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.
May 3, 2006
1. This year’s consultation comes at a time where Lebanon has witnessed events of unprecedented proportions that have changed in a fundamental way the political and economic landscape. After 30 years of civil strife and unsettled political situation, Lebanon has entered a new era that is full with promises but not without risks. The historic events of 2005, tragic as they are, offer Lebanon a historic opportunity for fundamental reforms on which the authorities have already embarked. They have formulated a bold and comprehensive medium-term economic reform program that is now the subject of wide consultation with domestic and international stakeholders and will be presented to international donors in the context of the Beirut conference that will take place in the coming months.
2. During the past year, the Fund has been very supportive of Lebanon and on behalf of the Lebanese authorities, we would like to thank management and staff for their continued constructive dialogue with Lebanon, as well as for highly appreciated technical assistance support. We would also like to thank staff for a very good set of papers that contain a well-balanced assessment of the current situation of the Lebanese economy and future prospects. The Lebanese authorities welcome the staff’s assessment that there is a considerable convergence of views on the reforms that are needed in the years ahead.
Developments in 2005
3. The Lebanese economy was severely tested in 2005 by a number of adverse momentous events, foremost of which was the assassination of Prime Minister Hariri in February. While the economic and financial ramifications of the shock were severe, especially during the first half of 2005, the economy exhibited a remarkable ability to weather the impact of the political turmoil, and reverse the initially strong and negative market reactions. While a surge in capital outflows and dollarization put pressures on the Lebanese pound and international reserves, swift and decisive actions by the authorities, contributed to stabilizing the markets by mid-year. These actions included increases in domestic interest rates and intervention in the foreign exchange market to defend the currency. By July, capital inflows had resumed, helped by the confidence created by the formation a new government with wide political support, and were sustained throughout the remainder of the year resulting in a balance of payments’ surplus of US$747 million by the end of the year. While interest rates declined to record lows on foreign currency denominated debt, strong investor’s interest in Eurobonds issues was unabated, with the broadening of the subscribers’ base beyond dedicated investors as demonstrated in the latest Eurobond issuances, where international participation reached 50 percent on longer-dated Eurobond issuances. Furthermore, the process of de-dollarization of deposits was renewed.
4. The authorities made tremendous efforts in the second half of the year to improve revenue collection, contain spending, and keep the fiscal position under control. The fiscal situation started to show signs of recovery after July 2005. Whereas primary expenditures had increased by 6.8 percent during January-July compared to the previous year, they declined by 4.6 percent in Aug-Dec 2005. Meanwhile, revenues also showed an improvement of 2 percent during the last five months of 2005 reversing partially the 4 percent decline in the first part of the year. As a result, the primary surplus ended at 2.4 percent despite weak economic activity, reduction in gasoline tax, and most importantly, the surge in transfers to the national electricity company (EDL) due to higher fuel prices and continued management and technical problems.
5. The Ministry of Finance (MOF) pursued a proactive approach at financing and debt management. In fact, the pre-funding decision taken as soon as the present government came into power was well received by the market which showed signs of reassurance, mostly demonstrated through the increased demand witnessed on the Eurobond secondary market performance and its reflection on decreased secondary market yields to their lowest levels. As of end April 2006, the Ministry of Finance has financed two-third of the domestic currency principal payments due for the year and has exchanged 70 percent of the Eurobond principal payments for 2006. It is worth noting that 2006 was one of the most difficult years in terms of financing, most specifically the period extending from January-April 2006.
Major Elements of the Reform Program
6. Despite the fact that the Lebanese economy has so far withstood shocks and averted major crises, the authorities are keenly aware of the need to address key vulnerabilities, most notably the worsening debt dynamics. Consequently, they have set up a high-level economic team mandated to prepare a medium-term economic program that addresses these vulnerabilities and promotes the economy’s growth potential. The objectives of this program are to raise the growth rate to 5–6 percent, promote job creation, reduce poverty, and improve social indicators. The preparation of the multi-pronged program has benefited from broad consultations at the domestic level, as well as with international financial organizations and donors.
A. Fiscal Policy
7. The fiscal adjustment pillar of the authorities’ program is broadly consistent with the staff’s adjustment scenario. There is broad agreement on the overall magnitude of the necessary adjustment in the primary surplus over the medium term, and on the nature of the measures to achieve the target. The differences lie in the timing and sequencing of the policy actions, where the authorities take account of the political reality on the ground and of the impact of a severe and too frontloaded adjustment on economic activities and growth at a time when the country has begun to pick the pieces from the events of 2005. The core revenue measures consist of a VAT increase of 2 to 3 percentage points in 2006 reaching the overall rate of 15 percent (from the present 10 percent level) by 2008, an increase in the tax on interest rates on interest income, the introduction of a global income tax, the lifting of the cap on gasoline prices, and a gradual increase in the excise tax to pre-cap levels. These measures will be accompanied, between 2006 and 2008, by structural measures to substantially reform tax administration.
