Lebanon
2010 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
Publication Date:
08 Oct 2010
eISBN:
9781455208586
Language:
English
Keywords:
ISCR; CR; revaluation tax; Banque du Liban; staff appraisal; deposit dollarization; deposit growth; private sector; monetary policy; banking system; U.S. dollar; broad money; Fiscal stance
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In this study, Lebanon’s economy performed well during the global financial crisis. The banking sector has been resilient in the face of the global crisis, thanks to relatively conservative funding and asset structures, and prudent banking regulations and supervision. The need to address the high government debt and to implement growth-enhancing structural reforms is emphasized. To underpin the medium-term fiscal strategy and growth, Executive Directors encouraged the authorities to take the opportunity of the positive economic environment to implement structural reforms.

Abstract

In this study, Lebanon’s economy performed well during the global financial crisis. The banking sector has been resilient in the face of the global crisis, thanks to relatively conservative funding and asset structures, and prudent banking regulations and supervision. The need to address the high government debt and to implement growth-enhancing structural reforms is emphasized. To underpin the medium-term fiscal strategy and growth, Executive Directors encouraged the authorities to take the opportunity of the positive economic environment to implement structural reforms.

1. BACKGROUND1

1. Lebanon’s economic and financial performance has been remarkable in the face of the global recession. The economy bucked international trends during the global financial crisis, maintaining strong growth momentum despite the country’s large underlying vulnerabilities.

2. This positive outcome reflected domestic and external factors. Confidence rebounded with the political reconciliation agreement reached in Doha in 2008 and the successful, though delayed, formation of a new national unity government in late 2009, which returned the country to relative political stability. Together with a global low-interest rate environment, this unleashed a sharp acceleration in capital inflows even during the global crisis.

3. Macroeconomic policies remained prudent during the upswing, but there was little progress on structural reforms. Buoyant revenues, supported by the reintroduction of fuel excises, led to an increase in the government’s primary surplus to 3 percent of GDP in 2009, which—together with strong growth–allowed for a marked reduction in the debt-to-GDP ratio. In addition, the Banque du Liban (BdL) took advantage of the abundant capital inflows to accumulate international reserves. While macroeconomic outcomes have been broadly consistent with the frameworks that were drawn up in the context of the 2007 Paris III donor conference and the two programs supported by the IMF’s Emergency Post-Conflict Assistance (EPCA), structural reforms fell substantially short of the authorities’ commitments (Box 1).

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GDP Growth, Government Debt, and Primary Balance

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig02

Gross International Reserves 1/

(in billions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff estimates and projections.1/ Excludes gold.

Economic Performance and Policies in Context

Lebanon’s macroeconomic performance has been stronger than anticipated at the time of the Paris III conference and the first program supported by Emergency Post Crisis Assistance (EPCA I) in early 2007. Average real GDP growth during 2007–09 was 8.5 percent, markedly higher than the 3 percent projected under Paris III/EPCA I. Strong growth, together with an increase in the primary fiscal balance broadly in line with expectations, allowed for a decline in the government’s debt-to-GDP ratio to 148 percent by end-2009. While this decline was somewhat less than projected under Paris III/EPCA I, the latter assumed resources from privatization of the mobile phone carriers, which did not materialize. At the same time, strong capital inflows and the ongoing dedollarization of deposits allowed for a much larger than anticipated build-up of international reserves.

A01ufig03

Real GDP

(Annual Percent Change)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig04

Primary Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig05

Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig06

Gross International Reserves

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff estimates and projections.

Progress toward the Paris III structural reform objectives has been much more limited. Price stability was maintained, gasoline excises were restored, and increases in capital expenditures and the tax on interest income are part of the draft 2010 budget. The authorities are also working to introduce a more uniform income tax, improve debt management and the budget process, and partially privatize the air carrier MEA. Some progress has also been made in capital market, business environment, and social sector reforms. However, the implementation of other commitments has made little headway, including raising the VAT rate; reforming the electricity sector; privatizing the mobile phone carriers; reducing the wage bill as percent of GDP; eliminating extrabudgetary funds (Fund for the Displaced and Council of the South); and reforming the pension system.

Macroeconomic policy since the last Article IV Consultations has been broadly in line with the staff’s advice. The authorities implemented the 2009 budget cautiously and saved the revenue overperformance, which led to a much higher than budgeted primary surplus and a marked decline in the government’s debt-to-GDP ratio. Similarly, the authorities gradually reduced interest rates—although at times somewhat slower than suggested by staff—with a view to moderating the pace of deposit inflows once it became apparent that the global crisis was virtually not affecting Lebanon and domestic political near-term risks abated.

4. While some headway has been made in reducing short-term risks, large underlying vulnerabilities remain and new vulnerabilities could emerge in the future. Domestic stability rests on the fragile political system that is split along confessional lines, and the country lies at the crossroads of regional tensions. The government’s debt, at 148 percent of GDP, still remains among the highest in the world, and almost half of it is denominated in foreign currency. The large banking system is highly exposed to the sovereign, and dependent on short-term deposit inflows from nonresidents. Bank lending is to a large extent dollarized, which creates exposure to unhedged borrowers. In addition, unless carefully managed, new vulnerabilities could emerge in the future from rapidly rising real estate prices, plans to develop public private partnerships (PPPs), or the ongoing regionalization of local banks.

