Lebanon: 2011 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Lebanon

International Monetary Fund

doi:10.5089/9781463939762.002.A001

Lebanon

2011 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Lebanon

Author: International Monetary Fund

Publication Date:: 09 Feb 2012

eISBN:: 9781463939762

Language:: English

Keywords:: ISCR; CR; Banque du Liban; Lebanese pound; foreign currency; authority; headline inflation; current account; private sector; Currencies; Europe

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Lebanon is facing a difficult global, regional, and domestic environment simultaneously for the first time in more than a decade. Domestic policies should aim at instilling confidence and tackling key policy challenges, such as preserving macroeconomic stability and paving the way for a more resilient, dynamic, and inclusive economy. The Banque du Liban (BdL) relied on its large foreign reserves build-up during the upswing to intervene forcefully when the Lebanese pound came under pressure from deposit outflows and currency conversions in the wake of the government crisis.

Abstract

BACKDROP

1. Lebanon’s economy lost momentum in 2011 after four strong years. Increased polarization of political parties since mid-2010, the fall of the coalition government in January 2011, and prolonged talks over the make-up of the new government until its formation in June shook market confidence. Compounded with the regional unrest, this led to an economic downturn, adversely affecting fiscal balances and financing conditions.

2. The authorities have so far skillfully managed the downturn. The Banque du Liban (BdL) relied on its large foreign reserves built up during the upswing to intervene forcefully when the Lebanese pound came under pressure from deposit outflows and currency conversions in the wake of the government crisis in January 2011 (Figure 1). The improved fiscal position—thanks to the marked decline in the debt-to-GDP ratio since 2006 and the sizeable primary surplus in 2010—freed up room for an accommodative fiscal stance in 2011 and allowed the government to maintain favorable access to the foreign currency debt market (Box 1).

3. Vulnerabilities have come to the fore. The downturn exposed Lebanon’s high dollarization and short maturity of the deposit base as well as the government’s large debt and recurrent financing needs. At the same time, the regional unrest highlighted pressing needs to address unemployment and social inequality, and pressures are high for large wage increases in both the public and the private sectors.

4. Rising risks call for strong domestic policies. Lebanon is facing a difficult global, regional, and domestic environment simultaneously for the first time in over a decade. Domestic policies should thus aim at instilling confidence and tackling key policy challenges—preserving macroeconomic stability and paving the way for a more resilient, dynamic, and inclusive economy.

Box 1.

Policies Since the 2010 Article IV Consultation

Macroeconomic policies broadly followed staff advice. The 2010 primary surplus surpassed staff’s recommended target by almost one percent of GDP. This reflected lower-than-expected capital spending because the budget was not passed (staff supported an increase to address Lebanon’s infrastructure deficit). To slow deposit inflows and contain reserve accumulation, the authorities gradually reduced interest rates in 2009–10 and kept them unchanged since mid-2010, in line with staff advice. Starting in late 2010, domestic and external shocks affected Lebanon’s economic performance, and the context for staff advice on near-term policies changed significantly.

Progress on structural reforms was mixed. Cabinet approved a reform strategy for the electricity sector, while parliament passed laws on investments in the electricity sector and on the development of capital markets. Banking sector supervision has continued to improve and some progress was made in modernizing tax administration and reforming public financial management, including by extending budget coverage and enhancing transparency. Reforms in other areas have though been slow (e.g., in telecom and statistics) or even stalled (e.g., in introducing a global income tax and implementing a Treasury Single Account).

THE ECONOMIC CONTEXT

The downturn may be bottoming out, but the road to recovery is yet to emerge. Risks are to the downside, with the conflict in Syria weighing heavily on the outlook. Medium-term growth prospects remain moderate without reforms.

A. 2011—A Lost Year

5. Growth has virtually come to a halt. Domestic demand is depressed, slowed down by falling investment, as are exports, hit by regional uncertainty. Real estate (Figure 2), tourism, retail and wholesale trade—key drivers of the recent high growth accounting for more than half of GDP—have been hit hard. With latest indicators pointing to some pick-up in activity, growth could reach 1–2 percent in 2011, markedly below an average of 8 percent during 2007–10.

