Lebanon: Staff Report for the 2014 Article IV Consultation
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
31 Jul 2014
eISBN:
9781484368282
Language:
English
Keywords:
ISCR; CR; Lebanon; refugee; policy; IMF staff estimate; refugee crisis; broad money; foreign currency; treasury bill; Lebanese authorities; Treasury bills and bonds
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KEY ISSUESContext: The economy is being severely tested by the Syria crisis. The refugee influx has reached one quarter of the population, fueling already high unemployment and poverty. The political impasse from the presidential elections—following months of negotiations over a new government—adds to the uncertainty. The economy is meanwhile suffering from a broad-based deterioration, with subdued growth and widening fiscal imbalances. Public debt is on the rise. Progress on structural reforms has been limited. On the positive side, deposit inflows have held up and foreign exchange reserves are sizeable; and security conditions have significantly improved, lifting tourism prospects.Key challenges: There is an urgent need for fiscal adjustment to achieve a sustainable debt reduction, and structural reforms to boost growth and address social inequities.Key policy recommendations:• Fiscal policy. The immediate priority is to stop the fiscal deterioration and return to primary surpluses, to avoid a possible loss of market confidence and put debt on a sustainable path. The consolidation strategy should minimize the impact of a planned salary increase for the public sector; include broad-based and non- distortionary revenue measures; and rebalance expenditure away from electricity transfers toward capital and social spending, to promote inclusive growth. Passing a budget for 2014 would help anchor confidence. Fiscal management should be strengthened and anchored in a medium-term perspective.• Monetary policy. The Banque du Liban (BdL) should continue to maintain high foreign exchange reserves as a buffer and signal of commitment to macro-financial stability. It should gradually withdraw from T-bill auctions, and adopt a strategy to improve its balance sheet over time.• Financial sector. Capital buffers should be strengthened, and the loan classification and restructuring rules and the AML/CFT regime further enhanced.• Structural reforms. Reforms in the electricity sector and the labor market are imperative to address current competitiveness pressures, lay the foundations for higher-productivity growth, and improve social conditions.• Refugee crisis. Lebanon cannot shoulder the costs of the massive inflow of Syrian refugees alone, and international budget support is needed. Strong government commitment to adjustment and reforms—along with a concerted policy framework to deal with the refugee crisis—would bolster credibility and help mobilize support.

Abstract

KEY ISSUESContext: The economy is being severely tested by the Syria crisis. The refugee influx has reached one quarter of the population, fueling already high unemployment and poverty. The political impasse from the presidential elections—following months of negotiations over a new government—adds to the uncertainty. The economy is meanwhile suffering from a broad-based deterioration, with subdued growth and widening fiscal imbalances. Public debt is on the rise. Progress on structural reforms has been limited. On the positive side, deposit inflows have held up and foreign exchange reserves are sizeable; and security conditions have significantly improved, lifting tourism prospects.Key challenges: There is an urgent need for fiscal adjustment to achieve a sustainable debt reduction, and structural reforms to boost growth and address social inequities.Key policy recommendations:• Fiscal policy. The immediate priority is to stop the fiscal deterioration and return to primary surpluses, to avoid a possible loss of market confidence and put debt on a sustainable path. The consolidation strategy should minimize the impact of a planned salary increase for the public sector; include broad-based and non- distortionary revenue measures; and rebalance expenditure away from electricity transfers toward capital and social spending, to promote inclusive growth. Passing a budget for 2014 would help anchor confidence. Fiscal management should be strengthened and anchored in a medium-term perspective.• Monetary policy. The Banque du Liban (BdL) should continue to maintain high foreign exchange reserves as a buffer and signal of commitment to macro-financial stability. It should gradually withdraw from T-bill auctions, and adopt a strategy to improve its balance sheet over time.• Financial sector. Capital buffers should be strengthened, and the loan classification and restructuring rules and the AML/CFT regime further enhanced.• Structural reforms. Reforms in the electricity sector and the labor market are imperative to address current competitiveness pressures, lay the foundations for higher-productivity growth, and improve social conditions.• Refugee crisis. Lebanon cannot shoulder the costs of the massive inflow of Syrian refugees alone, and international budget support is needed. Strong government commitment to adjustment and reforms—along with a concerted policy framework to deal with the refugee crisis—would bolster credibility and help mobilize support.

