Lebanon
2007 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Lebanon
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International Monetary Fund
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Publication Date:
14 Dec 2007
eISBN:
9781451943276
Language:
English
Keywords:
ISCR; CR; government; financing; Paris III program; maturing government paper; Eurobond; private sector; exchange rate; central bank; foreign exchange; current account; Commercial banks; Global
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This 2007 Article IV Consultation highlights that economic developments in Lebanon in 2006 were significantly affected by the July–August conflict with Israel. Real GDP is estimated to have been flat, with strong growth in the first half of the year offset by the disruptions during and after the conflict. Inflation increased, mainly reflecting supply shortages during the conflict and the ensuing blockade. Executive Directors have welcomed the authorities’ success in containing the primary fiscal deficit in the first half of 2007.

Abstract

This 2007 Article IV Consultation highlights that economic developments in Lebanon in 2006 were significantly affected by the July–August conflict with Israel. Real GDP is estimated to have been flat, with strong growth in the first half of the year offset by the disruptions during and after the conflict. Inflation increased, mainly reflecting supply shortages during the conflict and the ensuing blockade. Executive Directors have welcomed the authorities’ success in containing the primary fiscal deficit in the first half of 2007.

I. Introduction

1. The Lebanese authorities presented an ambitious five-year reform program to donors at the Paris III conference in January 2007. The program aims at raising growth, improving living standards, and reducing Lebanon’s large debt overhang and financial vulnerabilities, taking account of the special challenges created by the conflict with Israel in July-August 2006. A number of reforms were developed in close consultation with the Fund (Box 1), and, on April 9, 2007, the Executive Board approved the authorities’ request for EPCA in support of their 2007 program.

Implementation of Past Fund Advice

Since the Paris II conference of 2003, Fund advice has focused on the implementation of the authorities’ medium-term strategy of fiscal adjustment, privatization, and structural reforms. The pace of reform and fiscal adjustment has fallen short of the initial plans and of Fund recommendations because of political instability and insufficient domestic consensus on the reform agenda. The conflict between Hezbollah and Israel in 2006 caused a further setback and led to the authorities’ decision to delay most adjustment measures until 2008.

In developing their reform strategy, the authorities have, to a large extent, relied on Fund advice. Most of the tax policy and administration measures, as well as the public financial management reforms, embedded in the revised strategy presented by the authorities at the Paris III conference were developed in close consultation with staff, and have benefited from extensive Fund technical assistance. The Fund has supported the authorities’ view that the exchange rate peg remains key to financial stability.

2. Even with the strong fiscal adjustment envisaged for 2008-12, Lebanon will continue to be highly vulnerable to swings in investor confidence, and the level of public debt will remain high for years to come. Against this background, discussions for the Article IV consultation stepped back from the immediate program context and focused on: (i) making the reform strategy more resilient to inherent risks and potential shocks; (ii) reforms in the monetary policy framework and banking sector; and (iii) policies for 2007 and 2008 to support the authorities’ medium-term objectives.

II. Background and Recent Developments

3. Economic developments in 2006 were significantly affected by the conflict with Israel (Tables 1–10).1 Real GDP is estimated to have been flat in 2006, with strong growth in the first half offsetting the disruptions created by the conflict (Figure 1). accelerated in July-August, largely reflecting supply shortages during the conflict and the ensuing blockade. Financial pressures were managed effectively owing to the banking system’s strong liquidity position. Immediately after the conflict, donors pledged $1.7 billion for relief and recovery (mostly at the Stockholm conference in August 2006), and disbursements in 2006 roughly offset the immediate fiscal costs of the conflict (Text Table 1). Nonetheless, the overall fiscal deficit increased in 2006 because of rising interest expenditures and higher than expected transfers to the power company, Electricité du Liban (EdL). Government debt rose to over $40 billion (178 percent of GDP) at end-2006.

Table 1.

Lebanon: Selected Economic Indicators, 2003–12

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Sources: Lebanese authorities; and Fund staff estimates.

Defined as cash in circulation plus resident and non-resident deposits.

Short-term debt on a remaining maturity basis.

Table 2.

Lebanon: Central Government Primary Balance, 2003–08

(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 2005 onward includes additional transfers to the social security funds (NSSF) to clear the stock of arrears.

Includes (i) $275 million for telecom settlements (2006 and 2007); and (ii) $500 million to the Council of the South and the Displaced Fund (2007 to 2009).

The budgetary cost of the 2006 conflict is estimated to at $1.48 billion.

Includes transfers to municipalities.

Table 3.

Lebanon: Central Government Primary Balance, 2003–08

(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 2005 onward includes additional transfers to the social security funds (NSSF) to clear the stock of arrears.

Includes (i) $275 million for telecom settlements (2006 and 2007); and (ii) $500 million to the Council of the South and the Displaced Fund (2007 to 2009).

The budgetary cost of the 2006 conflict is estimated to at $1.48 billion.

Includes transfers to municipalities.

Table 4.

Lebanon: Government Expenditure by Function, 2002–06 1/

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Sources: Ministry of Finance; IMF Government Finance Statistics; and Fund staff estimates.

Includes treasury and foreign-financed capital expenditure by the Council for Reconstruction and Development.

Includes subsidies on diesel oil and interest, and transfers to municipalities.

Table 5.

Lebanon: Overall Fiscal Deficit and Financing, 2003–08

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

Figures in 2003 are affected by the role played by the Banque du Liban (BdL) in the debt exchange with banks that tends to increase BdL financing and decrease commercial bank financing of the government.

Debt cancellation and Banque du Liban revaluation of gold and foreign exchange.

Table 6.

Lebanon: Government Debt, 2003–12 1/

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

Includes all debt contracted by the treasury on behalf of the central government and public agencies other than the Banque du Liban; accrued interest; and Banque du Liban lending to Electricite du Liban. Excludes government arrears to the private sector.

