Recent Developments

3. The current year continues to be particularly difficult, with persistent serious political tension and security concerns ahead of the presidential election, which is expected to be held by November 2007. Notwithstanding the daunting political and security challenges, economic indicators point to a slow recovery from the 2006 Israeli attack on Lebanon. Real GDP is expected to rebound to about 2 percent in 2007. CPI inflation is projected to fall to around 2 percent by year’s end, following price pressures in the summer of 2006, due to supply shortages related to the war and the subsequent blockade. The financial system remains resilient. Gross international reserves recovered to about $12 billion at end-August, supported by strong deposit inflows. Moreover, trade flows have resumed after an interruption occasioned by the 2006 war.

4. Against this background, the authorities continue to consider the Fund-supported Emergency Post-Conflict Assistance (EPCA) to be critical in supporting their efforts to implement the 2007 agenda, thereby paving the way for more ambitious fiscal adjustment and structural reforms in subsequent years. Performance under the EPCA was strong, with all end-March 2007 quantitative targets observed, with the exception of the ceiling on government borrowing from the Banque du Liban (BdL), which was exceeded by a small margin. Indeed, in the first months of 2007, the government had to solicit further direct financing from the BdL, amidst serious political tensions and ensuing tight market conditions, as commercial banks failed to roll over maturing government paper. Moreover, all the quantitative targets for the second quarter of 2007 were observed with large margins.

5. Economic policy and performance in the first half of 2007, particularly the strong revenue collection and continued expenditure restraint, augur well for the achievement of the program’s end-year quantitative fiscal targets. However, actual disbursements of pledges committed at the Paris III and Stockholm conferences have so far fallen well below EPCA assumptions. While of the total US$7.6 billion pledged at the Paris III conference, agreements have been signed for about US$3.4 billion, out of US$1.6 billion in budgetary support pledged for 2007, only US$0.6-0.9 billion is likely to be received this year. At the same time, US$175 million has been disbursed to date and a US$100 million World Bank Development Policy Loan is in the process of being disbursed. Should disbursement fail to accelerate considerably in the last quarter of 2007 in line with Paris III pledges, the authorities would find it extremely difficult to identify additional fiscal measures to offset the resulting sizable shortfall, as rightly pointed out by staff. This outcome would weigh on the government’s indebtedness.

6. Notwithstanding their strong commitment to the objectives of the EPCA and the medium-term reform agenda, the authorities are aware of persistent vulnerabilities. In the short-term, the economy remains vulnerable to swings in confidence. Moreover, the political deadlock has increased risks, as reflected by Eurobond spreads and deposit dollarization, which remain higher than prior to the 2006 war. Looking ahead, despite the strong fiscal adjustment and structural reforms embedded in the authorities’ program to bring down the debt-to-GDP ratio significantly, the debt dynamics are likely to remain fragile and vulnerabilities high. Accordingly, in addition to the commitment of the authorities to pursue their ambitious reform agenda under the EPCA and beyond, continued strong international support remains essential to help Lebanon reduce its economic vulnerabilities. In particular, it is important that donors fully carry through their financial commitments made at the Paris III conference, in a timely fashion, and in line with the authorities’ macroeconomic objectives and policy priorities. The authorities continue to actively seek flexibility from donors to convert project loans pledges into budgetary support to further reduce the debt burden. They are particularly grateful for the Fund’s assistance in this regard.

Fiscal Policy and Reforms

7. Sound fiscal management to date in 2007 succeeded not only in avoiding a deterioration in the fiscal position, but also in improving the primary balance, while attempting to meet the large social and reconstruction needs of the Lebanese population. The first and second quarter performance was within the EPCA targets. Stronger than projected revenue collection, and containment of expenditures below the EPCA targets, helped contain the primary deficit and the accumulation of net debt. Moreover, 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.

8. In spite of unanticipated and sizeable conflict-related expenditure, the primary budget deficit, excluding grants, is expected to be contained at 3.7 percent of GDP at end-2007, as programmed, supported by higher than projected revenues. On the revenue front, the authorities remain committed to introducing a floor on gasoline excises of $0.20 per liter. Given the continued political instability, however, implementation of this measure may have to be postponed until after the presidential elections. Uncapping domestic gasoline prices in a context of high international oil prices would translate in a substantial hike in gasoline retail prices, which, in the present political and economic environment, may seriously exacerbate existing tensions. It is well to note that delaying implementation of this measure will not jeopardize the primary balance target for 2007, as envisaged under the EPCA. Indeed, the potential loss stemming form a delayed introduction of a floor on gasoline excises has already been largely compensated for by increases in other sources of revenue, including VAT, customs, income tax, and telecom transfer. Preliminary estimates indicate that the end-September 2007 revenue performance already exceeds the end-of-year target under the EPCA. The authorities have also requested technical assistance from the Fund to prepare for the removal of various subsidies and the liberalization of gasoline prices.