2. THE CURRENT STATE OF LEBANON’S ECONOMY

5. The expansion of the economy continues at a fast pace. Real GDP rose 9 percent in 2009 backed by a confidence rebound and large capital inflows, which fueled activity in the construction, tourism, commerce, and financial services sectors. The output gap has substantially narrowed or even closed and momentum carried into 2010, with growth now expected to reach at least 8 percent (Appendix 1). Inflation has risen since the fall of 2009, driven partly by energy prices. Real estate prices have also increased at a rapid pace. In view of the Lebanese pound’s peg to the U.S. dollar, the weak euro should help keep inflation in check in the coming months provided that there is no further build-up of price pressures in the non-tradable sector, which could be a risk if the economy accelerates further.

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Cyclical Indicators

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

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Contribution to Headline Inflation

(Y-o-y, in percent)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; Byblos Bank Group; and staff estimates and projections.

6. The current account deficit is set to widen in 2010, mainly reflecting domestic-demand driven growth. The current account deficit remained stable in 2009, as rebounding tourism inflows and lower prices for energy imports helped offset the effects of rising domestic demand. The current account will likely deteriorate this year as imports receive an additional boost from buoyant domestic demand and a partial rebound of oil prices.

7. Capital inflows remain robust despite some moderation in recent months. Non-resident inflows surged last year as political and security risks declined and the authorities kept domestic interest rates high while global rates dropped. As a result, commercial bank deposits grew by more than 23 percent in 2009 and deposit dollarization declined. This allowed the BdL to increase international reserves to over $29 billion, while sterilizing much of the impact on the domestic money supply through the issuance of CDs. Deposit inflows moderated in the first half of 2010, following a series of interest rate cuts, but remain healthy overall at an annualized growth rate of about 11 percent. Sovereign and CDS spreads have increased somewhat in recent weeks, broadly in line with emerging market averages.

A01ufig09

Deposit Growth and Dollarization

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig10

Sovereign Spreads

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

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

8. The banking system has remained sound, but credit growth has picked up recently as banks are seeking to reverse falling interest margins. Lebanon’s banks have weathered the global crisis well, thanks to relatively conservative funding and asset structures, which reflect prudent banking regulation and supervision. Supported by the strong economy, the banking system remains profitable and well-capitalized, highly liquid, and exhibits low and still falling NPL ratios. Exposure to Dubai was very limited, and is virtually non-existent with regards to Southern Europe. However, falling interest rates are putting pressure on bank profits, challenging the traditional business model that relied on intermediation of private deposits to the government and the BdL. Banks are responding by seeking new growth opportunities outside of Lebanon and expanding domestic credit to the private sector, which has accelerated to 21 percent y-o-y growth in April.

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Private Sector Credit Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Lebanon: Banking Sector Financial Soundness Indicators, 2007–10

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

Basel II ratio.

Net of provisions against problem loans.

9. Near-term risks to the economic outlook are mainly linked to the political and regional security situation. The risk of a relapse by opposing party blocks into political deadlock or spillovers from a sudden spike in regional tensions remains latent, and exposes Lebanon to the possibility of a sudden negative confidence shock. While there has been little fallout from Greece so far, an adverse shift in global market sentiment could lead to a repricing of sovereign risk, which would hurt the debt dynamics and could put pressure on international reserves. To some extent, this risk is mitigated by Lebanon’s limited exposure to external government debt markets and its loyal depositor base. However, future shocks could be different in nature and expose vulnerabilities more strongly than past crises.

10. Against this broadly positive backdrop, economic policy still faces a number of challenges.

  • In the near term, the key issue is to manage the buoyant economy cautiously, avoiding overheating risks, such as excessive pressures on non-tradable prices and the external current account. This requires, in the first place, a prudent fiscal policy stance. In addition, monetary and prudential policies have to be adapted to the post-global crisis environment to temper deposit inflows and avoid potential risks that could emerge in the future if property prices continued to rise rapidly, or from the regional expansion of local banks.

  • The main medium-term challenges are to address the country’s sizeable remaining macrofinancial vulnerabilities and implement growth-enhancing structural reforms. The key issue here is to avoid complacency and instead take advantage of the positive momentum to achieve debt reduction and re-launch long-delayed structural reforms, which could jointly help entrench stability and maintain high and sustainable rates of growth.

3. MANAGING THE BUOYANT ECONOMY IN 2010

11. The authorities’ short-term policy focus is increasingly shifting from bolstering the economy in the face of a global recession toward managing its rapid expansion. Fiscal policy seeks to reconcile plans for a substantial increase in infrastructure investments with the need to safeguard macroeconomic stability and debt reduction. The challenge for monetary policy, in turn, is to slow deposit inflows to a pace that can be absorbed without excessive credit growth or international reserves accumulation and associated sterilization costs. Finally, banking sector regulation and supervision is increasingly focusing on potential vulnerabilities emanating from high credit growth, sharply rising real estate prices, and the regionalization of domestic banks.