6. Inflation is up and the current account has weakened. Inflation has risen since mid-2010, though the halving of the fuel excise in February 2011 dampened the inflationary impact of higher oil prices. Headline inflation averaged about 5 percent in 2011, but core inflation remained moderate. Despite weak import demand, the current account deficit is set to widen to about 14 percent of GDP in 2011 owing to higher food and fuel prices and a drop in tourism.

7. Credit growth is slowing. The economic downturn, particularly the cooling of the real estate market, led to a slowdown in credit demand. At end-October, annual credit growth stood at 15 percent compared with 25 percent in 2010 (Lebanon—Selected Issues, 2012, Chapter 1). With banks competing for fewer domestic borrowers, lending rates have declined.

8. Deposit inflows remain robust, but dollarization is up. Inflows resumed in March following deposit outflows and currency conversions earlier in the year. With domestic interest rates offering an attractive premium over the low global rates, deposits are growing at 9 percent annually. Most of that growth however was in foreign currency deposits, and only recently have pound deposits started to pick up. As a result, deposit dollarization—an indicator of confidence in the pound—is on a downward trend though still above its end-2010 level. Sovereign and CDS spreads have risen and the stock index has dropped sharply, broadly in line with emerging market and regional averages.

9. Despite interventions, BdL’s gross foreign reserves increased. Interventions in January took a toll on its net foreign exchange position, but BdL recouped reserve losses by issuing foreign currency Certificates of Deposit (CDs) and because banks placed large excess reserves with the BdL. At about $32 billion as of end-November, reserves cover 27 percent of broad money or 43 percent of foreign currency deposits. In staff’s view, they would be sufficient to withstand a shock of similar magnitude as the 2006 war with Israel and the 2005 assassination of Prime Minister Hariri.

10. Fiscal policy was accommodative. Tax revenue dropped, reflecting the downturn and the reduction in the fuel excise (with an annual loss of almost one percent of GDP). Overall revenue though should increase slightly as a share of GDP because Telecom is expected to resume its transfers to the budget. Primary expenditure was up, owing largely to an increase in military wages and allowances and higher transfers to the electricity company. As a result, the primary surplus is expected to fall to about one percent of GDP from 2.7 percent of GDP in 2010.

B. Outlook and Risks—Regional Uncertainty Looming Large

11. Growth could increase in 2012. Assuming that the external environment improves, growth is projected at 3½ percent, supported by a recovery in tourism and retail trade buoyed by an improved domestic environment and continued growth in the Gulf Cooperation Council (GCC) countries (Box 2 and Lebanon—Selected Issues, 2012, Chapter 2). Planned increases in public investment, including a large-scale project in the electricity sector, could provide an additional boost. Headline inflation will stay elevated despite the recent retreat in food and fuel prices because of wage increases and a possible VAT rate hike. With a rebound in exports expected to be largely offset by higher capital imports, the current account deficit would remain broadly unchanged.

12. But near-term risks are large and to the downside, mostly because of Syria. The uprising in Syria keeps Lebanon on edge given their close political and economic ties. It has already affected investor confidence in Lebanon, disrupted tourism, increased costs of bilateral and transit trade, and prompted banks to reduce their exposure to Syria.

Box 2.

Lebanon’s Interconnectedness

Lebanon is highly integrated with the world. Exports of goods and services amount to about 60 percent of GDP and imports of goods and services to 75 percent. Emigration has been traditionally high, and the Lebanese diaspora is a source of substantial remittances of about 15 percent of GDP. FDI and nonresident deposit inflows each are estimated at 11 percent of GDP on average over the last five years.

Current account links are strongest with Arab countries, especially the GCC. MENA accounts for two-thirds of tourism and remittances inflows and more than 40 percent of goods exports, with the region’s oil exporters contributing most. Among countries affected by the Arab Spring, Egypt, Libya, and Tunisia make up 4 percent of goods exports and ½ percent of tourism. While bilateral trade with Syria accounts for 6–9 percent of goods exports and tourism, transit trade and tourism through Syria from the GCC, Jordan, and Turkey are reportedly more substantial. Exposure to Europe stems primarily from exports of goods (4½ percent of GDP), mainly sales of gold items to Switzerland. Links to the U.S. and Australia have increased in recent years, reflecting higher remittances and tourism.