Defined as gross debt less central government deposits.

Denominated in domestic currency; mainly to the National Social Security Fund, and the National Deposit Insurance Fund.

Table 7.

Lebanon: Monetary Survey, 2003–08

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Sources: Banque du Liban; and Fund staff estimates and projections.

Broad money is taken to be M5 which is defined as M3 (currency + resident deposits) + non-resident deposits.

Table 8.

Lebanon: Balance Sheet of the Banque du Liban, 2003–08

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Sources: Banque du Liban; and Fund staff estimates and projections.

Defined by currency (not by residency), as official foreign currency assets, including gold and SDR, less foreign currency liabilities. These include the $1.5 billion deposits by the Saudi and Kuwaiti governments in August 2006, but exclude liabilities to the government of Lebanon and other official creditors.

Includes certificates of deposits in foreign currency held by commercial banks.

Includes the deposits by the Saudi and Kuwaiti governments. Excludes all other special bilateral long-term deposits.

Defined as all official foreign currency assets, less encumbered foreign assets.

Defined as gross international reserves including gold and Eurobonds issued by the Republic of Lebanon.

Table 9.

Lebanon: Commercial Banks’ Balance Sheet, 2003–08

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Source: Banque du Liban.

Includes nonresident deposits.

Includes bonds denominated in foreign currency.

Includes other items net as assets.

Table 10.

Lebanon: Balance of Payments, 2003–12

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Sources: Lebanese authorities; BIS; and IMF staff estimates and projections.

Change in the foreign liabilities of the BdL.

Differs from banks’ reported data, to include estimated deposit flows by Lebanese nationals living abroad but classified as residents.

Net of non-deposit foreign liabilities.

Excludes Eurobonds and encumbered reserves.

Includes all banking deposits held by non-residents, including estimated deposits of Lebanese nationals living abroad but classified as residents.

Includes private sector foreign currency deposits in commercial banks.

Figure 1.
Figure 1.

Lebanon: Recent Developments, January 2005–March 2007

Citation: IMF Staff Country Reports 2007, 382; 10.5089/9781451943276.002.A001

Source: Lebanese authorities; J.P. Morgan; Bloomberg; and Fund staff calculations.1/ Coincident indicator is a composite indicator of economic activity monitored by the central bank.2/ Defined as gross international reserves minus principal and interest due over the next 12 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.
Text Table 1.

Lebanon: Economic Impact of the July–August 2006 Conflict, 2006–09

(In billions of U.S. dollars)

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Sources: Lebanese authorities; and Fund staff estimates.

May not add up due to rounding.

Excluding support pledged at the Paris III conference.

4. Despite continued political uncertainty, economic developments in the first quarter of 2007 pointed to an incipient recovery. Indicators of economic activity during the first quarter suggest that GDP had recovered, faster than expected, to the level of early 2006. Inflation has receded as the impact of supply shortages during the 2006 conflict is fading out, notwithstanding the depreciation of the U.S. dollar to which the currency is pegged. Due to strong year-on-year import growth, the trade deficit widened in the first quarter of 2007. With lower capital inflows and limited donor disbursements, gross international reserves fell by $300 million, to $11 billion at end-March.2

5. The political tensions that erupted after the conflict with Israel between the government and the opposition remain high. If not resolved, the political confrontation could lead to a constitutional crisis by the time of the presidential election later this year. On June 10, the United Nations established a tribunal to investigate the assassination of former Prime Minister Hariri. After a period of calm, the security situation deteriorated again in late May with fighting between the Lebanese army and the Fatah al-Islam militants in northern Lebanon and several bomb explosions in and around Beirut.

6. The political tensions have also affected financial markets, though money demand remains robust. Notwithstanding considerable monthly volatility, bank deposits have grown at an average (annualized) rate of 9 percent between October 2006 and May 2007.3 Lebanese Eurobond and Credit Default Swap spreads remain some 200 basis points above the levels prevailing prior to the 2006 conflict, but have also been quite volatile reflecting political developments. Deposit dollarization (currently at 76 percent) is also higher than prior to the conflict, while the stock market index has remained broadly constant since end-2006 in very low trading.

III. Outlook and Authorities’ Views on Policies4

7. Discussions were based on a scenario developed by staff that incorporates full implementation of the Paris III reform program (Text Table 2). Fiscal adjustment and privatization are expected to begin in 2008, and, as a result, government debt would be reduced by almost 50 percentage points to below 130 percent of GDP by 2012, in line with the authorities’ targets. In addition to the contribution of fiscal adjustment (7 percentage points), the debt reduction comes from privatization (31 percentage points), the projected Paris III donors assistance (6 percentage points), and the transfer of unrealized gold valuation gains from the Banque du Liban (BdL) to the budget (7 percentage points). The associated improvement in confidence is assumed to result in a pick-up of growth to 4-5 percent a year (similar to the historical average rate over the last 15 years), and a narrowing of interest rate spreads. The authorities considered the macroeconomic scenario realistic, but believed that they will obtain a higher fiscal yield from their reforms.

Text Table 2.

Lebanon: The Paris III Fiscal Adjustment Objectives, 2006–12

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Sources: Lebanese authorities; and Fund staff.

Includes the fiscal impact of exogenous factors and one-off effects.

A. Minimizing Risks to the Paris III Reform Strategy

8. The Paris III reform strategy is subject to a number of risks, which were acknowledged by the authorities. Given the large debt overhang and fiscal and external imbalances that are financed by short-term deposit inflows, Lebanon will remain vulnerable to shocks to confidence for years, even with full implementation of the reforms. The most immediate risk to the strategy is the political risk that reforms cannot be initiated or would be reversed. Shortfalls in growth or higher than projected real interest rates constitute the main macroeconomic risks. Lastly, there are some uncertainties over the yield of reforms, as well contingent liabilities that have yet to be quantified. The effects of these risks are illustrated by the debt sustainability analysis (Box 2).