Context

1. The crisis in Syria is having a dramatic impact on Lebanon. It has created unprecedented inflows of refugees, now exceeding one million or about one quarter of Lebanon’s population—the largest level among neighboring countries despite Lebanon’s smaller size. The refugees have settled throughout the country in more than 1,600 locations; in some areas, the number of refugees is now larger than the host population. Security has been severely affected and local communities and public services have been strained. Unemployment and poverty have increased. The humanitarian support for the refugees has been substantial, though regional and international support to the government and affected host communities has so far been significantly below the authorities’ estimated needs.

A01ufig01

Syrian Refugees in the Region

(In millions)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Source: UNHCR.

2. Political uncertainty remains high. The Syria crisis has further exacerbated sectarian divisions and complicated domestic politics, resulting in prolonged periods of impasse. It took eleven months to form and ratify (in March) a national unity government. Parliament failed to elect a new president within the constitutional deadline of May 25. This vacuum could last several months before consensus on a new president could be reached; it is currently disrupting efforts to pass legislation—including a much debated salary increase for the public sector, which is causing repeated strikes. Parliamentary elections in November (already postponed from June 2013) add to the uncertainty in 2014.

3. Vulnerabilities have increased. Fiscal performance has worsened, and public debt—already one of the highest in the world as a share of GDP—has been on an upward trajectory since 2012. Financing needs remain high. Deposit inflows have held up, thus continuing to feed into commercial banks’ foreign exchange deposits with the Banque du Liban (BdL)—the main source of reserves—and to fund the government. The nexus between the sovereign and banks—whereby banks hold most of the government debt and support reserves—continues to provide stability but could amplify shocks.

A01ufig02

Debt and Financing Needs

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.1/ Central government fiscal deficit plus domestic and external amortization.2/ Current account deficit plus total external amortization (incl. nonresident deposits).

4. Lebanon has an opportunity to change course. It has a history of weathering severe shocks, but unlike in the past, pressures are now multi-faceted and prolonged. The government has shown determination in addressing security conditions, which have significantly improved in recent months. But the same resolve is also needed to tackle widening imbalances and advance reforms to promote stronger, sustainable, and more equitable growth. The 2014 Article IV Consultation provided an opportunity to discuss these themes and identify areas for change.

Key Developments Over the Past Two Years

Macroeconomic conditions have suffered a broad-based deterioration since the last Article IV—largely driven by the Syria crisis—though signs of resilience remain.

5. Economic growth has remained significantly below pre-Syria crisis levels. Spillovers from the Syria crisis have weighed on the economy—already in a downturn in 2011—through far-reaching real, external, and fiscal channels (Box 1 and Selected Issue Paper). Growth stood at 2.5 percent in 2012, and further decelerated to 1.5 percent in 2013 as traditional drivers of growth—real estate-related activities, construction and tourism—have been affected by increasing uncertainty and deteriorating security (Figure 1). Tourism, in particular, was badly hit by the GCC countries’ advisories against travel to Lebanon, in place during the past two years. Some restrictions were lifted in May, reflecting improved security conditions.

Figure 1.
Figure 1.

Lebanon: Real Sector Developments, 2002–14

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; Byblos Bank; and IMF staff estimates.

6. Inflation appears contained, though there are measurement issues. At 4 percent, the average official CPI for the last two years does not show pressures in housing and food prices, which have been particularly affected by additional demand from refugees. However, rent increases were not included until recently in the CPI;1 while in areas where the refugees have settled, rents have reportedly increased by at least 20 percent last year. Official food inflation has also not increased, as Syria-related disruptions to transit routes have diverted to domestic markets food previously exported to regional markets, thus relieving demand pressures.

7. The external current account deficit has remained large, at about 13 percent of GDP in both 2012 and 2013 (Figure 1). The trade balance has remained broadly unchanged as a share of GDP over the two years, as both imports and exports contracted—the latter reflecting a drop in gold exports and lower exports to the region. Similarly, the service balance has been affected by a drop in tourism receipts from the GCC countries, though partly contained by additional spending on services by a growing number of non-resident Syrians.2 Net current transfers have picked up, reflecting significant humanitarian assistance, as well as lower outflows due to Syrian workers likely supporting relatives that moved to Lebanon.

Spillovers from the Syria Crisis

The conflict in Syria is overshadowing Lebanon. Over 1 million refugees have arrived to Lebanon since the onset of the conflict. The impact of the crisis has been felt throughout the economy, though quantification is hampered by the lack of reliable data (see Selected Issues Paper).