A. 2010 Budget—Balancing Spending Needs and Stability Goals

12. The authorities’ draft 2010 budget implies a substantial fiscal relaxation to accommodate higher capital expenditures. The draft budget, which was approved by cabinet in mid-June following extended deliberations and is currently under discussion in parliament, envisages a 2.4 percent of GDP (200 percent nominal) increase in capital spending, including substantial investments in electricity generation, which has fallen significantly behind demand (Box 2). Revenue measures amount to 0.8 percent of GDP and include a 2 percentage point increase in the interest income tax, an asset revaluation tax, and higher registration fees for high-end properties. A much-discussed VAT hike was dropped for lack of political support. Full implementation of the budget would imply a fall in the primary surplus from 3 percent of GDP in 2009 to 0.5 percent of GDP this year, but would still allow a further moderate decline in the government debt-to-GDP ratio given strong economic growth.

13. The primary surplus in 2010 may be higher than budgeted. The authorities and staff believe that the actual primary surplus could reach about 1.5 percent of GDP because of the delays in approving the budget, normal lags in the execution of public investment, and favorable revenue trends.

14. Staff noted that from a cyclical perspective there was little need for a fiscal impulse and encouraged the authorities to aim for a higher primary surplus. The currency peg, which limits room for countercyclical monetary policy, places the onus for short-term demand management on fiscal policy (supported by prudential measures). Moreover, achieving a higher primary surplus would also contribute to faster debt reduction. Staff suggested a primary surplus target of at least 2 percent of GDP for 2010, which could be attained by cautiously executing current spending and saving any revenue overperformance. Planned investments to address pressing infrastructure bottlenecks could be accommodated within this fiscal envelope, although related structural reforms should proceed in parallel to ensure that these investments correct rather than reinforce existing deficiencies. For example, staff cautioned that in the electricity sector a substantial increase in investment without a simultaneous movement toward cost recovery could lead to additional losses and subsidies from the budget.

Lebanon’s Infrastructure Deficit

Public investment in Lebanon is low by international and historical standards, and there are severe infrastructure bottlenecks. Capital spending averaged only 2.5 percent of GDP during 2003–08, and reached a low of 1.5 percent of GDP in 2009. Low investment levels have contributed to generating severe infrastructure gaps, mainly in electricity, telecommunications, water, and the road network, adversely affecting the medium-term growth potential.

A01ufig12

Average Public Investment, 2003-08

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff calculations and projections.

Many infrastructure sectors also suffer from deficiencies in their regulatory frameworks and poor governance and inefficiencies of public utilities. The electricity sector requires high budgetary transfers, and Electricité du Liban (EdL) is inefficient in its structure and operations. Partly due to a lack of competition, Lebanon lags behind its neighbors in telecommunications, in quality, range of services offered, and competitiveness of pricing.

15. The financing outlook for the government remains favorable and should allow further progress toward achieving a safer debt structure. There was agreement that—barring a major shock—the government’s remaining financing needs for 2010 could be covered by the market, as banks remain very liquid despite the recent slowdown in deposit growth. Following the rollover of $1.2 billion in 10-year Eurobonds in March, the government does not face major foreign currency maturities until November–December ($1.4 billion). Staff seconded the authorities’ intentions to use the opportunity to gradually lengthen the maturity profile and lower the foreign currency share of government debt. The latter could be achieved by continuing to fund in local currency some of the government’s foreign currency debt service. However, such a strategy should be closely coordinated with the BdL and implemented with a view to safeguard an adequate level of international reserves. Staff also highlighted the desirability of gradually increasing the share of non-bank funding, and welcomed the authorities’ intention to mobilize concessional loans pledged at past donor conferences.

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Government FX Debt Service

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff calculations and projections.

Lebanon: Gross Financing Requirement

article image
Sources: Banque du Liban; and staff estimates.

Lebanon: Foreign Assistance to Government

(In millions of U.S. dollars)

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Sources: Lebanese authorities; and Fund staff estimates.

B. Managing Monetary Policy in the Face of Large Capital Inflows

16. After two years of substantial accumulation, international reserves have reached adequate levels. The authorities noted and staff agreed that Lebanon’s fiscal and financial vulnerabilities and its exposure to potential political shocks provided a justification for the accumulated foreign exchange buffer. In staff’s view, reserves now cover a comfortable share of broad money and short-term debt, are large enough to withstand plausible Lebanon-specific shock scenarios, and have reached optimal levels according to an applied insurance model. At the same time, self-insurance has come at a cost, as the BdL had to sterilize reserves purchases, mainly through the issuance of high-yielding LL CDs.2 The resulting interest cost weighs significantly on the BdL’s net income position.

17. With comfortable reserves in view of the staff, monetary policy has shifted focus to moderating deposit inflows. Policy interest rates have been allowed to drop markedly (by more than 400 bps since mid-2008 on 5-year T-bills/BdL CDs, of which 70bps in April and May of 2010 alone). However, the decline in deposit rates has been more gradual and modest, reflecting imperfect monetary transmission with variable lags (Appendix 2). Deposit rates have recently started to fall more rapidly, and given the recent erosion of bank interest margins, further declines are likely in the pipeline.

