidly only after 2009. To help improve its financial situation, the central bank has already introduced fees on many of its operations, lowered remuneration of commercial bank deposits, and realized gains from the sale of a bank in its portfolio. The sale of Middle East Airlines (owned by the central bank) and other real assets is also under consideration. However, these measures can only cover a fraction of the losses, and additional measures would be necessary to close the financial gap at a faster rate.

D. Financial Sector Vulnerabilities

30. The ability of banks to tap into the pool of regional savings has enabled Lebanon to finance large fiscal and external imbalances over the last 15 years, but the mutual dependency of the government and the commercial banks has also heightened the transmission of shocks between the fiscal and financial sectors. The main systemic risk lies in the possibility of large-scale deposit withdrawals, possibly triggered by concerns over the solvency of the sovereign. Because of the high degree of dollarization, such withdrawals could unravel into a banking, balance of payments, and debt crisis. Until now, weaknesses in fiscal fundamentals have had limited effects on depositor confidence, despite the high exposure of banks to sovereign debt (Figure 8). The authorities and bankers attributed this to the strong reputation of domestic banks, the authorities’ demonstrated ability to honor their financial obligations, and the banking sector’s ample liquidity buffer in foreign exchange—the liquid foreign assets of commercial banks and the central bank combined provide cover for 35 percent of total deposits.

Figure 8.
Figure 8.

Lebanon: Commercial Banks’ Assets, 2002–05

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2006, 201; 10.5089/9781451822694.002.A001

Sources: Banque du Liban; and Fund staff estimates.

31. Given the importance of maintaining confidence in the banking system, the authorities continue to place emphasis on effective banking supervision. In order to further enhance confidence in banks, and increase incentives for prudent risk management, the authorities and the banks are keen to phase in Basle II standards, starting possibly in 2008. They stressed that the move to 100 percent risk weighting for foreign currency government debt under Basle II would still leave the banking sector adequately capitalized—the average capital adequacy ratio would fall to about 10 percent.10 While there is no currency mismatch in the balance sheet of banks, banks carry significant indirect exchange rate risk related to domestic dollar lending—particularly to households and non-exporting firms. In general, such risk seems to be considered of a systemic nature and therefore not one that banks have an incentive in guarding against at the individual level.

32. Ample regional liquidity has contributed to the appreciation of bank shares on the Beirut stock exchange and is making it possible for them to raise large amounts of new capital. Banking sector capital is expected to increase from around $4 billion in 2004 to around $5½ billion by end–2006. The banks concerned noted that the increases in capital were intended to meet new capital requirements under Basle II and to finance their regional expansion plans (into Algeria, Egypt, Iraq, Jordan, Sudan, and Syria). Still, an overleveraged private sector and a financially strained public sector suggest that Lebanon may be overbanked and point to the need for banking sector consolidation over the medium term. The view of the authorities, shared by banks, was that some of the smaller banks would have to exit the market, but that the larger banks were well placed to develop alternative activities.

33. The underdeveloped capital market is seen as an impediment to better risk diversification and private investment. The authorities believe that the capital market could provide the overleveraged private sector with a fresh infusion of capital, help mobilize longer term financing from abroad, and support the privatization drive. However, the absence of an independent stock market regulator, and of a law against insider trading, were of concern to many officials and market participants, and raised doubts about the foundations on which the stock market boom is based. The authorities noted that legislation addressing these issues was pending in parliament.

E. Structural Policies

34. Structural impediments to private sector development could limit the growth dividend associated with debt reduction. Despite the overall market-orientation of the Lebanese economy, private sector observers and public officials recognized that private initiative and competition have been stymied and distorted by government intervention, red tape and corruption, and by the strong hold that special interests have on government subsidy, tax, and competition policies. The World Bank estimates that monopoly rents may account for as much as 15 percent of GDP. Governance problems were particularly high on the list of private sector complaints, as reflected in business surveys.11

35. A broad growth agenda is intended to address these shortcomings. The government’s priorities include: liberalization and privatization of the telecom sector and sale of other government assets; a new competition policy backed by a newly created competition authority; ongoing streamlining of administrative impediments in collaboration with the business community; improved efficiency of government spending; and membership in the WTO (targeted for end–2006). Privatization of the telecom sector is at the core of the structural agenda. The secretary general of the telecom regulatory authority was appointed in February 2006, and the authorities are in the process of finalizing the appointment of the board, ahead of the privatization of the two mobile telephone companies, slated for 2006. Privatization of the fixed telephone line and a third mobile license should follow in 2007.

36. High on the list of government priorities is the establishment of a modern and well-functioning social safety net. Income distribution in Lebanon remains very uneven and the most vulnerable segments of society are presently protected only though generalized subsidies. Based on available information, Lebanon’s social indicators have improved in recent years, but they still fall short of expectations.