Debt Sustainability Analysis

The debt sustainability analysis (DSA) reveals that under a number of shocks, the debt-to-GDP ratio would revert to an unsustainable path. The DSA shows the impact of six shocks on the baseline debt trajectory as well as the implications of using historical values for the interest rate, growth rate, and the primary balance (Figure 2, and Table 11):

Table 11.

Lebanon: Public Sector Debt Sustainability Framework, 2003–26

(In percent of GDP, unless otherwise indicated)

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Sources: Lebanese authorities; and Fund staff projections.

Central government gross debt.

Derived as [(r - ρ(1+g) - g + ae(1+r)]/(1+g+ρ+gρ)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

This path assumes that, from 2008 onwards, real GDP growth is set at its 10-year average level while the primary fiscal balance and real interest rates are the same as in the baseline scenario.

This path assumes that, from 2008 onwards, real interest rate and real GDP growth are set at their 10-year average level while the primary fiscal balance is the same as in the baseline scenario.

Figure 2.
Figure 2.

Lebanon: Public Debt Sustainability, 2002–26

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2007, 382; 10.5089/9781451943276.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ Growth shock based on average 2002-06 values. Interest rate shock is permanent one-half standard deviation shock. Figures in the boxes represent average projections for the respective variables in the baseline scenario and shock scenario; historical refers to 10-year averages.From 2012, the primary fiscal surplus reverts slowly to a long-term level of 3 percent of GDP.2/ Through 2012, the planned revenue and expenditures reforms generate half of their estimated yield in the scenario; after 2012, the primary surplus slowly declines to 1 percent of GDP.3/ Lack of consensus on reform prevents privatization and allows only partial fiscal adjustment.4/ No privatization in the projected period. Assumes no adverse dynamic impact of no privatization.

  • Panel 1: The baseline scenario—full implementation of the Paris III agenda.

  • Panel 2: A permanent increase in the real interest rate by 170 basis points (i.e., one-half standard deviation from its past distribution) relative to the baseline.

  • Panel 3: A drop in average GDP growth from 4 percent in the baseline to 3 percent, i.e., the average rate for 2002–06.

  • Panel 4: A shortfall in the yield from fiscal reforms, i.e. halving of the yield of the fiscal reform package. This reduces the average primary surplus to just over 1 percent of GDP in 2007–12, compared with over 4 percent of GDP in the baseline, and implies that the primary surplus converges to 1 percent of GDP in the long-run, compared with 3 percent of GDP in the baseline.

  • Panel 5: Absent sustained reforms, no privatization and only partial fiscal adjustment (the primary surplus reaches only 3 percent by 2012); growth remains sluggish at 3 percent per annum, while interest rate spreads widen by 220 basis points relative to the baseline.

  • Panel 6: No privatization—since privatization essentially brings forward the income stream from the privatized companies, the scenarios with and without privatization converge to the same debt-ratio in the long-run. However, this abstracts from the negative impact that abandoning privatization plans would have on growth and possibly interest rates relative to the Paris III scenario.

9. The authorities concurred with staff that broad domestic support was needed to achieve and sustain the targeted fiscal adjustment. They considered that the tranched donor support, which was conditional on reform implementation, would provide an effective incentive to maintain the reform momentum over time. Beyond that, they noted that the growth and social pillars of their Paris III program were intended to build public support for reforms by compensating for the inevitable difficulties of fiscal adjustment.

10. The program’s growth pillar is centered on privatization, improvements in the business climate, and opening of markets. The authorities emphasized that privatization of the telecom sector was the lynchpin of their growth strategy, and that additional public sector enterprises were also being slated for privatization. Furthermore, they were establishing a competitiveness council, consisting of private sector and government representatives that would be tasked with identifying legal and administrative impediments to growth. In this context, they were taking steps to streamline the process of obtaining business licenses, and, more generally, to lower the cost of doing business. The authorities also thought that accession to the World Trade Organization—envisaged for 2008—would contribute to further liberalizing markets; they expected to have all relevant legislative changes ready for parliament by the end of 2007.

11. The main elements of the social pillar are to improve service delivery in health and education and strengthen the social safety nets. The authorities noted they could achieve a lot by redirecting the existing envelope of social spending, improving public services, and creating public social safety nets (including through a cash transfer system).

12. The authorities were less concerned about uncertainties over the yield of reforms, arguing that there was also an upside potential. For example, the ongoing revision of the reform plan for EdL was expected to lower reform costs, while yielding the same reduction in transfers from the budget. They also expected tax administration reforms to increase tax buoyancy relative to staff’s revenue projections. However, the authorities acknowledged the risk of added spending pressures on account of the security situation.

13. Reforms to address imbalances (and possible contingent liabilities) in the pension and health system are being developed. The authorities did not see immediate pressures developing in the public pension system, and felt therefore that they had time to assess imbalances (ongoing) and introduce reforms. The reform of the private pension system—currently in parliament—envisions the system’s transformation from an end-of-service allowance to a fully funded pension system. Transition costs may have to be borne by the state, but their extent would only be revealed once the audits of the National Social Security Fund’s (NSSF’s) accounts are completed (Table 12), and the contribution and replacement rates for the new system are finalized. In the meantime, the authorities plan to introduce professional asset management to raise the private pension systems’ return on investment. Another source of open-ended budget transfers are the losses of the health fund of the NSSF. In this regard, the authorities are discussing with the World Bank options for addressing underlying structural problems in contribution rates and coverage, which, among other problems, create a bias toward hospitalization that is pushing up costs.

Table 12.

Lebanon: National Social Security Fund Operations, 2000–06

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Source: National Social Security Fund (NSSF).