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Interest Rates

(In Percent)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff estimates and projections.1/ 5-yr BdL CD rate until June, 2009. 5-yr T-bill rate thereafter.

18. A pause in policy interest rate reductions may be warranted to ensure a smooth adjustment process. There was broad agreement that care should be taken not to overshoot on reducing policy rates, as risks were judged to be asymmetric. The risk of a possible drying up of inflows because of lags in the response of market interest rates to past monetary policy actions was believed to be costlier than the risk of temporarily accumulating more reserves than optimal. Cautious interest policy would also reduce the risk of having to backpedal if world interest rates and/or emerging market risk premia were to rise, for example in the context of the Southern European crisis. Given the importance of guiding market expectation in the adjustment process, staff encouraged the BdL to clearly communicate its monetary policy objectives to the public.

19. The exchange rate peg provides a strong nominal anchor and remains the lynchpin of financial stability.3 Maintenance of the peg is essential in light of the government’s high debt and debt service obligations in foreign currency, and the substantial currency mismatches of corporations and households, owing to widespread loan dollarization. Staff encouraged the authorities to work towards reducing these vulnerabilities. The authorities agreed with staff’s assessment that, although the recent strength of the U.S. dollar has led to some real appreciation of the Lebanese pound, the real effective exchange rate remains broadly in line with fundamentals (Box 3).

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CPI-Based Real Exchange Rate Developments

(Index, 1995=100; January 1995-April 2010)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: National authorities; and Fund staff calculations.Note: A higher value indicates a more appreciated exchange rate.

Real Exchange Rate Assessment

Lebanon’s exchange rate appears broadly in line with its fundamentals. After several years of decline in line with a weakening U.S. dollar, the real effective exchange rate (REER) has risen somewhat since mid-2008. The recent increase in the real exchange rate reflects both a strengthening of the U.S. dollar and sustained domestic inflation.

Lebanon’s strong export performance suggests that the country does not face major competitiveness problems. Both goods and services export volumes are estimated to have grown by close to 15 percent on average over the past five years (2005-09), and by 6 percent on average over the last twenty years despite a major appreciation of the U.S. dollar and hence the Lebanese pound during the 1990s. Among services exports, tourism, which accounts for one third of exports, has been particularly dynamic in recent years, as reflected—for example—in substantially higher tourist arrival numbers.

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Exports of Goods and Services, 2000-2009

(Constant prices of 2005, in billions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: National authorities; and Fund staff calculations.

The application of the three methodologies proposed by the IMF’s Consultative Group on Exchange Rate Issues (CGER) does not yield evidence of a marked exchange rate misalignment. The macroeconomic balance and the external sustainability approaches point to a somewhat overvalued exchange rate (between 3 and 9 percent), while the equilibrium real exchange rate approach suggests a modest undervaluation (by up to 10 percent). The differences between the results likely reflect methodological differences and limited data availability, as some variables commonly used for equilibrium exchange rate estimations are not available for Lebanon. Taking into account the individual methodologies’ strengths and weaknesses in the Lebanon context, all three methodologies should be given about equal weight in the overall assessment.

Lebanon: Real Exchange Rate Overvaluation Estimates Using CGER Approaches 1/

article image

Using CGER parameters and a current account elasticity of 0.4.

Net external asset position (NEAP) estimate based on International Financial Statistics data.

Net external asset position (NEAP) estimate based on Bank for International Settlements data.

For each parametrization, compares the norms with a) underlying 2009 current account stripped of temporary factors and b) steady state (2015) current account.

Range of estimates obtained using different model specifications.

C. Tailoring Supervision to an Evolving Banking Sector

20. The authorities are focusing bank regulation and supervision on preventing excessive risk taking. For example, they limited the loan-to-value ratio for most real estate loans to 60 percent. Staff agreed that the BdL and the Banking Control Commission (BCC) should remain vigilant to the potential risks of weakening credit standards, increasing leverage in specific sectors, and deteriorating asset quality. Staff noted that, despite conservative prudential regulation on leverage and limited bank exposure to the real estate sector, care should be taken that the recent surge in housing prices and accelerating credit growth do not feed off each other to produce a real estate bubble. Moreover, prudential regulation may need to support monetary and fiscal policies in dealing with the booming economy. In particular, if credit growth accelerates further, the authorities should consider increasing effective reserve requirements, including by phasing out existing exemptions that were created to stimulate lending in domestic currency. Looking forward, the BdL and BCC could also consider the merits of introducing countercyclical prudential regulation.

21. The regional expansion of Lebanese banks justifies the BCC’s heightened focus on effective cross-border supervision. Current supervisory activities are broadly in line with good practices and could be further enhanced through continued efforts to deepen de facto cooperation and information sharing with host country supervisors, and greater focus on conducting stress testing and scenario analyses (Box 4).