8. Revenue measures will be complemented by decisive action on the expenditure side. The government’s plan emphasizes the rationalization of current expenditures, including through a reduction in transfers to public sector entities, and the containment of the wage bill over the medium term through limiting government hiring, freezing wages in real terms, reviewing the salary and benefit structure in some public entities including for current and former members of parliament, reducing waste in the public sector, and closing the Fund for the displaced and the Council of the South. Of critical importance is the need to strengthen public expenditure management, and improve transparency and accountability in the budget process. The MOF has developed, with the Fund’s assistance, an action plan for public financial management reform, with a clear time-bound outline of measures. The government also plans to adopt a Fiscal Accountability Act and a new Public Procurement Law, and intends to strengthen the financial control of state-owned enterprises.
9. The government is establishing a comprehensive strategy to deal with the EDL, given the deep-rooted and complex problems of this sector. Short-term initiatives include negotiating new fuel and gas supply contracts to reduce the premium on imports, reducing losses by improving metering, cracking down on illegal networks, and increasing collection rates with the support of the justice and security services. Selected tariff increases may also be considered. The implementation of the EDL plan is estimated to generate savings in the order of 2 to 3 percent of GDP over the medium term, and is considered a critical element to the fiscal adjustment process. A special cabinet session was held recently to discuss the reform plan of EDL to be followed by other sessions.
10. The coordination between the BDL and the MOF has substantially improved recently, as the staff report indicates. In this context, the MOF has agreed to refrain from central bank borrowing, and to repay its maturing obligations rather than roll them over. In fact, the Ministry of Finance repaid US$2.9 billion worth of LL TBs to the BDL for the period of June 2005 till March 2006, slashing BDL’s portfolio by 33 percent. There has been a convergence of views on the appropriate level of international reserves, and better coordination between the two institutions regarding the timing and maturities of their respective debt instruments. The implementation of a clearer division of labor between the institutions has improved with the regular meetings at the senior level of officials of the two institutions under the aegis of the Prime Minister.
B. Privatization
11. The government aims to proceed with privatization of major public sector entities, not only to strengthen public finances and reduce debt, but also to improve efficiency in the delivery of services, reduce the cost of doing business, improve competitiveness, and foster growth. The privatization effort includes the telecommunication and energy sectors, and assets under the control of the BDL. The government is finalizing the appointment of the Board of the new Telecommunication Regulatory Authority, ahead of the privatization of the two existing mobile licenses at the end of the year. A hiring of a financial advisor to specify pre-qualification criteria and request expression of interest will follow. Fixed line operator Liban Telecom is expected to follow suit in 2007 and a third mobile license is expected to be sold in 2008–09, in the context of a comprehensive strategy for the sector. Regarding EDL, after completion of steps outlined above, and the appointment of the regulatory agency, the selection of strategic investors and privatization will proceed.
12. The central bank successfully restructured and executed the sale of the commercial bank it owned (BLC) to Gulf investors. This transaction reflected a strong interest in the Gulf in investment opportunities in Lebanon and the substantial increase in oil revenue in the region on account of high oil prices, and an inflow of close to US$1 billion came to the Beirut Stock Exchange (BSE), essentially into banks’ shares. The increase in banks’ capital reflects also the decision of BDL to move to Basil II capital adequacy ratios. The BDL is considering the sale of the shares it holds, including Middle East Airlines and Intra Investment Company, which will contribute to strengthening its own financial position, while stimulating activity in the capital markets.
C. Capital Markets
13. The Lebanese authorities consider financial sector reforms as a major pillar in the reform strategy, as developed capital markets are necessary to diversify the financial sector in view of the relative size of the banking sector and the stock exchange. Major strides were made over the past few months in order to deepen further capital markets, attracting longer term capital to the country, and diversifying risks, most notably through the issuance of Lebanon’s first longer dated bond—5 years in Lebanese Pounds—as a new benchmark instrument, in accordance with international practice. The Securitization Law, which was waiting approval by Parliament since 1999, was enacted on December 9, 2005. By enabling institutions to securitize assets, the law introduces adequate long-term investment instruments to such institutions as pension funds and insurance companies which hold long-term liabilities. In the same vein, the Investment Fund law, enacted in December 2005, provides the enabling environment for marketing and operating collective investment schemes, including the protection of depositors’ assets. The Capital Market Law, which provides a framework for the regulation and development of capital markets in Lebanon, including through the establishment of an independent regulatory body, the Capital Market Council, was approved by the Cabinet in March 2006 and awaits Parliament ratification.
14. The authorities acknowledge that more remains to be done to promote a well-functioning capital market. They agree that developing a secondary market for fixed-income instruments and removing obstacles to the development of the insurance sector and other institutional investors, in line with staff recommendations, remain a priority. Several steps were undertaken in this direction, including the following draft legislations that await Parliament approval: the law on Dematerialization of Securities, the Securities Lending law, the Insider Trading law, improvements to the Bank Mergers law, and the Insurance Regulatory Commission law.