14. In parallel, the authorities plan to develop institutions that will help sustain the adjustment effort. They have taken steps to develop a medium-term budget framework to better align short-term policies with strategic objectives, and are also aiming to move gradually toward program budgeting. They also consider adopting a fiscal responsibility law to provide a self-reinforcing mechanism of fiscal adjustment and debt reduction that reduces the risk of backtracking. The authorities acknowledged that such institutional reforms will require substantial preparation.

B. Monetary and Exchange Rate Policies

15. The authorities consider that their monetary policy framework has enabled them to deal effectively with financial pressures. They believe that interest rate stability, notably in treasury bill (T-bill) rates, played a key role in maintaining confidence during periods of pressure (Table 13). However, they recognized that the counterpart to that was the need for the BdL to occasionally rely on alternative instruments (central bank CDs, special discount windows, swaps, etc.) to manage liquidity and safeguard international reserves. The authorities also reiterated that the BdL’s mandate was to maintain financial stability, and that, in their view, this involved providing financing to the government in times of shortfalls from other sources. Nonetheless, they agreed that such financing should only be temporary, and that prolonged shortfalls in market demand would have to be met by raising T-bill rates.

Table 13.

Lebanon: Interest Rates, 2003–07

(In percent, end-of-period)

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Source: Banque du Liban.

16. The monetary authorities confirmed their intention to introduce new short-term instruments for managing liquidity once the financial situation improves. They considered a resolution of the political and security situation, and an improved fiscal environment as preconditions for moving toward short-term, market-based instruments of monetary control (such as repos and reverse repos). However, they acknowledged that this would require greater price flexibility in T-bill auctions. In the context of monitoring performance relative to the EPCA monetary and fiscal targets, the authorities are planning to establish a technical working group to enhance information sharing between the ministry of finance and the BdL.

17. The authorities continue to regard the exchange rate peg as key to financial stability. Exchange rate stability was particularly important given balance sheet risks related to widespread dollarization and the government’s high foreign currency debt servicing obligations. They agreed with staff that fiscal imbalances, but also temporary factors related to the post-conflict environment, were at the core of Lebanon’s high current account deficit, and noted that the planned fiscal adjustment would help improve the current account position significantly. Against this background, and the fact that trade competitiveness was being maintained, the authorities concurred with the staff analysis (Box 3), which does not suggest that the exchange rate is misaligned. Furthermore, the authorities were confident that the envisaged structural reforms would generate the competitiveness gains needed to sustain growth.

18. The authorities were confident that the weakening of the BdL’s balance sheet has not impaired monetary control. They noted that the weakening was largely the result of managing past crises, although quasi-fiscal activities carried out by the BdL had also contributed. They did not see an immediate risk to their ability to control liquidity, and thought that the BdL’s balance sheet could absorb the transfer to the government of unrealized gold valuation gains. Looking forward, the authorities expected that fiscal adjustment and improvements in confidence would help reduce dollarization, which would facilitate a further build-up of net international reserves and strengthen the BdL’s income position.

Assessment of the Level of the Real Exchange Rate

Traditional indicators do not suggest that Lebanon has an external competitiveness problem.

  • Largely reflecting the weakening of the U.S. dollar, the real effective exchange rate (REER) has depreciated 20 percent relative to its 2000–02 average, offsetting some competitiveness losses since the mid-1990s. The bilateral real exchange rate vis-à-vis the U.S. dollar—to which the Lebanese pound is pegged—has remained broadly stable over the past decade.

  • Lebanese exports have remained competitive during difficult times. Merchandise exports grew at an average rate of 5 percent a year in volume terms in 2004–05 (staff estimate based on Lebanese customs data), and maintained positive momentum in 2006 (2 percent) and into 2007, despite the conflict-related disruptions in production and the two-month air, land, and sea blockade. As such, Lebanon’s exports have more than kept pace with the buoyant demand in the region; the market shares vis-à-vis all trading partners have been stable in 2005–06. Exports of services (primarily but not exclusively tourism) have suffered from the political and security disruptions of 2005–07, but still have strong growth potential as was demonstrated in 2004.

uA01fig01

Lebanon: CPI-Based Real Exchange Rate Developments

(Index, 1995=100; January 1995–March 2007)

Citation: IMF Staff Country Reports 2007, 382; 10.5089/9781451943276.002.A001

Sources: National authorities; and Fund staff calculations.

Applying the three methodologies proposed by the IMF’s Consultative Group on Exchange Rate Issues (CGER) does not suggest that the REER is misaligned.

  • Equilibrium real exchange rate approach: An estimation of the long-run equilibrium REER derived from key macroeconomic fundamentals (the net external asset position (NEAP), the productivity differential with trading partners, terms of trade, and government consumption) suggests that the REER could actually be modestly undervalued relative to its estimated equilibrium level. However, the result is well within the margins of error in this type of analysis.

  • External sustainability approach: In this approach, the underlying current account deficit in 2007 is compared to the current account deficit that would stabilize Lebanon’s NEAP at the end of 2006. The empirical estimate of Lebanon’s NEAP is subject to large uncertainty, and depending on the choice of the NEAP, the REER is either slightly undervalued or slightly overvalued, also within the typical margin of error.

  • Macroeconomic balance approach: For this approach, a current account norm of–5 to–6 percent of GDP is derived based on macroeconomic fundamentals (fiscal balance, dependency ratio, population growth, NEAP, oil balance, output growth, income relative to the United States in purchasing power parity terms). The current account norm is then compared to medium-term projections based on the authorities’ planned policies under the Paris III program. With full implementation of the authorities’ program, the projected current account deficit for 2012 would narrow to–5½ percent of GDP. However, if the fiscal adjustment planned under the Paris III program is not achieved in full, the projected current account deficit under current policies would exceed the norm which could potentially lead to external instability. This result is also reflected in the historical scenarios of the DSA (Figure 2) that show an unsustainable debt path if the program is not implemented and the key macroeconomic variables remain at their average levels over the last decade.