22. Further progress is needed in the areas of anti-money laundering and combating the financing of terrorism (AML/CFT). The authorities are committed to conform their AML/CFT framework to the Financial Action Task Force’s 40+9 Recommendations. The recent Middle East and North Africa Financial Action Task Force Mutual Evaluation Report recognized significant progress accomplished by the authorities in several areas, including the performance of the Financial Intelligence Unit, while noting that the framework needs further strengthening in other areas, in particular the criminalization of money laundering and the financing of terrorism, and the reinforcement of the AML/CFT supervisory system.

The Regionalization of Lebanese Banks

Lebanese banks have substantially increased cross-border activities in recent years by opening affiliates abroad and increasing non-resident lending from their headquarters in Lebanon. There are currently more than 50 affiliates (branches, subsidiaries and representative offices) of Lebanese banks operating in about 20 countries. Total assets of foreign affiliates amount roughly to $25 billion, or 19 percent of the domestic banking sector. Loans to non-residents booked by parent banks have tripled since 2006, reaching 16 percent of private sector credit.

Lebanese Banks Abroad 1/

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Sources: Fund staff estimates based on preliminary data from authorities.

Top 10 countries by the total assets of affiiliates.

The foreign expansion has been motivated by the limited growth potential of the domestic credit market and untapped opportunities in countries with growing banking sectors. Lebanese banks have traditionally been active in Europe, but more recently they have primarily targeted countries in North Africa and the Middle East with business models that adapt to host country conditions. For example, in Syria, Egypt, and Jordan banks engage in universal banking, while Cyprus is used as a gateway for offshore services. In Europe, banks concentrate on trade finance and private banking, while in Africa, they cater largely to the Lebanese diaspora.

The growing regionalization of banks calls for effective regulation and cross-border supervision, which the Banque du Liban and the BCC are undertaking. The authorities have implemented a number of measures to strengthen the oversight of Lebanese affiliates abroad. Any equity investment by a Lebanese bank abroad requires prior approval from the BCC. Foreign affiliates are required to submit monthly financial statements and audit reports to their parent banks and the BCC, and parent banks must set up a special committee to oversee their foreign affiliates. To limit the foreign exposure, total net financing from a parent bank to its affiliates cannot exceed 25 percent of equity, while non-resident lending is subject to a ceiling that depends on the sovereign rating of borrower’s country. The BCC has also signed memoranda of understanding with most host country supervisors, which establish procedures for information exchange and off- and on-site inspections.

4. A MEDIUM-TERM ROADMAP FOR CONTINUED STABILITY AND SUSTAINED GROWTH

23. The authorities and staff agreed that lowering the government debt-to-GDP ratio remains the top medium-term priority to reduce Lebanon’s macro-financial vulnerabilities. Under the staff’s baseline no-policy change scenario, the debt-to-GDP ratio would remain above 135 percent throughout the medium term and could become explosive if the economy suffers a negative shock and policies are not strengthened (Box 5). Large gross financing requirements also carry substantial rollover risks, and the high interest burden (45 percent of revenues) crowds out productive public spending, limiting the economy’s growth potential. Against this backdrop, the authorities reiterated their commitment to pursue an ambitious reduction of the public debt over the medium term.

24. The baseline scenario would imply a further temporary relaxation of the fiscal primary balance in 2011. Given the delays in the approval of the 2010 budget and spending lags, the increase in public investment set in motion in the 2010 draft budget would be executed to a significant extent in 2011. With unchanged policies, this would lead to a further decline in the primary surplus next year to about 0.5 percent of GDP, before returning to around 1.5 percent of GDP in 2012-15. With this, the debt-GDP ratio would stabilize at around 137 percent of GDP over the medium-term.

25. Staff also presented a reform scenario that envisages sizeable fiscal consolidation and the implementation of long-delayed structural reforms. The scenario centers on increasing the government’s primary surplus to 5 percent of GDP by 2015, while creating fiscal space to maintain a permanently higher level of public investment and social spending to broaden the social safety net (Tables 7 and 8; and Box 5). The additional adjustment would boost confidence, help reduce interest rates, and raise the medium-term growth potential. Under these assumptions, the government debt-to-GDP ratio could decline by 25–30 percentage points by 2015.

A01ufig17

Primary Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

A01ufig18

Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: Lebanese authorities; and staff estimates and projections.

26. Fiscal space would need to be created through a combination of expenditure rationalization and tax measures.

  • On the spending side, staff argued for a rationalization of current expenditures, stressing in particular that there is room for shifting the high and poorly targeted budget transfers to EdL (4.2 percent of GDP in 2009) to more productive uses. This requires reforms to EdL’s administration to achieve efficiency gains and a decisive move in the tariff structure toward cost recovery. The authorities agreed on the importance of reforming the electricity sector, noting that a strategy to this effect has been developed with support from the World Bank and was recently approved by cabinet. They also noted that budget subsidies to EdL had been 1 percent of GDP lower during the first quarter of 2010 than in the first quarter of 2009, reflecting lower fuel costs but also some improvements in the collection of electricity bills.