D. Growth and Competitiveness
15. The private sector remains the backbone of the Lebanese economy and the main engine of growth. As the Selected Issues paper indicates, although available macroeconomic indicators suggest that competitiveness is not an immediate concern, Lebanon’s competitiveness could significantly benefit over the medium-term from improvements in the business environment. While a number of steps were implemented in recent years to eliminate administrative and legal bottlenecks, the authorities are cognizant that further efforts remain to be undertaken in this regard. The authorities’ reform program envisages several measures to facilitate the conduct of business, including the simplification of the tax code, streamlining administrative procedures, and easing restrictions on entry and exit. Also, work on legislative reform to modernize and improve the legal framework is ongoing. A new consumer protection law was already ratified by parliament, a WTO compatible antidumping law and a basket of E-commerce laws are awaiting ratification, and a modern competition law is currently being finalized. Support of small and medium-term enterprises (SMEs) is also a priority, and an SME unit and a guarantee fund to facilitate access to credit were already set up. Furthermore, trade liberalization remains a core element of the government’s policy, and Lebanon is steadily advancing toward membership in WTO. It also has recently committed to the European Neighborhood policy which would further enhance harmonization of standards and regulations with those of the EU.
E. Social Sector
16. The authorities are mindful of the effects of the adjustment strategy on lower income groups and are developing a comprehensive medium term social strategy to be finalized in 2006. This will involve the establishment of an Interministerial Committee for Social Development Policy to monitor, coordinate and implement the new strategy, and reduce overlap in the provision of social services. In line with this effort, the Pension System is being reformed with assistance of the World Bank. The aim will be to put the system on a financially sound and sustainable basis and a special cabinet session was held recently to discuss the reform of the National Social Security Fund (NSSF). The reforms will also aim at preserving the acquired rights while relieving fiscal burdens, promoting equity and social protection, and paving the way for a more flexible labor market as the private scheme restricts labor mobility. Moreover, the social safety nets will be strengthened and expanded, and the health and education sectors will be enhanced, to insure affordability, improve quality, and ultimately achieve universal coverage.
International Support
17. The authorities are committed to the implementation of the comprehensive strategy contained in their reform program. However, notwithstanding the strong fiscal adjustment and structural reforms that are embedded in the program to bring down significantly the debt to GDP ratio, the debt dynamics will remain fragile and vulnerabilities will remain high. In view of the necessity to bring the debt to GDP ratio significantly below the adjustment scenario level of 133 percent in 2011, and the exposure of the financial system to the sovereign, the authorities intend to request concessional financial support from the international community in the context of an international conference to be held in Beirut.
18. International financial support will ease the pains of adjustment and will help the authorities sustain their reform efforts in the years ahead. It is worth noting that the authorities undertook a substantial domestic adjustment effort during 2000–04. Most notably, on the fiscal side, the primary balance shifted from a deficit of 7.6 percent of GDP in 2000 to a surplus of 3.4 percent in 2004, an impressive adjustment of about 11 percent of GDP. Furthermore, the central bank increased its gross reserves from US$5.9 billion at end–2000 to US$9.5 billion at end–2004, thereby strengthening overall confidence in the economy.
19. Concessional assistance would contribute significantly to reducing the debt level. Staff calculations indicate that, for every US$1 billion of grant-equivalent support in 2006, the debt ratio would be reduced by about 5.7 percentage points by 2011. The indirect positive effects of such assistance would also be much larger as the confidence generated would have critical implications for boosting investments, lowering interest rates, and providing a positive stimulus to market participants and expectations, which would translate into significantly higher growth rates. These effects on confidence and growth were indeed clearly observed after the Paris-II conference that was convened in November 2002. The authorities expect that, with such donor support, the growth rate levels achieved in 2004 (of about 6 percent) could be easily reached and exceeded, and that for every percentage point increase in the growth rate, the debt-to-GDP ratio would decline by about 1.7 percentage point. Similarly, a one percentage point decline in the interest rate would lead to an equal decline in the debt ratio. Therefore, in order to decisively reverse the debt dynamics and break the vicious circle of high deficit and high debt ratios, domestic reforms would need to be complemented with sizeable financial support from the international community. Preparations are under way for the holding of a conference in Beirut in the coming months to solicit such support.
Conclusion
20. In conclusion, the Lebanese authorities have undertaken significant adjustment efforts over the past few years, which have allowed the Lebanese economy to avoid crises despite major shocks. They highly appreciate the continued support Lebanon has received from the Fund. They are keenly aware that key vulnerabilities remain, and have decided to embark on a major adjustment effort to address these vulnerabilities in a decisive manner with the support of the international community.