19. The BdL has introduced a scheme to provide relief to banks and businesses affected by the 2006 conflict. Under the scheme, the BdL would provide loans to banks at below-market interest rates which the banks would re-invest in fresh T-bills. Banks would then use the interest differential to provide a 60 percent subsidy toward the reconstruction of productive facilities destroyed during the conflict. The authorities argued that in the absence of any assistance, some banks with large exposures would find it difficult to absorb conflict-related losses. The authorities estimated the total subsidy under the scheme would be at most $180 million, although disbursements could be significantly lower owing to strict eligibility requirements.

C. Banking Sector Vulnerabilities

20. The banking sector is profitable and its capitalization is increasing, though vulnerabilities remain high (Tables 14–15). The balance sheet of domestic banks stands at $77 billion (320 percent of GDP) and exposure to the sovereign (government and central bank) is around 50 percent of assets. The authorities were concerned about the substantial maturity mismatch that banks carry on their books, largely from sourcing their holdings of government paper from short-term deposits (Table 16). In addition, the high degree of dollarization exposes banks to substantial credit risk. Reducing these vulnerabilities will ultimately depend on the success of the debt reduction strategy, although the authorities are working in parallel to encourage banks to strengthen risk management and diversify their portfolio. While some banks are targeting a reduction in their sovereign exposure, their systemic exposure to the government makes it difficult for them as a group not to roll over government paper. The authorities took some comfort in the fact that banking sector profitability increased in 2006 and early 2007, although this was in part the reflection of regulatory measures to ease provisioning rules in the wake of the conflict.

Table 14.

Lebanon: Banking Sector Financial Soundness Indicators, 2003–07

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Sources: Banque du Liban, Banking Control Commission and staff estimates.

As of June 2006.

2007 figures are as of April.

2007 figures are the annualized February data.

FC and LL stand for “foreign currency” and “Lebanese pound”, respectively.

FC deposits of residents and nonresidents as a share of total deposits of residents and nonresidents.

Table 15.

Lebanon: Indicators of Financial and External Vulnerability, 2003–07

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Sources: Lebanese authorities; Bank for International Settlements; and Fund staff estimates and projections.

On an annualized basis.

2007 refers to February data.

Includes estimates for public debt and banking deposits held by non-residents, and non-resident claims on the nonfinancial sector.

On a remaining maturity basis (scheduled amortization over the next year).

Short-term foreign currency debt of the public sector and the banking sector plus external debt of the nonbank sector.

Excludes gold and encumbered assets.

“F.C.” denotes foreign currency.

Table 16.

Lebanon: Size and Distribution of Deposits, February 28, 2007 1/

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Source: Banque du Liban, Banking Control Commission.

“L.L.” denotes Lebanese pounds.

“F.C.” denotes foreign currency.

21. The authorities welcomed the regional diversification strategy of commercial banks. The larger banks are expanding very rapidly their presence in countries where their expertise puts them at a strong comparative advantage by setting up local subsidiaries and branches, and potentially by cross-border lending.5 They are also developing domestic private sector lending, in particular retail lending. Among the larger banks, 20 percent of assets are by now in foreign operations, with the objective of generating half of their profits abroad within three years. The banking control commission has taken steps to facilitate and enhance its monitoring of the banks’ diversification strategy. Thus, for instance, in 2006 it issued a circular raising the limits on the exposure of Lebanese banks to non-resident borrowers, and has signed, or is negotiating, memoranda of understanding on consolidated supervision with supervisory authorities in countries where Lebanese banks are expanding.

22. The authorities expect commercial banks to strengthen risk management in response to the introduction of Basel II standards in 2008. The banking system seems well-prepared for the introduction of Basel II, and the authorities expect all banks to meet the tightened capital adequacy criteria. The increased risk weight on foreign currency denominated government and BdL debt instruments would force banks to internalize in part the systemic risks associated with sovereign foreign currency debt.6 The authorities are also trying to encourage banks to better manage their maturity mismatch. To that end, they decided, for the time being, not to reopen the repo window for Lebanese lira T-bills which they had closed during last year’s conflict to ease pressures on the Lebanese lira.

23. The authorities saw scope for consolidation of the banking sector over the medium term. In particular, smaller banks whose main source of income is lending to the government may lose ground to larger banks which are better positioned to adapt to Basel II and diversify their asset structure. The promotion of mergers, including through financial incentives provided by the BdL, has been the main instrument to facilitate the exit of non-viable banks in the past. The BdL believes this is the most suitable instrument in the Lebanese context, because of concerns that outright bank failures would destabilize the system. However, this instrument could give rise to moral hazard, notably in terms of depositor, shareholder, and management behavior.

D. Policies for 2007 and 2008

24. Political tensions and outbreaks of violence are key obstacles to reform implementation and economic recovery. The political stalemate is constraining the government’s room for maneuver and paralyzing legislative activity. This, combined with security concerns, is expected to weigh negatively on economic activity. As such, real GDP growth is projected at about 2 percent in 2007. Under the fixed exchange rate regime, CPI inflation should return to around 2 percent by year-end. Capital (including deposit) inflows are subject to a high degree of uncertainty and are therefore projected conservatively—money growth is put at 5 percent for the year as a whole. Reflecting reconstruction expenditure and replenishment of inventories, the current account deficit is expected to increase to 11 percent of GDP in 2007, largely financed by official inflows and foreign direct investment.