  • On the revenue side, staff presented a menu of options to generate additional revenues of about 3 percent of GDP over five years. The final revenue package should take equity and efficiency considerations into account and focus on increasing uniformity, broadening tax bases, and possibly raising some tax rates that are moderate by international standards (Appendix 3). Potential measures encompass reforming the income tax, including to cover capital gains for individuals; broadening the VAT base by eliminating exemptions; raising excises on alcohols; and protecting the real value of excise taxes through indexation. In addition, both the VAT and the corporate income tax rates are comparatively low and offer potential for a gradual increase. The authorities intend to submit later this year a new income tax law to parliament that goes in the recommended direction. They will also consider further tax reforms for the 2011 budget, although this would require consensus-building.

27. Telecom privatization could enhance the economy’s growth potential while helping to reduce the public debt. The authorities ruled out privatizations in the very short term, but considered that the sale of the two public mobile phone providers could be envisaged at a later stage. The telecom sector is inefficient in infrastructure investment and pricing, and privatization could be one route towards unlocking the sector’s large growth potential.

Government Debt Sustainability Analysis

Debt level and structure. Lebanon’s sovereign gross debt amounted to LL 77 trillion (US$51 billion) as of end-2009. This was equal to 148 percent of GDP, 139 percent of GNDI, and 53 percent of commercial bank assets. Domestic currency debt accounted for 58 percent of total government debt and carried an average maturity of 1.6 years. Foreign currency debt made up for the remaining 42 percent of the government debt and had a higher average maturity of 4.6 years. The government debt is mainly held by commercial banks (58 percent), the BdL (15 percent), and other government institutions (8 percent).

Baseline scenario. Under the baseline (“no policy-change”) scenario, we assume that the medium-term primary balance (including grants) of the government is kept constant at 1.5 percent of GDP. Real growth would slow to a potential growth rate of around 4 percent, and Lebanese interest rates would increase over time in line with projected world interest rates. Under this scenario, the debt-to-GDP ratio would remain roughly unchanged from its 2010 level of nearly 140 percent of GDP, as the debt-reducing effects of the primary surpluses and economic growth would be offset by high interest payments resulting from the large debt stock (Table 11 and Figure 1, panel 1).

Shocks. The risks to this outlook would be substantial. Higher interest rates, lower economic growth, and fiscal shocks could reverse the downward trend for the debt-to-GDP ratio observed during 2006–10:

  • A permanent increase in the real interest rate of 230 basis points (one-half standard deviation from its past distribution) relative to the baseline would lead to an increase in the debt-to-GDP ratio to 158 percent by 2015 (Figure 1, panel 2).

  • A permanent decrease in real GDP growth of 1.7 percentage point (one-half standard deviation from its past distribution) relative to the baseline would raise the debt to 161 percent of GDP (Figure 1, panel 3).

  • A combination of the former two shocks would lead to an increase in the debt to 183 percent of GDP (Figure 1, panel 4).

  • A permanent decrease in primary balance of 1.6 percent of GDP (one-half standard deviation from its past distribution) relative to the 2000–09 average would lift the debt to 150 percent of GDP (Figure 1, panel 5).

Reform scenario. Fiscal consolidation, higher investment in social and physical infrastructure, and structural reforms to strengthen economic institutions would lower interest rates and raise medium-term growth. Telecom privatization could also contribute to lowering the debt. Under such a scenario, debt could decline to below 110 percent by 2015 (Figure 1, panel 6).

Figure 1.
Figure 1.

Lebanon: Public Debt Sustainability, 2005–15

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 306; 10.5089/9781455208586.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ Growth and interest rate shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline scenario and shock scenario; historical refers to 10-year averages.2/ The primary balance is one -half standard deviation lower than the 2000-09 average.3/ Higher primary balance, higher growth, lower interest rates, telecom privatization (as described in the main text).

28. The authorities are planning to develop public-private partnerships (PPPs) as an alternative avenue to involve the private sector in addressing the country’s infrastructure gaps. Staff agreed that PPPs can offer better value for money than the public provision of infrastructure services, but noted that they may also generate important fiscal liabilities. A number of preconditions should therefore be met before embarking on a PPP program, such as a legal framework that ensures adequate risk transfer to the private sector, prescribes a clear process for the evaluation and approval of PPPs, and establishes a “gatekeeper role” for the Ministry of Finance to assess and manage fiscal risks. Other elements of a sound PPP framework involve competitive bidding procedures, incentive-based regulation, capacity-building at the government level, and proper accounting and reporting of fiscal implications (Box 6). The authorities are currently in the process of strengthening an earlier draft framework law for PPPs, which could be re-submitted to parliament during the summer.

Public Private Partnerships in Lebanon

Public-Private Partnerships (PPPs) are mechanisms for the provision and operation of infrastructure assets and services, and represent an alternative to traditional public procurement or privatization. The main advantage of PPPs is the potential for higher quality services at lower costs. The main risks with PPPs are related to unforeseen fiscal contingencies.