Financial links are mostly with MENA and Europe. Staff estimates that almost 40 percent of total bank deposits belong to nonresidents, a significant share of which comes from Lebanese living in MENA. Wholesale funding is limited and mainly from BIS-reporting banks ($5.5 billion or 4 percent of bank assets). On the asset side, the BdL and commercial banks hold three quarters of their foreign assets in deposits with BIS banks, reportedly most in Europe. Commercial banks have subsidiaries/branches in or direct lending to MENA, Europe, and Africa, but equity and loan exposures remain moderate as a share of their assets (see charts). The largest exposure in terms of assets and loans is to Syria, with $7½ billion assets in seven subsidiaries and $1½ billion in direct loans from Lebanon. Exposure to peripheral euro zone countries is small. Foreign banks in Lebanon are small, though some hold minority shares in Lebanese banks. Lebanese nonbanks mostly rely on domestic funding and have limited net claims on BIS banks ($5 billion). Most FDI (90 percent) comes from Kuwait, Qatar, Saudi Arabia, and the UAE.

Further escalation of the uprising and sanctions by the Arab League could have far-reaching political and economic repercussions. Lebanon is also facing risks related to the worsening outlook in Europe. While the direct impact would likely be muted, second-round effects could be sizeable if regional oil exporters were affected via a lower oil price or financial losses. Though the recent payment of dues to the Special Tribunal for Lebanon (STL) brought to conclusion a much debated matter, domestic tensions could flare up over other divisive issues, including Lebanon’s stance on Syria, future cooperation with the STL, and wage increases. A materialization of these risks could dampen growth prospects and push up the sovereign risk premium and interest rates, thus worsening government debt dynamics, eroding bank profit margins, and exposing maturity mismatches on banks’ balance sheets.

13. At unchanged policies, the medium-term growth outlook is moderate. With output at its estimated potential, Lebanon can no longer rely on rapid growth as in the past years. Growth in the medium term must come from new sources, which will be difficult to tap without addressing structural weaknesses. In the absence of reforms, growth is expected to remain modest at 4 percent.

14. Vulnerabilities remain large. The economy has become more resilient in recent years thanks to a marked reduction in the government debt-to-GDP ratio and a build-up of large foreign reserves. Still, government debt at 134 percent of GDP at end-October 2011 (about 40 percent of which is in foreign currency) remains among the highest in the world and gives rise to large recurring financing needs. Financing of the persistent and large current account deficits hinges on continued inflows of nonresident deposits. The banking sector (with assets of 350 percent of GDP) funds itself from short-term deposits, about a quarter of which it intermediates to deposits at the BdL and another quarter to long-term government debt, thus exposing itself to the sovereign and a maturity mismatch (Figure 3). Finally, banks’ expanded presence in the region makes them vulnerable to the ongoing unrest.

15. The authorities broadly shared staff’s assessment of the outlook and risks. The uprising in Syria, particularly if protracted, presents the most serious risk to the economy. Because the impact from an escalation is impossible to quantify at this point, staff and the authorities discussed broad contingency measures. The authorities emphasized that an assessment of vulnerabilities should factor in Lebanon’s proven resilience to withstand past shocks in large part due to loyal depositors (Figure 4). On medium-term growth prospects, they expected investment in the electricity sector to boost potential growth.

POLICY THEME #1—NAVIGATING UNCERTAINTY AND SAFEGUARDING MACRO STABILITY

The near-term challenge is to instill confidence and preserve macroeconomic stability in the face of uncertainty and spending pressures. This requires above all a prudent 2012 budget. In addition, interest rates should be allowed to rise to reduce government reliance on BdL financing.