25. The authorities expected to be able to contain the primary fiscal deficit (excluding grants) to 3.7 percent of GDP in 2007 as programmed. First-quarter performance was within program targets (Box 4). However, the authorities recognized the risks of unforeseen expenditure pressures, such as from security measures and transfers to EdL on account of higher oil prices. They indicated that, as in 2006, they would maintain tight expenditure control—delaying low-priority spending until later in the year—to build up a buffer in the event of unforeseen shocks. On the revenue front, the widening gap between domestic and international oil prices reduced the gasoline excise to near zero in May. On current trends, gasoline excise revenues would fall short of program targets by around ½ percent of GDP for the year. However, the authorities were confident that, if the political situation stabilized, they could introduce a floor on excises (of $0.20 per liter) by September 2007, as agreed under the program, which is expected to yield ½ percent of GDP during the remainder of 2007. At the same time, they noted that other revenues have been more buoyant than expected.

Performance Under the Program Supported by EPCA1

The authorities met all end-March 2007 quantitative targets under EPCA, except for the ceiling on government borrowing from the BdL, which was exceeded by a small margin (Table 17). Stronger than projected revenue collection helped contain the primary deficit and the accumulation of net debt in the first quarter. However, insufficient demand for government paper by commercial banks led the government to rely more on BdL financing than programmed. The outcome was LL 106 billion ($70 million) above the LL 903 billion ($602 million) flow envisaged for the first quarter. Despite the difficult market situation, the gross reserves target was met with a modest margin. No domestic or external arrears were accumulated.

Table 17.

Lebanon: Quantitative Indicative Targets Under the EPCA, March-December 2007

(Preliminary. In billions of Lebanese pounds, unless otherwise indicated; end-of-period) 1/

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Source: Lebanese authorities.

At program exchange rates.

In millions of U.S. dollars. Defined as Banque du Liban’s foreign exchange deposits abroad, foreign exchange holdings (including SDR), gold and holdings of investment grade liquid foreign currency-denominated securities, less encumbered foreign assets.

Includes CDR and HRC balances at the Banque du Liban.

Includes the decline in net borrowing of LL2380 billion on account of the gold revaluation transfer.

The authorities also reported on progress toward achieving the monitorable actions for end-June (Table 18). On May 21, the cabinet approved the draft budget for 2007, which includes the foreign financed component of the Council of Development and Reconstruction and activities of the Higher Relief Council. The auditing of EdL has already started, and the launching of the audit of NSSF is on track. With respect to privatization, the authorities have modified their strategy to privatize only the licenses of the two mobile phone companies and effect the transfer of assets and contracts through separate transactions. This would avoid the need for a special law prior to privatization, and ensure that privatization can proceed as planned, making the end-June submission of such a law to parliament no longer relevant.

Table 18.

Lebanon: Monitorable Actions for the Period March-December 2007

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1 IMF Staff Country Report No. 07/177.

26. The authorities were confident that they could meet their financing needs through donor support and from the market during the remainder of 2007. They pointed to recent T-bill auctions and a Eurobond issue in May as indications that commercial banks had returned to the market, and, therefore, saw no immediate need for raising T-bill rates. At the same time, negotiations with key donors are proceeding, and disbursements of grants and loans could amount to $1.9 billion in 2007 (Text Table 3). As such, the authorities were confident that they would reduce net borrowing from the BdL and achieve the programmed build-up of international reserves over the rest of 2007 (Tables 19–20). As another risk to their financing strategy, they listed EdL’s fuel payments over which they had only limited control. Negotiations with domestic banks on a possible Paris III contribution have not progressed, with banks being reluctant to make commitments before reform implementation is underway.

Text Table 3.

Lebanon: Paris III Aid

(In millions of U.S. dollars, unless otherwise specified)

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Sources: Lebanese authorities, and Fund staff estimates.

Projection assumes partial conversion of project assistance pledges to budget support, and non-acceptance of a majority of remaining project assistance, particularly project loans.

Discounting debt service projections at Lebanon’s average projected interest rate for market financing in U.S. dollars (7.45 percent).

Table 19.

Lebanon: External Financing Requirements and Sources, 2003–08

(In millions of U.S. dollars)

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Sources: Lebanese authorities; BIS; and IMF staff estimates and projections.

Excluding exceptional grants to government.

Excluding IMF.

Table 20.

Lebanon: Indicators of Capacity to Repay the Fund, 2003–12

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Sources: Data provided by the Lebanese authorities; and IMF staff estimates and calculations.

Projections are based on repurchase obligations and are at February 28, 2007, exchange rates.

27. The authorities reported on recent steps toward fiscal adjustment in 2008. On the revenue side, the draft 2007 budget already provides for increasing the value-added tax rate and the tax on interest income as of 2008. Preparations for the introduction of a global income tax in 2008 were advancing, with a view to submitting the draft law to parliament in 2007. The authorities also expected ongoing revenue administration reforms, such as the introduction of a medium taxpayer office, new audit procedures, and changes to the property valuation system, to yield revenue gains. On the expenditure side, they were finalizing the reform plans for EdL (Box 5) and NSSF, and were developing a reform plan for the health sector, all in cooperation with the World Bank. With respect to EdL, they were more optimistic than staff about the potential yield of reforms.7 Moreover, they were aiming for an across-the-board cut in discretionary spending of five percent in 2008, and a reduction of expenditure duplication across ministries through better cooperation and information sharing. They also pointed to the planned establishment of a debt management office charged with reducing debt service costs and improving asset management, although details remain to be worked out.

Energy Sector Reforms

Electricity production in Lebanon comes at a high budgetary cost, while service delivery is of poor quality. Budget transfers to EdL net of debt service amounted to $750 million (3.3 percent of GDP) in 2006. Weak management, poor governance, inadequate infrastructure, and reliance on oil instead of less expensive gas are the sector’s main problems. Technical losses are estimated at 15 percent of production, while non-technical losses (essentially illegal connections) account for another 18 percent. At the same time, power cuts are endemic.