The Syria crisis is also having a profound and perhaps long-lasting social impact. The World Bank estimates that poverty increased by 4 percentage points in 2013,1 and the labor supply will rise by about 50 percent by end-2014, with a pronounced impact on unskilled labor, youth and women.

Lebanon could not create sufficient jobs even before the Syria crisis. According to the World Bank, only some 3,800 jobs were generated per year (one for every six new entrants to the labor market) in 2005–09.1 Reflecting insufficient job opportunities, the unemployment rate stood at 11 percent in 2011, slightly above the MENA average of 10 percent. Like in the MENA region, unemployment was much higher among the youth—over one third of labor force participants aged 15–24 are unemployed. Around half of the labor force was employed in the informal sector.

A01ufig03

Labor Force Estimates and Projections, 2011–19

(In millions)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: ILO Economically Active Population, Estimates and Projections (6th edition, October 2011); UNHCR for Syrian refugee population estimates; and IMF staff estimates and projections.

The influx of refugees has deeply impacted the labor market, potentially increasing unemployment to about 20 percent. The unemployment rate among refugees is roughly 30 percent.2 More than 60 percent of refugees work in the low-skilled sector (agriculture, personal services and construction), and are willing to accept much lower wages than Lebanese workers, putting downward pressure on wages and displacing Lebanese workers.

Illustrative scenarios highlight the challenge of reducing unemployment, even when assuming that the refugees begin to return to Syria as early as 2016 (see Selected Issue Paper).3 Under the baseline scenario, unemployment would be reduced only marginally, to around 18–19 percent (blue line in the chart). Growth alone might not be a game changer. Higher growth rates (of 5–6 percent) would help reduce unemployment, but would not bring it significantly below the baseline level (black line in the chart; this, however, assumes that the employment elasticity would remain unchanged). This analysis underscores the need for reforms that create job-rich growth.

The authorities have appealed to the international community to help fund the costs of the Syrian crisis. There has been significant humanitarian support (amounting to close to $1 billion in 2013 alone, see Selected Issue Paper), though so far budget support, including through a dedicated trust fund established by the World Bank, has been limited.

A01ufig04

Unemployment Rate Projections - Baseline

(Assuming gradual return of refugees; 30 percent remaining in 2019)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Country authorities; and IMF staff estimates and projections.
1 World Bank, 2012, “Republic of Lebanon: Good Jobs Needed, the Role of Macro, Investment, Education, Labor and Social Protection Policies (“Miles”)” Report No. 76008-LB.2 International Labor Organization, 2013, “Assessment of the Impact of Syrian Refugees in Lebanon and their Employment Profile.”3 These trajectories are based on the MCD employment template (see Chami et al., 2012, “A Template for Projecting Labor Market Indicators,” IMF Technical Notes and Manual 12/01).

8. Fiscal imbalances have widened. In 2012, a primary deficit—the first since 2006—of ¼ percent of GDP was recorded, and the public debt-to-GDP ratio increased to 134 percent of GDP, reversing its previously-declining trend; debt further rose to 141 percent of GDP in 2013, as the primary deficit reached 1 percent of GDP. This deterioration reflected broad-based spending pressures and revenue declines from weak economic activity, but also policy decisions adopted in 2012, namely the introduction of a VAT exemption on gasoil (with an estimated annual impact of ½ percent of GDP) and a cost of living adjustment for public sector wages (with an annual cost of 1¼ percent of the 2012 GDP, Box 2).

A01ufig05

Fiscal Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.

9. Hosting the large refugee population is adding to fiscal strains. The direct budgetary costs are not known with precision, as there are no dedicated budgetary lines for refugee-related spending by line ministries; expenditure tracking is further hampered by the fact that refugees are not concentrated in specific areas or camps. The World Bank estimated the overall fiscal impact of the Syria crisis at a cumulative $2.6 billion over the period 2012–14 (about 6 percent of the 2013 GDP), with an additional $2.5 billion needed to return public services to their pre-crisis quality (Box 1 and Selected Issue Paper).3

10. Despite the higher risks, T-bill rates have remained broadly unchanged. The government raised interest rates on T-bills with maturity shorter than 7 years in March 2012, by 50 basis points, in line with Fund advice (Box 3). This increase managed to temporarily boost banks’ appetite for government paper. Despite higher risks and market pressures for further increases from mid-2012 onward, the government has kept rates on existing maturities unchanged. Instead, it has resorted to infrequent issuances of longer-term higher-yielding T-bills outside the regular auctions, and has continued to rely on BdL purchases on the primary market (see below).4

A01ufig06

Deposit and Lending Interest Rates and Yield Curve

(In percent)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.