A. The 2012 Budget—Supporting Confidence, Growth, and Equity

16. The first draft of the 2012 budget is being revised. The draft budget envisaged an increase in primary expenditure by 4 percent of GDP, largely for capital spending, including investment in electricity generation capacity. Revenue would increase by 1 percent of GDP, reflecting a drop in nontax revenue and substantial tax measures. The latter include primarily an increase in the VAT rate (to 12 from 10 percent), an increase in the withholding tax on interest (to 8 from 5 percent), and a 3 percent fee on real estate sales. Full implementation of the budget ¹ would have implied a primary deficit of 2 percent of GDP. The authorities noted that the budget revision will incorporate recently approved public wage increases by keeping the deficit unchanged through further revenue measures or lower expenditure. ² With the budget containing controversial tax measures, it is not clear if it will be passed.

17. Discussions focused on maintaining fiscal discipline. Staff argued that implementing the budget would interrupt a decade-long record of primary surpluses and a reduction in the debt-to-GDP ratio since 2006. This would send a negative signal to markets at a time when public finances are increasingly coming under scrutiny around the world and thus risk jeopardizing macroeconomic stability. With government already having difficulties in placing local currency debt in the market in 2011, a more expansionary budget would also exacerbate financing pressures. Staff recommended that the budget should target a small primary surplus, which would imply a broadly neutral fiscal stance, and keep the debt-to-GDP ratio on a downward path. This could be achieved by implementing the proposed increases in the VAT rate and the withholding tax on interest, rescinding the February cut in the fuel excise, and limiting the public sector wage increase while allowing some increase in social and capital spending compared to 2011. The authorities agreed on a primary surplus in principle, but explained that this would be achieved because, as in previous years, capital budget allocations were unlikely to be fully spent due to lags in execution. Staff cautioned that relying on underexecution of spending to control the deficit would undermine the credibility of the budget.

18. Anchoring the 2012 budget in a medium-term agenda is important. Staff agreed that the 2012 draft budget rightly included higher infrastructure and social spending. Achieving a primary surplus though requires prioritization based on a reform agenda and capacity constraints. In particular, while some increase in public wages may have been warranted, the recently approved increase may lead to a crowding out of other spending and a loss in competitiveness. Moreover, given the permanent nature of current spending, any increase should be fully financed by higher recurrent revenue or permanent saving elsewhere. The authorities broadly shared staff’s views and noted that work was in progress on embedding priorities in a medium-term fiscal framework.

19. The budget presents an opportunity to make fiscal policies more equitable. Staff supported most revenue measures and higher social spending, including to mitigate the adverse social impact of the VAT increase. It recommended postponing the introduction of the real estate fee and an asset revaluation tax, and subsuming them into a comprehensive capital gains tax, which would focus on realized gains. Additional revenue could be raised by increasing excises on alcohol and tobacco and rescinding the reduction in the fuel excise, which disproportionately benefits the well-off. Staff also welcomed progress in introducing a national targeting program for the extreme poor, which could serve as an effective tool to relieve social pressures.

20. Higher investment in the electricity sector is welcome. Parliament approved in September 2011 a 3-year investment of 3 percent of GDP to boost Lebanon’s electricity generation by almost half. Staff noted that an increase in generation capacity would imply higher subsidies to the sector unless complemented by reforms. The authorities concurred, noting plans to address sector losses and bring tariffs to cost-recovery levels in the medium term in line with a strategy developed with the World Bank, which envisages substantial private sector participation. Staff highlighted the importance of communicating a comprehensive strategy to the public to shore up support for future tariff increases.

B. Reducing the Government’s Reliance on Banque du Liban Financing

21. The government faced difficulties financing itself from the market. Political uncertainty combined with tight pound liquidity reduced banks’ appetite for government debt in pounds. Pound liquidity dried up in 2011, and banks cannot use their foreign exchange deposits to lend in pounds given restrictions on open currency positions. Only high-yielding 7-year T-bills draw strong demand, and the government has resorted to them for financing twice this year. Banks largely shy away from T-bills with shorter maturity which yield about the same or less than what banks pay on pound deposits. They instead prefer lending to the private sector or holding cash. The resulting shortfall in demand for T-bills with shorter maturities was picked up by the BdL. This prevented interest rates from rising.