The government is finalizing a comprehensive energy sector reform plan in close cooperation with the World Bank. EdL’s financial management will be enhanced through: corporatization (which would allow hiring a more professional work force); the appointment of a new board of directors and qualified advisors; auditing of EdL’s accounts; and installing remote meters. Reforms also seek to promote private sector involvement and increase capacity through independent power producers; tendering is envisaged for early 2008. Fuel costs are to be reduced by switching to natural gas in at least one power plant in the second quarter of 2008; this plant might also be privatized alongside the entry of independent power producers. A National Control Center, planned for 2008, is expected to realize efficiency gains in distribution. Toward the end of the reform period, the authorities plan to unbundle and partially privatize the sector. A regulator would be set up in parallel.

The tariff structure is far from achieving cost recovery and suffers from inefficiencies. Given the high production costs and losses, the average tariff of 9.4 cents/kWh achieves cost recovery at a fuel price of $25/barrel. The above reforms would narrow the gap relative to current oil prices, but an increase in tariffs may also be required, although international experience suggests that tariff increases should be introduced following improvements in service quality to avoid even higher non-payment and illegal connections. At the same time, Lebanon’s tariff is already significantly higher than regional tariffs which puts Lebanese producers at a disadvantage. In addition, there are inefficiencies in the tariff structure, for example, the peak tariff for industry encourages self generation.

28. The authorities also emphasized ongoing efforts toward strengthening public financial management. The carryover of committed and uncommitted spending from one budget year to the next has seriously weakened the ability to control budgetary outcomes and to align spending to current priorities. To address this problem, the authorities intend to roll-back the carry-over of committed spending starting in the 2008 budget. As a first step, they plan to explicitly revoke the ability of line ministries to carryover uncommitted expenditures beyond one month into the new budget year in the 2007 budget. The authorities explained that the 2008 budget circular also introduces the notion of medium-term planning and top-down spending envelopes for line ministries. In particular, they would pilot medium-term budgeting that incorporates the implications of investment spending for future current spending in four ministries and agencies.

E. Other Issues

29. The authorities are working on improving the statistical system, but significant data problems remain. With support from INSEE, they are revising the national accounts, including the compilation of quarterly GDP data. The 2004 National Accounts have just been released. However, statistical provision in other areas (balance of payments, prices, employment, wage and social indicators) remains seriously deficient. Lebanon is due to be assessed by the Middle East North Africa Financial Action Task Force in January 2008.

IV. Staff Appraisal

30. The authorities’ reform strategy lays out a promising path toward reducing Lebanon’s large debt overhang and financial vulnerabilities. The authorities’ medium-term fiscal adjustment objectives are appropriately ambitious in the circumstances. The reform measures are designed to yield the targeted improvement in the primary balance, and, combined with pledged donor support and privatization, should reduce the debt-to-GDP ratio significantly over the next five years. The challenge now is to move from the planning stage to implementation, which would be facilitated by improvements in the political and security situation.

31. Performance in the first quarter of 2007 bodes well for the attainment of the program objectives for the year, but the uncertain economic and financial environment requires close monitoring. The authorities’ intention to create a buffer by maintaining strict expenditure discipline is welcome. At the same time, gasoline excise revenues should be safeguarded by promptly raising gasoline prices in line with recent increases in international oil prices. The authorities’ commitment to reduce reliance on central bank financing over the remainder of the year is equally welcome. Every effort should be made to limit any new borrowing from the BdL to short-term bridge financing in order to safeguard international reserves. To that end, greater interest rate flexibility is necessary.

32. This transition year is the time to prepare the ground for sizeable adjustment and deep-seated reforms starting in 2008. The decision to include in the draft 2007 budget law the 2008 increase in the value-added tax and the tax on interest income provides a strong positive signal in this direction. The authorities are also encouraged to ensure that all legislative and administrative work for the introduction of the GIT in 2008 is completed before the end of 2007. The largest source of adjustment on the expenditure side over the medium term is to come from structural reforms of the energy and social sectors, which have been a source of large fiscal leakages over the years. Completion of these reform plans and their swift implementation are therefore key priorities for 2007-08. The success of energy sector reforms will require a careful sequencing of infrastructural and governance initiatives to avoid compounding existing problems, and NSSF reforms should be guided by fiscal considerations.

33. Significant improvements in public financial management are necessary to strengthen budgetary control, improve the allocation of scarce resources to priority areas, and enhance the effectiveness of policies. Staff encourages the authorities to follow-up on the action plan developed with Fund technical assistance to improve cash and budget management functions. At the same time, across-the-board expenditure cuts should, in general, be avoided because they are hard to sustain and undermine the quality of public spending. More generally, comprehensive public financial management reforms would be a prerequisite for the envisaged adoption of a fiscal responsibility law.

34. Fiscal adjustment will facilitate the reform of the monetary policy framework. Once more stable and predictable market conditions prevail, the central bank should be able to focus on guiding interest rates through transparent short-term instruments, which would allow the BdL to achieve its balance of payments and monetary objectives more efficiently. This will need to be accompanied by price flexibility in T-bill auctions. Such an environment would create the conditions for the government securities market to develop, thereby attracting a wider range of investors and helping the government diversify its financing base. As a first step, the authorities could consider reopening the repo window and relying on the repo rate to influence banks’ behavior. In the short term, the interlinkages between the government’s cash and debt management and the BdL’s liquidity and reserve management call for close cooperation between the two institutions to increase the efficiency of financial policies. Steps being taken in this direction are welcome.