11. The BdL has proactively sought to maintain stability. Supported by sustained deposit inflows, the BdL has continued to attract banks’ foreign exchange deposits, keeping gross reserves at a comfortable $35 billion at end-April—about 11 months of imports or 25 percent of broad money. The BdL has also continued to finance the government. On the pound side, it has been offering banks long-term deposits with yields generally matching T-bills with similar maturities, and channeled this liquidity to cover demand shortfalls in the T-bill auctions. On the foreign currency side, it has been increasingly providing funding to the government, with an impact on its net foreign exchange position. Finally, the BdL has supported credit to the private sector—still growing at an annual rate of 10 percent—by providing $1 billion in low-cost funds to banks to on-lend to specific economic sectors.5 All these operations have further weakened its balance sheet.

A01ufig07

BdL’s Foreign Exchange Reserves

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.1/ Gross reserves (excluding gold) minus foreign currency liabilities.

12. Foreign exchange and financial markets have been largely resilient. Deposits have continued to grow at 7–8 percent a year, though with some occasional outflows. Dollarization declined in 2012, but has been since on an upward trend, reaching 65.8 percent at end-April—still below the end-2011 level (Figure 3). Eurobond spreads have moved in line with regional averages and stand at levels similar to end-2011. Standard & Poor’s upgraded the outlook in April, from negative to stable—on account of the continued resilience of deposit inflows and improved political conditions following the government formation—while maintaining the rating for the sovereign and the three largest banks at B-.

Figure 2.
Figure 2.

Lebanon: Fiscal Sector Developments, 2006–13

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.
Figure 3.
Figure 3.

Lebanon: Monetary and Financial Sector Developments, 2006–14

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; Bloomberg; Haver; and IMF staff estimates.

Public Sector Wages

A substantial increase of public sector wages was set in motion in 2012. This includes three components: (i) an increase in the minimum wage; (ii) the application of a cost of living adjustment; and (iii) the adoption of a new salary scale.1 The first two elements were approved in September 2012, effective February 1, 2012. The salary scale adjustment has been subject to considerable debate and changes, by cabinet and two parliamentary committees; it still has not been passed by parliament. If approved as per the latest draft, it would add another LL970 billion annually (1.3 percent of the 2014 GDP) to the wage bill.

If implemented, the salary scale adjustment would further exacerbate budget rigidities. Lebanon’s wage bill—while not higher than comparators in the region—represents a large share of spending and absorbs more than 30 percent of government revenue. The planned increase—and its possible impact on pensions and other personnel costs—would thus further limit fiscal space.

Focusing on wages only can be misleading. Central government employees receive about twenty different allowances and indemnities in addition to their basic salary—exceeding it in some cases. On average these represent about one third of basic salary spending. Over the period 2003–12, allowances and indemnities amounted to an average of 2.7 percent of GDP, bringing total personnel costs to around 10 percent of GDP.

Measures were proposed to mitigate the costs of the salary scale adjustment. In addition to revenue measures (see text), it was proposed to increase working hours in the public administration from 32 to 35 per week; other originally proposed measures (such as reducing the maximum number of overtime hours; capping bonuses and benefits as a share of total monthly salaries; and revising the number of years of service for eligibility to retirement) are currently not under consideration.

Salary increases will directly and permanently impact pensions. Pensions are adjusted in line with salary increases granted to those in active duty, and not just to reflect cost of living adjustments, as standard practice in many countries. In addition, pension benefits are also granted to surviving spouses and unmarried, divorced or widowed daughters of retirees, if unemployed—thus significantly extending the period over which pension benefits are drawn. All these elements, which add to the costs of the salary adjustment scale, have not been considered explicitly in the ongoing debate.

A01ufig08

Wages as a Share of Total Expenditure for Lebanon and Selected Regional Comparators, 2013

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Country authorities; and IMF staff estimates.1/ Central government.
A01ufig09

Central Government Wages and Salaries, 2012 1/

(In billions of LL)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Source: Lebanese authorities.1/ Central government employees include military, education, civil and customs personnel.
1 The monthly minimum wage was increased to LL675,000 from LL500,000 (equivalent to $448 and $332, respectively). Prior to this increase, a cost of living adjustment for the public sector was last granted in 1999. A minimum wage increase for the private sector was implemented in 2008.