The international experience with PPPs has been mixed and several preconditions should be in place to maximize the chances of success. While there is evidence that PPPs have contributed to efficiency gains, particularly in the United Kingdom where they have been used since the 1990s, there is also evidence to the contrary. The country experiences suggest that five preconditions should be in place for PPPs to be successful and contain fiscal risks. First, a sound institutional framework covering all major aspects of the PPP process and conducive to private participation. Second, a government and a public administration with sufficient technical expertise to handle a PPP program, including the capacity to evaluate and select among projects. Third, the allocation of PPP contracts based on competitive bidding, and reliance on incentive-based regulation. Fourth, an adequate risk transfer to the private sector. And fifth, proper accounting and reporting of the fiscal implications of PPPs. To reduce fiscal risks, the Ministry of Finance should be given a strong role in the process and set up a specialized PPP unit to screen and evaluate potential projects. This unit should have the authority to approve or reject feasibility studies, tender documents, preferred bidders, and PPP contracts.

PPPs could be a valuable alternative to traditional public procurement of infrastructure in Lebanon, but should only be pursued if they provide efficiency gains and limit fiscal risks and contingent liabilities. The latter is particularly important in Lebanon, given the country’s high debt-to-GDP ratio. To ensure positive outcomes, the authorities will need to refine the existing PPPs draft law to include comprehensive legal provisions, investment project evaluation and selection, accounting and reporting procedures, and a strong role for the Ministry of Finance before potential projects are considered.

29. Fiscal institutions should be strengthened to support the medium-term strategy. Staff argued that there is scope to modernize tax administration to further improve compliance and avoid the perception that taxpayers are affected unevenly by any new tax measures. Synergies in tax collection could be realized from integrating the VAT and income tax administrations, strengthening the large taxpayers unit, and introducing electronic filing of tax returns. In addition, amnesties on fines and penalty interest for tax arrears should be discontinued. The introduction of the planned more uniform income tax law would constitute a simplification of existing procedures, easing the administrative burden on tax payers and the tax administration. On the public financial management side, staff welcomed the provision in the draft 2010 budget to cast future budgets in a multi-year framework, and encouraged the authorities to reenergize efforts to broaden the coverage of the budget, introduce a Treasury Single Account, and strengthen the treasury’s capacity. The authorities are gradually enhancing the debt management capacity at the Ministry of Finance, including by preparing a decree to operationalize the debt management unit, which is welcome.

30. The BdL’s balance sheet should be strengthened. The management of past crises and large sterilization operations in the last two years have substantially weakened the BdL’s net income position. Lower interest rates and a much slower pace of reserve accumulation are helping to ease the drain of the sterilization operations on the BdL’s finances. In addition, the BdL should prepare a strategy for strengthening its income position. In this context, staff argued that phasing out the exemptions from reserve requirements would be beneficial. Privatization of the non-financial assets, including the planned partial sale of the national air carrier MEA and the ongoing divestment of the real estate portfolio, would also help improve the BdL’s financial balance.

31. Further efforts are required to improve the statistical system, including its coverage, quality, and timeliness. Staff called on the authorities to address important remaining statistical gaps, in particular improving national accounts and balance of payments statistics, as well as expanding the coverage of fiscal statistics to encompass the various extrabudgetary entities. In addition, the development of regular and timely wage, employment, and real estate statistics would allow for enhanced economic monitoring and policy development (see the Informational Annex).

5. STAFF APPRAISAL

32. Lebanon’s economy has performed remarkably well, bucking international trends in the face of the global crisis. Growth has been fueled by regained political stability and continued capital inflows, while inflation has remained under control so far.

33. The authorities are to be commended for pursuing prudent macroeconomic policies, though structural reforms have remained largely stalled. The government took advantage of the favorable environment to increase the primary surplus in 2009, which contributed to a further reduction in the debt-to-GDP ratio, while the BdL used the opportunity provided by abundant capital inflows to bolster its international reserves. However, little progress has been made toward strengthening economic institutions and addressing other structural weaknesses.

34. Short-term risks have declined, but Lebanon’s underlying vulnerabilities remain high and new ones could emerge. The public debt-to-GDP ratio is still among the highest in the world and government financing and financial sector stability are reliant on continued inflows of short-term non-resident deposits. In this environment confidence depends crucially on continued political stability and the absence of regional tensions. Additional vulnerabilities could emerge, for example from rapidly rising real estate prices, potential fiscal contingencies from planned PPPs, or the ongoing internationalization of local banks, unless these processes are carefully managed.

35. Thus, while significant progress has been made, the Lebanese authorities continue to face a number of policy challenges. In the near-term, a key issue is to manage the buoyant economy cautiously to prevent overheating. In addition, policies should be proactive to prevent the build-up of new vulnerabilities. Over the medium term, the main challenges are to decisively reduce the high government debt and address emerging structural bottlenecks. While Lebanon’s economy has been remarkably resilient to shocks in the past, it will be important to avoid complacency and act on these fronts, as future crises could be very different in nature and expose vulnerabilities more strongly than in the past.

36. The fiscal expansion in 2010 should be limited in light of the fast-growing economy. Staff believes that a higher-than-budgeted primary surplus of at least 2 percent of GDP this year is both appropriate and achievable, and would leave enough room for a substantial increase in capital expenditures. Higher public investment is important to address growing infrastructure gaps, but must be accompanied in parallel by reforms to improve the efficiency and cost recovery of public utilities, particularly the electricity sector.