22. Staff argued for allowing pound interest rates to rise. The authorities felt that holding interest rates steady after the fall of the government in January has helped to prop up confidence. Staff noted that pursuing interest rate stability under the currency peg over an extended period has been costly for the BdL’s balance sheet and foreign reserves. It argued that letting interest rates on T-bills with maturities of less than 7 years rise would compensate for higher risks and make them attractive to banks, allowing the treasury to reduce its reliance on the BdL or the 7-year T-bills. This could also lower the average cost of borrowing and allow targeting a smoother maturity profile of government debt. The authorities broadly agreed, but felt that under current uncertainty marginally higher interest rates might not bring investors back while letting rates rise rapidly would risk undermining depositor confidence. They also hoped that a recent pick-up in pound deposit inflows would eventually translate into greaterdemand for T-bills. Staff supported a gradual move, but noted that the yield curve in the secondary market already shows higher rates for T-bills with lower maturities.³

Gross Financing Requirements, 2012

Sources: Banque du Liban; and IMF staff estimates.

Gross Financing Requirements, 2012

			Q1	Q2	Q3	Q4	Year
A. Primary Deficit ($ mln.)			-130	-489	466	-3	-156
		percent of GDP	-0.3	-1.1	1.1	0.0	-0.4
B. Interest ($ mln.)			825	1,071	855	1,054	3,805
	On LL debt		521	611	565	590	2,286
	On FX debt		304	461	290	464	1,519
C. Amortization ($ m ln.)			2,965	2,163	2,959	3,099	11,185
	On LL debt		2,405	1,743	2,454	2,839	9,442
	On FX debt		559	420	505	259	1,743
Gross Financing Need = B+C-A
		In $ mln.	3,660	2,745	4,280	4,149	14,835
		Percent of GDP	8.3	6.2	9.7	9.4	33.7
Memorandum Item:
GDP ($ mln.)							44,013

Sources: Banque du Liban; and IMF staff estimates.

Gross Financing Requirements, 2012

			Q1	Q2	Q3	Q4	Year
A. Primary Deficit ($ mln.)			-130	-489	466	-3	-156
		percent of GDP	-0.3	-1.1	1.1	0.0	-0.4
B. Interest ($ mln.)			825	1,071	855	1,054	3,805
	On LL debt		521	611	565	590	2,286
	On FX debt		304	461	290	464	1,519
C. Amortization ($ m ln.)			2,965	2,163	2,959	3,099	11,185
	On LL debt		2,405	1,743	2,454	2,839	9,442
	On FX debt		559	420	505	259	1,743
Gross Financing Need = B+C-A
		In $ mln.	3,660	2,745	4,280	4,149	14,835
		Percent of GDP	8.3	6.2	9.7	9.4	33.7
Memorandum Item:
GDP ($ mln.)							44,013

Sources: Banque du Liban; and IMF staff estimates.

23. Steps to tap the Eurobond market are appropriate. Lebanon successfully placed $1.5 billion 7-, 9-, and 15-year Eurobonds in November 2011 ($1.2 billion of which involved exchanging Eurobonds maturing in 2012). Staff welcomed the reduction in financing needs in 2012. It supported the authorities’ intention to seek parliamentary approval for new foreign currency borrowing to take advantage of banks’ ample foreign exchange liquidity and globally low interest rates, and to reduce reliance on BdL reserves. Staff noted that financing government spending through additional foreign currency borrowing could increase banks’ pound liquidity, which could then be channeled to the local currency T-bill market.

POLICY THEME #2—SECURING SUSTAINED INCLUSIVE GROWTH AND ECONOMIC RESILIENCE

The medium-term challenge is to generate sustainable and inclusive growth while further reducing existing vulnerabilities and preventing a build-up of new ones. This requires implementing long-delayed reforms in infrastructure, improving the business climate and labor market, reducing debt, strengthening the social safety net, and continuing to protect the banking sector from excessive risks.

A. Launching Structural Reforms and Strengthening Competitiveness

24. Growth should accelerate and become more balanced and inclusive. Rapid growth during 2006–10 concentrated in and around Beirut. Anecdotal evidence suggests that employment creation was limited and focused on low-paying jobs in the construction, retail, and hospitality sectors (Box 3). As a result, unemployment, especially among the youth and educated, remains chronic and poverty widespread. There was agreement that achieving higher and more sustained growth and, ultimately, making a tangible dent in unemployment and poverty requires a better infrastructure, business environment, and labor market (Lebanon—Selected Issues, 2012, Chapter 3).