35. Progress is also needed on strengthening the central bank’s balance sheet to preserve the monetary authority’s ability to control liquidity over the medium term. An improvement in the overall financial situation and de-dollarization will help in this regard. However, financing operations, such as the transfer of unrealized gold valuation gains to the budget, and quasi-fiscal activities, such as providing subsidized lending to banks, adversely impact on the BdL’s income and balance sheet positions and should therefore be avoided. More generally, public support to the private sector should be provided through the budget to ensure consistency with policy priorities. The privatization of the assets held by the BdL would also strengthen its financial position, while contributing to the government’s growth agenda.

36. The exchange rate peg to the U.S. dollar has contributed significantly to maintaining financial stability under very difficult circumstances and without impairing competitiveness. The peg played an important role as a nominal anchor during recent financial pressures. In the current circumstances, international reserves held by the BdL combined with the banking system’s liquidity cushion appear sufficient to meet temporary pressures on the exchange rate, and the REER appears broadly in line with fundamentals. Going forward, macroeconomic policies need to be geared toward supporting the exchange rate peg. The debt overhang and the large external current account deficits are the counterpart of fiscal imbalances and, therefore, should be addressed by implementing the authorities’ Paris III fiscal adjustment program.

37. Domestic banks remain the primary source for the government’s financing needs. The resulting interdependence of the government, the central bank, and the commercial banks has created incentives for all actors to behave in a concerted way to preserve financial stability. However, this interdependence also creates systemic risks, in that shocks to either the fiscal or the financial sector would be quickly passed on to other sectors. In this regard, the commercial banks’ strategy of regional expansion and focus on private sector lending is welcome both from a risk management perspective, and given the envisaged decline in government financing needs over the medium term. The authorities have been aptly accompanying this process through regulatory and supervisory reforms, and it is important that they deepen these efforts as banks expand into new cross-border activities, including by implementing the applicable Basel Core Principles. Moreover, there is a need to strengthen the bank resolution mechanism to facilitate consolidation when needed, while minimizing moral hazard and increasing banks’ management accountability and shareholder responsibility.

38. The authorities’ program appropriately emphasizes private sector growth and improved delivery of social services. Privatization of the telecom sector is a crucial element of the growth strategy and should be accompanied by endowing the regulatory authority with the powers and capacity to ensure proper competition in the sector. Staff also welcomes the authorities’ intention to widen the privatization agenda to other sectors, as well as ongoing efforts to improve the business climate. In this regard, the growth agenda should be complemented by actions to dismantle oligopolistic practices and eliminate barriers to entry and exit.

39. Timely and flexible disbursement of Paris III pledges is another important element for the success of the authorities’ strategy. Progress has been made in locking in the terms and conditions for the release of funds from some key donors, but negotiations are still underway with others. Staff fully supports the authorities’ request that donors make timely disbursements and convert their pledges from project to budget support, or at least align their project disbursements to the government’s own spending priorities.

40. Risks to the reform strategy call for a continuous reassessment of policies. Shocks to the macroeconomic environment, shortfalls in the privatization program, and contingent fiscal liabilities (from actuarial imbalances in the public and private pension systems, open-ended transfers to the health fund, and unforeseen costs from power sector reform) all have the potential to throw the economy off course relative to the targeted debt reduction path, and to require corrective actions. Equally important are implementation risks, particularly in view of domestic and regional tensions and the need to maintain consensus around the reform program. The authorities’ emphasis on a multipillar approach of fiscal adjustment, growth promotion, and improved social services should help mitigate these risks. In addition, a wider public debate about the economic and financial challenges facing Lebanon would be important to sustain public and political support for reform and adjustment during and beyond the Paris III horizon.

41. Data gaps hamper the analysis of real and external sector developments. High level commitment is needed to address these shortcomings through a comprehensive strategy to strengthen the statistical system.

42. It is proposed that the next Article IV consultation will be held on the standard 12-month cycle. Quarterly reports on performance under the program supported by EPCA will be issued for the information of Executive Directors, as requested by Directors at the time of the EPCA approval.

1

Developments in 2006 were discussed in more detail in IMF Staff Country Report No. 07/177.

2

Excluding gold valuation changes.

3

A temporary peak in deposits at end-2006 was reportedly related to some window dressing” by banks aimed at posting high deposit growth rates for the year

4

Staff’s views are given in Section IV.

5

In addition to their traditional bases in Europe and Cyprus, Lebanese banks are (or plan to be) present in Algeria, Egypt, Iraq, Jordan, Nigeria, Oman, Qatar, Sudan, Syria, Tunisia, and the United Arab Emirates.

6

The risk weight on Eurobonds would increase from 20-50 percent presently to 100 percent, and that on central bank foreign currency debt from zero to 100 percent. The risk weight on domestic currency sovereign debt is expected to remain at zero.

7

Staff’s scenario envisages that net transfers to EdL (excluding debt service, but including investment costs) would decline to 1.3 percent of GDP by 2012, from 3.3 percent of GDP in 2006.

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Cover IMF Staff Country Reports
Lebanon: 2007 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Lebanon
Author:
International Monetary Fund
Volume/Issue:
Volume 2007: Issue 382
Publisher:
International Monetary Fund
ISBN:
9781451943276
ISSN:
1934-7685
Pages:
70
DOI:
https://doi.org/10.5089/9781451943276.002
  • Figure 1.
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    Figure 1.

    Lebanon: Recent Developments, January 2005–March 2007

  • Figure 2.
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    Figure 2.

    Lebanon: Public Debt Sustainability, 2002–26

    (Public debt in percent of GDP)

  • View in gallery

    Lebanon: CPI-Based Real Exchange Rate Developments

    (Index, 1995=100; January 1995–March 2007)

Figure 1.

Lebanon: Recent Developments, January 2005–March 2007
Figure 2.

Lebanon: Public Debt Sustainability, 2002–26

(Public debt in percent of GDP)

Lebanon: CPI-Based Real Exchange Rate Developments

(Index, 1995=100; January 1995–March 2007)