IV. Staff Appraisal

37. The events of 2005 exposed the significant vulnerabilities of the Lebanese economy, but also its resilience in the face of shocks. The very heavy public debt overhang, the high degree of dollarization, large fiscal and current account deficits, and reliance on short-term deposit inflows to finance these deficits remain the core vulnerabilities. The risks associated with these imbalances have been muted by a benign external environment, ample regional liquidity, and the relative stability of the depositor base, even in the face of worsening fundamentals. Factors explaining this unique strength include the liquidity cushion held by banks, a strong reputation of safe banking built over decades, and the authorities’ skillful handling of the financial pressures experienced in 2005.

38. With market confidence restored, the ongoing political transformation creates an opportunity to address the country’s macroeconomic imbalances through fundamental and lasting reforms. The ultimate objective of the adjustment and reform program should be to protect Lebanon against the risk of a financial crisis and raise the country’s growth potential. A positive external environment has helped revitalize economic activity in 2003–04, and the recovery that began in the second half of 2005 should gain strength in 2006. However, the uncertainty associated with the large macroeconomic imbalances continues to exact a cost in terms of private investment, while inefficiencies and red tape thwart competition and productivity growth. Delays in the adoption of the authorities’ program could also create renewed financing pressures.

39. Although not without risks, the strategy of gradual debt reduction through sustained fiscal adjustment remains the most promising way out of the debt overhang. Upfront debt restructuring carries too large a risk that it will not converge to a stable macroeconomic situation. Still, Lebanon will continue to operate at high levels of debt into the medium term, and the highly fractured political system may not be able to deliver the sustained pace of adjustment required. To restore credibility, the authorities should aim at locking in a large upfront adjustment based on a strong fiscal effort in the first year of their program. With additional measures in 2007–08 and a vigorous privatization effort, the strategy would place the debt-to-GDP ratio on a clear downward path. Concessional financial assistance from abroad and a contribution from domestic creditors, commensurate with their financial strength, would also be required to accelerate convergence to a sustainable debt level.

40. The magnitude of the required fiscal adjustment calls for both revenue and expenditure measures, backed by institutional reforms to strengthen budgetary control. Expenditure reforms are likely to yield meaningful gains only over time, and revenue measures should necessarily be part of the initial package. Given the fiscal adjustment need, the tax revenue yield could be raised by aligning the VAT rate to that of other countries in the region, and introducing a more efficient and more progressive income tax system. The taxation of gasoline should also be revisited, since the state cannot afford to shield the economy from the high cost of oil. On the expenditure front, there is scope for reducing nonproductive outlays, such as subsidies, and poorly targeted capital and current spending. The impact of rising fuel costs on the losses of the electricity company has overtaken efforts to improve collection and reduce technical losses, and restoring the financial viability of the electricity sector should be a core element of the adjustment strategy. Pension reform also appears urgent to correct looming imbalances in the system. Needed improvements in the statistical framework would help strengthen policy formulation and implementation.

41. The exchange rate peg remains the appropriate monetary anchor for Lebanon, and needs to be supported by a flexible interest rate policy and a comfortable international reserve buffer. Not only does the high degree of dollarization constrain the effectiveness of the exchange rate as an instrument of adjustment, but until confidence can be anchored to stronger fundamentals, the exchange rate peg is also key to financial stability. Shocks to confidence are transmitted mostly through the large deposit base, and the large liquid foreign holdings of commercial banks offer an important first line of defense against such shocks. With this added buffer, and in light of recent experience, the present level of international reserves appears to strike a reasonable balance between the competing objectives of minimizing the cost of holding reserves and maintaining sufficient liquidity.

42. The central bank’s balance sheet is no longer in a position to carry the full cost of sterilization operations or to finance the public sector. Strong policy coordination between the fiscal and monetary authorities, backed by enhanced institutional arrangements, is required to improve monetary management and strengthen the central bank’s balance sheet over time. Until now, the monetary impact of central bank losses has been muted by the buoyant demand for money. However, in the event of an adverse shock to deposits, it will become increasingly difficult to sterilize the liquidity impact of central bank losses and maintain, at the same time, an adequate cushion of international reserves. Timely actions to strengthen the balance sheet of the central bank should be an integral part of the adjustment strategy. They should include a recentering of central bank operations on monetary and liquidity management, and an unburdening of its balance sheet of real assets. It is also important to capitalize on the improved degree of collaboration between the central bank and the ministry of finance to place explicit constraints on central bank financing of the government, to institutionalize policy coordination, and to achieve a better distribution of the fiscal costs of financial stabilization.

43. The success of the adjustment strategy depends crucially on preserving depositor confidence. Confidence is linked to the credibility of the government’s program, the effectiveness of the central bank’s financial management, and perceptions about the soundness of the banking sector. On the last point, staff is encouraged by the proactive stance of banking sector supervision in monitoring risks and providing an effective regulatory framework, which could be reinforced by providing legal protection to supervisors. Although the systemic problem of the commercial banks’ exposure to the government cannot be addressed fundamentally by regulatory means, a strong supervisory framework can help mitigate the exposure of banks to market and other credit risk. This is particularly important in a context where the Lebanese banks will gradually have to develop profitable activities other than intermediating government paper. This will likely entail a consolidation of the banking sector. The authorities would be well served by preparing the necessary safeguards, including a well functioning deposit guarantee scheme, for such consolidation to take place in an orderly market-based manner. Adoption of an independent and strong securities regulator with adequate legal protection is also urgent to build confidence in and protect the stability of the burgeoning stock market.