9. Important progress has been achieved in preparing the fiscal adjustment effort envisaged for 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. The draft Global Income Tax law is near completion and should be ready for submission to parliament by year end. In addition, the review of the Tax Procedure Code has been finalized by the parliamentary committees, and is awaiting ratification by Parliament. Ongoing revenue administration reforms, including the introduction of a medium taxpayer office, new audit procedures, and the update of the real estate tax database, are expected to yield revenue gains. On the expenditure side, the authorities’ medium-term program aims at gradually eliminating transfers to the public sector, which hinges on reforming the energy and social sectors that have drained budget resources over the years. In this connection, and in close cooperation with the World Bank, reform plans for Electricité du Liban (EdL) and the National Social Security Fund (NSSF) are being finalized.¹ Administrative measures include better cooperation and information sharing across ministries and the planned establishment of a debt management office, in addition to measures aimed at strengthening treasury and debt management capabilities. The authorities have achieved further progress in implementing the public financial management reform plan developed with Fund assistance, and aimed at enhancing budget monitoring and control procedures. A pilot project for program budgeting at the Ministry of Public Health was also introduced in the draft 2008 budget.

Monetary Policy and Banking Sector Policies and Reforms

10. The monetary policy framework has enabled the authorities to effectively control financial pressures. The exchange rate peg continues to serve the economy well by providing a firm anchor to financial stability. It proved crucial given balance sheet risks related to widespread dollarization and the government’s high foreign currency debt servicing obligations. The debt overhang and the large external current account deficits are the counterpart of fiscal imbalances, as well as temporary factors related to the post-conflict environment. They would be addressed by implementing the Paris III fiscal adjustment program. In this context, the authorities are of the view that the current exchange level is appropriate, and agree with staff’s assessment outlined in Box 3. Furthermore, they are confident that Lebanon’s competitiveness could significantly benefit over the medium term from the planned structural reforms.

11. Interest rate stability has largely contributed to facing financial pressures, reflected in higher dollarization and pressures in the foreign exchange market. Admittedly, these conditions have required the BdL to occasionally resort to various financial and long-term monetary instruments to manage liquidity and safeguard international reserves. These included the issuance of dollar-denominated certificate of deposits, special discount windows, and swaps. While the authorities believe that the BdL could temporarily provide financing to the government under tight market conditions, in line with its mandate to maintain financial stability, they concur with staff that prolonged shortfalls in market demand for government paper would have to be met by raising treasury bills rates. The authorities are of the view that flexible interest rates are essential to counter further increases in dollarization, which might adversely affect the central bank’s foreign reserves levels. They consider that an appropriate spread between returns on foreign currency and Lebanese pounds in the domestic market should thus be assured in order for commercial banks to subscribe in government paper. On the current account level, an adequate spread between domestic returns on dollar investments and international rates would help ensure the necessary inflows of capital into the economy. The authorities are of the view, however, that an upward adjustment in domestic interest rates at this stage may not attract sufficient market financing given the existing uncertainties, and thus have an adverse signaling effect. Once more stable and predictable market conditions prevail, the central bank should be in a better position to maintain price stability using short-term monetary instruments. This would help strengthen its balance sheet and reduce its cash losses. Going forward, fiscal adjustment and improved confidence would help reduce dollarization, which would facilitate a further buildup of net international reserves and strengthen the BdL’s income position. Improved political and security conditions, however, remain essential to the reform of the monetary policy framework.

12. The banking sector remains profitable, well-capitalized, and well-supervised. However, vulnerabilities are high, as reflected in domestic bank’s high exposure to the sovereign, the substantial maturity mismatch on their books, as well as the high degree of dollarization which exposes them to credit risk. In this context, and given potential systemic risks between the fiscal and the financial sector, the authorities welcome the commercial banks’ focus on private sector lending and their strategy of regional diversification. The regulatory and supervisory framework has appropriately adapted to these developments. This is evidenced in the circular issued by the banking control commission in 2006, raising the limits on the exposure of Lebanese banks to non-resident borrowers, and the progress in developing memoranda of understanding on consolidated supervision with supervisory authorities in countries where Lebanese banks are expanding. Commercial banks are expected to further strengthen risk management with the introduction of Basel II standards in 2008.

Other Structural Reforms

13. Reforming the social and energy sectors, which have drained the government’s financial resources for years, is pivotal to the medium-term structural reform agenda. Reforms to address imbalances, and possible contingent liabilities, in the pension and health system are being developed. A draft pension law, providing for transforming the private pension systems from an end-of-service allowance to a fully funded system, has been submitted to parliament. Furthermore, the authorities, supported by the World Bank, are looking into options for addressing the losses of the health fund of the NSSF. The government is currently finalizing a comprehensive energy sector reform plan in close cooperation with the World Bank, with the objective of restructuring EdL to pave the way for partial privatization. The main reform measures envisaged for 2008 include: (i) the completion of an audit of EdL accounts for 2002-2006, (ii) the completion of EdL’s asset registration and valuation, (iii) the corporatization of the company, (iv) the launch of a pilot project for remote meter installation and distribution management by private operators, (v) launching the privatization of the Beddawi power plant, and (vi) soliciting private sector investment in new capacity.

14. The privatization of the telecommunications sector is expected to start as early as October 2007. A legal opinion by the ministry of justice concluded that the law for the sale of the fixed assets of the two state-owned mobile phone operators was no longer necessary. Accordingly, the government expects that invitations for expressions of interest for the two companies to be issued by the end of 2007. The authorities are committed to undertaking the privatization of the mobile sector companies through a transparent public offering. The privatization of the fixed line, as well as a third mobile license, are planned to be launched in 2008.

15. In conclusion, looking forward, for the reform agenda for 2008 and beyond to be successfully implemented, three critical conditions have to be met. First, a satisfactory outcome of the current ongoing presidential elections. Second, the international community’s delivery of aid committed under Paris III. And finally, a reasonable environment of peace and security in Lebanon and the region as a whole.