25. Infrastructure is one of the government’s priorities (Figure 5). In addition to the electricity sector, reforms of the water sector are under discussion. Ongoing Telecom investments are making information technology services faster and more accessible throughout the country. Unlocking the sector’s growth potential, though, requires opening it up to competition and upgrading its regulatory framework; privatization could also be considered. Public-private partnerships could help attract private infrastructure investment, but they should operate within a sound framework that minimizes contingent liabilities for the public sector.

26. Improvements in the business climate and labor market are also needed. While Lebanon’s business regulations fare relatively well compared with the region, staff noted that it is equally important to ensure transparent and even enforcement of rules. Labor market efficiency should be improved by attuning education to the needs of the market and reforming the end-of-service indemnity, which impedes labor mobility, while limiting government interference in private sector wage setting.

27. Strengthening competitiveness would support the currency peg.⁴ The peg to the U.S. dollar has served Lebanon well and remains the linchpin for financial stability in a highly dollarized economy. Staff estimates point to a modest overvaluation of the pound relative to its fundamentals (Box 4). The real effective exchange rate has appreciated slightly since early-2010, indicating some loss of competitiveness, and the recently approved wage increases might lead to a further loss. While export performance has been solid so far, competitiveness needs to improve to ensure that the current account is on a sustainable path. Thus, it is important to pursue productivity-enhancing measures.

Box 3.

Labor Market

Unemployment is concentrated among the youth and educated. The unemployment rate was 10 percent in 2007 according to official statistics. The share of youth and that of the highly educated in the unemployed were 45 and 30 percent, respectively.

Similar to other MENA countries, there is a large difference (almost 50 percentage points) between male and female labor force participation rates. But unlike most of these countries, Lebanon has only a small gender gap in unemployment (of 2 percentage points).

The economy’s capacity to generate quality jobs appears weak. From 1998 to 2009, output grew by about 4 percent on average per year. Employment though remained broadly unchanged and concentrated in low productivity sectors. Informal employment appears to have increased, with now more than one third of those employed allegedly in the informal sector. Informal employment relies to a large extent on foreign workers, and remittance outflows are now about twice their size in the early 2000s.

Skill mismatches, labor market rigidities, and high reservation wages cause market inefficiencies. The labor force is highly educated and many work abroad at some point in their career. But there appears to be a skill mismatch as companies identify labor skills as a major constraint to business. Employers also identify labor regulations, including the design of the end-of-service indemnity, as an impediment to employment. With the recently approved wage increase, the minimum wage would be among the highest in the region though, when adjusting for costs of living, broadly in line with the regional average. Lastly, high remittances and education costs contribute to voluntary unemployment by keeping reservation wages high.

Minimum Wage in Lebanon and the Region, 2011

Sources: World Bank’s Doing Business 2011; World Development Indicators, April 2011; Kabbani, N., and E. Kothari, “Youth Employment in the MENA Region: A Situational Assessment,” World Bank Social Protection Discussion Paper No. 0534, September 2005; and IMF staff estimates.

^{^1/}Data for Lebanon, Morocco, Syria, and Tunisia reflect minimum wage increases of December 2011, July 2011, March 2011, and May 2011, respectively.

^{^2/}Household consumption data for Lebanon is for 2008.

Minimum Wage in Lebanon and the Region, 2011

	Minimum wage (US$/month) ^1/	Ratio of annual minimum wage to 2009 GDP per capita	Ratio of annual minimum wage to 2009 household final consumption expenditure per capita ^2/	Percentage change in the US$ minimum monthly wage from early 2000s to 2011
Egypt	31	0.2	0.2	-9
Jordan	201	0.6	0.7	66
Lebanon	576	0.8	1.2	188
Morocco	273	1.2	2.0	22
Syrian Arab Republic	208	1.0	1.5	197
Tunisia	173	0.5	0.9	15
MENA6 average	244	0.7	1.1	80
World average	305	0.4	0.7	…

^{^1/}Data for Lebanon, Morocco, Syria, and Tunisia reflect minimum wage increases of December 2011, July 2011, March 2011, and May 2011, respectively.