Policies Since the 2011 Article IV Consultation

Macro policies have been partly in line with staff advice. The 2011 consultation called for fiscal discipline (preserving a primary surplus position) and a reduction in the public debt-to-GDP ratio. However, the fiscal position has deteriorated substantially starting in 2012—a primary deficit was recorded in 2012 for the first time since 2006—reflecting weak growth and expansionary policy measures (most notably, the reduction of excises, the removal of VAT on gasoil, and public sector wage increases). In line with staff recommendations, the authorities raised in 2012 interest rates on T-bills with maturities less than seven years to reduce the budget’s reliance on BdL financing.

There was some progress on structural reforms. The 2011 consultation highlighted the need for reforms toward faster and more inclusive growth and economic resilience. On the positive side, measures included the approval of the capital markets law and continued strong bank supervision, along with initial steps toward exploring offshore oil and gas reserves. In addition, the ministry of finance established a macro-fiscal unit (which has produced a medium-term expenditure framework), and a public debt directorate (which has developed a Medium-Term Debt Strategy). There was some progress in implementing the comprehensive electricity sector strategy (see Box 4). Investment in the electricity sector to increase capacity is welcome, though it will need to be accompanied in the future by tariff increases toward cost recovery levels to reduce the sizeable subsidies to the electricity company, once electricity provision increases. Other reforms have been slow to implement—particularly in telecommunication, the global income tax and the Treasury Single Account. The provision of statistical information has generally remained weak, though progress is being made in a number of areas.

Outlook and Risks

Risks remain high given Lebanon’s exposure to developments in Syria, and would be amplified by a lack of corrective policies.

13. Without a resolution in Syria, economic performance is expected to remain weak. Growth is likely to linger at around 2 percent this year, reflecting domestic and regional uncertainties. For projection purposes, staff assumes that the Syria conflict will be resolved by 2016, when growth will return to potential—a moderate 4 percent—and refugees will start gradually returning to Syria. Inflation is projected to pick up later this year and next year, reflecting the impact of a planned wage increase (see next section). The current account deficit is projected to decline only slightly over the medium term, as a rebound in exports will be to a large extent offset by higher imports. Financing needs would remain high, reflecting large fiscal and current account deficits.

14. Downside risks—outlined in the Risk Assessment Matrix—are high. While Syria poses the most serious threat to the economy, domestic risks from a further weakening of fiscal policies and delays in structural reforms, along with other external risks (e.g., from a higher-than-expected increase in global interest rates) are also looming. A materialization of these risks could dampen growth and push up government financing costs, with further adverse effects on debt dynamics. It could also trigger a loss of confidence, which would set in motion negative feedback loops to deposits, dollarization, and reserves. In particular, more spillovers from the Syria crisis could further destabilize social structures and increase economic costs; a prolonged refugee crisis would strain the already-weak public service provision, with added costs to the budget, put further pressure on the labor and housing markets, and threaten law and order. Failure to address infrastructure bottlenecks could reduce Lebanon’s competitiveness and growth potential. Higher-than-expected increases in global interest rates could push Lebanon into tighter monetary policy, with rising financing costs negatively affecting the government and the banking sector.

Lebanon: Fiscal and External Financing Needs

(In billions of U.S. dollars, unless otherwise indicated)

article image
Sources: National authorities; and IMF staff calculations.

General government fiscal deficit (excl. grants) plus general government external amortization.

General government fiscal deficit (excl. grants) plus general government domestic and external amortization.

Current account deficit plus total external amortization (incl. nonresident deposits).

Authorities’ views

15. The authorities broadly shared staff’s assessment of the outlook and risks. They agreed that further spillovers from the Syria crisis present the most serious risk to the economy. More specifically, they expressed high concern about the impact of the refugees on Lebanon’s economy and local communities, especially if significant donor budget support fails to materialize. Some noted that the lack of a government strategy on refugees was taking its toll, and the open border policy needed to be revisited; consideration of alternative forms of hosting the refugees (e.g., in designated areas) was taking hold in some political quarters.

16. The authorities nonetheless remained confident in Lebanon’s ability to withstand shocks. They underlined the proven resilience of deposits and BdL’s large reserve buffer. Finally, they also noted the upside potential stemming from Lebanon’s possible involvement in Syria’s post-conflict reconstruction, which could significantly boost growth.