44. In order to revitalize economic growth, the short-run costs of adjustment should be counterbalanced by an explicit growth agenda. There appears to be considerable scope for productivity gains in the private sector. To realize them, there is a need to: (i) enhance the quality of government services, raise the productivity of government capital spending, and reduce the burden of red tape on the private sector; (ii) reactivate the liberalization and privatization of the telecom sector, to lower input costs for the economy and promote the creation of new services; and (iii) improve the business climate and competition by reducing the high costs of entry and exit, strengthening contract enforcement, eliminating monopolistic practices, and addressing corruption decisively.

45. In all, there is considerable convergence of views between the authorities and staff on the reforms that are needed in the period ahead, but Lebanon can ill afford protracted delays in these reforms. In the view of staff, vulnerabilities and risks remain very high, and an incremental approach to reform will remain exposed to political risks down the road. The authorities should seize the unique opportunity offered by the ongoing political transformation and the interest of the international community in supporting Lebanon to make sizeable upfront progress in their reform and adjustment agenda.

46. It is proposed that the next Article IV consultation with Lebanon take place on the standard 12–month cycle.

Table 1a.

Lebanon: Selected Indicators (Baseline Scenario), 2002–11

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Sources: Lebanese authorities; and Fund staff estimates and projections.

Based on the end-December WEO projections of oil price, international interest rates, and external demand.

GDP figures reflect revised national accounts published in July 2005.

On checks issued basis. The underlying primary surplus for 2005, excluding one-off arrears repayments to the social security fund and settlement of central bank advances to the electricity company, is equivalent to 3.4 percent of GDP.

Defined as: gross debt of the government of Lebanon; minus deposits; minus liabilities of the government of Lebanon to the central bank (BdL; plus total liabilities of the BdL to entities other than the government of Lebanon; minus gross international reserves of the BdL; minus gold at the market price; minus SDR and reserve position in the IMF; minus fixed assets; minus other claims of the BdL on entities other than the government of Lebanon

Defined as: gross international reserves minus principal and interest due over the next 12 months on all foreign currency liabilities of the BdL to entities other than the government of Lebanon.

2004 Household Survey and UN projections.

Table 1b.

Lebanon: Selected Indicators (Adjustment Scenario), 2002–11

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Sources: Lebanese authorities; and Fund staff estimates and projections.

Based on the end-December WEO projections of oil price, international interest rates, and external demand.

GDP figures reflect revised national accounts published in July 2005.

On checks issued basis. The underlying primary surplus for 2005, excluding one-off arrears repayments to the social security fund and settlement of central bank advances to the electricity company, is equivalent to 3.4 percent of GDP.

Defined as: gross debt of the government of Lebanon; minus deposits; minus liabilities of the government of Lebanon to the central bank (BdL; plus total liabilities of the BdL to entities other than the government of Lebanon; minus gross international reserves of the BdL; minus gold at the market price; minus SDR and reserve position in the IMF; minus fixed assets; minus other claims of the BdL on entities other than the government of Lebanon.

Defined as: gross international reserves minus principal and interest due over the next 12 months on all foreign currency liabilities of the BdL to entities other than the government of Lebanon.

2004 Household Survey and UN projections.

Table 2.

Lebanon: Central Government Primary Balance, 2002–11

(In billions of Lebanese pounds)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Domestic excises, which are collected at customs, are classified as taxes on international trade.

On checks issued basis.

Excludes principal and interest payments paid on behalf of EdL.

From 2004 onward includes additional transfers to the social security funds (NSSF) to avoid reoccurrence of arrears.

Includes two transfers for telecom settlements of $97 million (LL 146 billion) each (paid in equal installments over three years) starting in 2006 and 2007

Includes transfers to municipalities.

Table 3.

Lebanon: Central Government Primary Balance, 2002–11

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Domestic excises, which are collected at customs, are classified as taxes on international trade.

On checks issued basis.

Excludes principal and interest payments paid on behalf of EdL.

From 2004 onward includes additional transfers to the social security funds (NSSF) to avoid reoccurrence of arrears.

Includes two transfers for telecom settlements of $97 million (LL 146 billion) each (paid in equal installments over three years) starting in 2006 and 2007.

Includes transfers to municipalities.

Table 4.

Lebanon: Overall Fiscal Deficit and Financing, 2002–11

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Sources: Lebanese authorities; and Fund staff estimates and projections.

Figures for 2003 are affected by the intermediation role played by the BdL in the debt exchange with banks, that tends to increase BdL financing and decrease commercial bank financing of the government.

Includes letters of credit equivalent to 0.7 percent of GDP in 2005 for oil deliveries to EdL from Algeria and Kuwait.