^{^2/}Household consumption data for Lebanon is for 2008.

Minimum Wage in Lebanon and the Region, 2011

	Minimum wage (US$/month) ^1/	Ratio of annual minimum wage to 2009 GDP per capita	Ratio of annual minimum wage to 2009 household final consumption expenditure per capita ^2/	Percentage change in the US$ minimum monthly wage from early 2000s to 2011
Egypt	31	0.2	0.2	-9
Jordan	201	0.6	0.7	66
Lebanon	576	0.8	1.2	188
Morocco	273	1.2	2.0	22
Syrian Arab Republic	208	1.0	1.5	197
Tunisia	173	0.5	0.9	15
MENA6 average	244	0.7	1.1	80
World average	305	0.4	0.7	…

^{^1/}Data for Lebanon, Morocco, Syria, and Tunisia reflect minimum wage increases of December 2011, July 2011, March 2011, and May 2011, respectively.

^{^2/}Household consumption data for Lebanon is for 2008.

B. Reducing Debt and Other Vulnerabilities

28. The authorities remain committed to reducing the debt-to-GDP ratio over the medium term. There was consensus that high public debt remains the root cause of Lebanon’s macrofinancial vulnerabilities. In addition to substantial rollover needs, it implies large interest payments that absorb much of the budget (40 percent of 2011 revenue) and crowd out priority spending. Because banks are heavily exposed to the government, stability of the financial system hinges on the state of government finances. Staff observed that the sharp reduction in the debt-to-GDP ratio over the past years was largely a windfall from strong growth. With growth expected to stay moderate, a future reduction in the ratio will have to come from sizeable primary surpluses.

Box 4.

Real Exchange Rate Assessment

The real effective exchange rate appreciated slightly since early 2010. This reflects rising inflation differentials with trading partners, while the nominal effective exchange rate (NEER) has depreciated since mid-2010 due to U.S. dollar weakness. The pace of appreciation picked up slightly in September 2011, in line with U.S. dollar strengthening.

Export indicators so far do not indicate competitiveness issues. Lebanon’s trade deficit—about 32 percent of GDP per year during 2006–10—is fairly sustainably financed by tourism and remittances inflows. Goods export volumes are estimated to have grown at an average of 17 percent per year during 2006–10 and tourism receipts at 19 percent. Though the share of exports of both goods and services globally has grown steadily since 2000, there was some leveling off in 2010.

Lebanon’s exchange rate appears to be modestly overvalued. The macroeconomic balance and the external sustainability approaches point to a modest overvaluation in the range of 11–17 percent, while the equilibrium real exchange rate approach suggests a slight overvaluation of about 3 percent. The variation in the results likely reflects methodological differences and limited data availability.

Real Exchange Rate Overvaluation Estimates Using CGER Approaches ^1/

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

^{^1/}Using CGER parameters and a current account elasticity of 0.37.

^{^2/}Net external asset position (NEAP) estimate based on IFS data.

^{^3/}Net external asset position (NEAP) estimate based on BIS data.

^{^4/}For each parametrization, compares the norms with a) the underlying 2010 current account stripped of temporary factors and b) the steady state (2016) current account.

^{^5/}Derived from the net external asset position-stabilizing current account.

^{^6/}Range of estimates obtained using different model specifications at end-2010.

Real Exchange Rate Overvaluation Estimates Using CGER Approaches ^1/

		NEAP 1 - IFS ^2/		NEAP 2 - BIS ^3/
Macrobalance approach ^4/
	Current account norm (in percent of GDP)	-6.4		-5.9
		Underlying	Steady state	Underlying	Steady state
	Current account (in percent of GDP)	-10.8	-10.5	-10.8	-10.5
	Overvaluation (in percent)	12.1	11.2	13.3	12.4
External sustainability approach ^5/
	Overvaluation (in percent)	12.4		17.2
Equilibrium real exchange rate ^6/		Range
	Overvaluation (in percent)	3.2 - 3.3