37. Monetary policy has rightly focused on moderating deposit inflows as international reserves have reached adequate levels, but a pause in policy interest rate reductions may now be warranted. The authorities have reduced policy interest rates substantially and the pace of deposit growth has slowed to a level that can be more readily absorbed by the economy. Given the imperfect monetary transmission mechanism with uncertain lags in Lebanon, staff suggests a cautious approach to further policy rate reductions. With interest rate policy now effectively being conducted jointly by the BdL and Ministry of Finance, policy plans need to be well-coordinated.

38. The exchange rate peg has been important for financial stability. The peg has acted as an important nominal anchor for the economy. In addition, the government’s high foreign-currency debt and balance-sheet mismatches of corporations and households suggest that the peg remains the adequate exchange rate regime. While maintaining the peg, efforts should continue to reducing these important vulnerabilities over time.

39. Bank regulation and supervision should continue to focus on preventing excessive risk taking. The banks’ conservative funding and—the large exposure to the sovereign aside—asset structures, backed by effective banking supervision and regulation, have limited exposures to global liquidity conditions and the real estate market. However, high liquidity and declining interest rates are leading banks to increase private sector credit and expand their businesses in the region. Bank supervision and regulation should hence remain vigilant, with heightened focus on the banks’ regionalization.

40. The medium-term fiscal strategy should target a substantial reduction in the public debt-to-GDP ratio, while allowing space for permanently higher investment and social spending. These goals can be achieved by rationalizing current expenditures, in particular reducing budget transfers to the electricity sector, and putting in place a socially balanced tax package.

41. The medium-term fiscal strategy should be supported by a number of institutional reforms. These include strengthening the tax administration and reenergizing the implementation of public financial management reforms. In particular, a strong framework needs to be put in place to minimize the risk of contingent liabilities stemming from PPPs. In addition, reforming the telecom sector, through privatization or otherwise, would help unlock the sector’s large growth potential.

42. The BdL’s balance sheet is in need for strengthening. The sterilized accumulation of international reserves, while appropriate, has weakened the net income position of the BdL. While lower interest rates and a slower pace of reserve accumulation are already helping to ease the drain of the sterilization operations on the BdL’s finances, the authorities should devise a medium-term plan to bolster the BdL’s balance sheet.

43. Clear, timely and proactive communication of policy intentions will be important to anchor expectations and confidence, and build ownership for necessary reforms. Communication of the government’s debt reduction objective will be particularly relevant. The intended movement toward multi-year fiscal frameworks is a welcome step in this regard. Similarly, the BdL should clearly present its policy objectives, including its views on the adequacy of international reserves, to help guide market expectations especially at time of policy shifts.

44. The statistical system needs to be further improved. Despite recent efforts, data insufficiencies, including in the areas of the national accounts, employment and wage statistics, coverage of the fiscal accounts, and balance of payments statistics, still hamper economic analysis and policy development. A high-level commitment from the government is needed to push the statistical reform agenda forward.

45. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

Table 1.

Lebanon: Selected Economic Indicators, 2008-15

(Population: 3.9 million; 2009)

(Per capita GDP: US$8,467; 2009)

(Quota: SDR 203 million)

(Poverty rate: 28 percent; 2004-05)

(Unemployment: 8.1 percent; 2007)

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Sources: Lebanese authorities; and Fund staff estimates.

Through 2008: based on the CPI index by Consultation and Research Institute; from 2009: based on the CPI index by Central Administrationof Statistics.

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

Includes non-resident deposits.

Short-term debt on a remaining maturity basis, including short-term non-resident deposits.

Table 2.

Lebanon: Central Government Overall Deficit and Financing, 2008–15

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

Includes domestic excises, which are collected at customs and are classified as taxes on international trade.

Excludes principal and interest payments paid on behalf of EdL.

Includes transfers to the National social security fund (NSSF), bread subsidy, Displaced Fund, and Council of the South.

Includes transfers to hospitals, High Relief Committee, and the interest subsidy.

Includes transfers to municipalities.

Public debt figures include accrued interest.

Table 3.

Lebanon: Central Government Overall Deficit and Financing, 2008-15

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

Includes domestic excises, which are collected at customs and are classified as taxes on international trade.

Excludes principal and interest payments paid on behalf of EdL.

Includes transfers to the National social security fund (NSSF), bread subsidy, Displaced Fund, and Council of the South.

Includes transfers to hospitals, High Relief Committee, and the interest subsidy.

Includes transfers to municipalities.

Public debt figures include accrued interest.

Table 4.

Lebanon: Government Debt, 2008-15 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 possible government arrears to the private sector.

Defined as gross debt less government deposits.

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

Table 5.

Lebanon: Monetary Survey, 2008-12

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

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

Defined by currency (not by residency), as official foreign currency assets, including gold and SDR, less foreign currency liabilities. Liabilities include the exceptional deposits by GCC governments, but exclude liabilities to the government of Lebanon and other official creditors.

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

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