Policy Discussions

17. Policy discussions centered on the urgent need for credible fiscal adjustment and structural reforms. The current fiscal deterioration needs to be reversed and the primary surplus restored, while addressing underlying weaknesses in public service provision and social safety nets. Tackling these challenges will help ensure fiscal sustainability, anchor market confidence, and improve equity. Strong commitment to fiscal discipline could also help mobilize budget support for the costs of the refugee crisis, by providing a policy framework and dispelling skepticism about the government’s ability to tackle pressures head on.

A. Ensuring Fiscal Sustainability

Discussions on fiscal policy were overshadowed by the still unresolved debate on a salary scale adjustment for the public sector and revenue measures to offset its costs. The size, composition, and timing of the package are still under parliamentary consideration.

18. Fiscal policy needs an anchor. There have been no approved budgets since 2005 and accounts have not been officially closed since 1993. Fiscal policy has been lacking a medium-term perspective, with spending conducted largely through treasury advances and ad-hoc measures in times of pressures. Despite progress on fiscal reforms, policymaking continues to fare low in terms of transparency (Figure 4).

Figure 4.
Figure 4.

Lebanon: Structural Indicators, 2013

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; World Bank; World Economic Forum; PRS Group; and IMF staff calculations.
A01ufig10

Expenditure Composition

(In billions of Lebanese pounds)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.

19. Large budget rigidities persist. Over 70 percent of current spending comprises of transfers to the loss-making Electricité du Liban (EdL), public sector wages, and interest payments. Capital spending—already compressed by regional standards—has been often cut to curb deficits, further exacerbating Lebanon’s infrastructure deficit (Figure 2).

20. Significant spending pressures are building up. The main increase will stem from a much debated salary scale adjustment for the public sector, with an estimated cost (excluding pensions) of 1.3 percent of the 2014 GDP on a permanent basis.6 This increase is part of a salary package proposed by cabinet in 2012 (Box 2). Parliament approved some elements (including offsetting revenue measures), before legislative sessions were suspended due to the presidential elections.7 At the same time, ongoing capital projects in the electricity sector (about 1 percent of GDP, see below) and additional social spending related to the Syrian refugees (about 0.3 percent of GDP through 2016) add to spending pressures in the near term. On the positive side, transfers to EdL are projected to decline, but largely on account of lower oil prices (Box 4). Staff thus noted that the authorities should not rely on these savings, which are subject to significant oil price uncertainty; and that without reforms of the electricity sector and increases in tariffs—unchanged since 1996—EdL will continue to be a significant drag on public finances.

21. The revenue measures approved so far will be insufficient to offset higher spending. These measures include: (i) an increase in the interest income tax rate from 5 to 7 percent; (ii) an increase in the corporate income tax rate from 15 to 17 percent; (iii) a new capital gain tax on real estate transactions; (iv) increases in tobacco excises; and (v) increases in various stamps and fees. Staff estimated the measures’ annual yield at around 1 percent of the 2015 GDP. Increases in the VAT rate from 10 to 11 percent, and to 15 percent for selected luxury items; and the application of penalties on illegal seashore buildings are still under discussion.

22. On current policies, risks to public debt sustainability would increase. The budget deficit would rise to about 12 percent of GDP in 2015, largely reflecting the salary scale adjustment, and remain broadly at that level afterwards (text table). The primary position would reach a deficit of 2.5 percent of GDP in 2015, and then gradually improve—largely benefitting from a reduction in transfers to EdL as oil prices are projected to decline over the medium term—but remain negative. Under this scenario, debt and financing needs would continue to rise, reaching 155 percent and 40 percent of GDP, respectively, thus exposing Lebanon to considerable debt vulnerabilities (Annex I).

Lebanon: Main Fiscal Indicators Under Baseline Scenario

(In percent of GDP; unless otherwise indicated)

article image
Sources: Lebanese authorities; and IMF staff estimates.

Includes various stamps and fees.

Includes social spending.

Electricity Sector Reforms

The electricity subsidy absorbs a large share of public spending. The government transferred 4.5 percent of GDP to Electricité du Liban (EdL) in 2013. As electricity tariffs have remained unchanged since 1996 (when the price of oil was $23 per barrel) while oil prices have generally increased, the size of the transfers has surged over the years.

A01ufig11

EdL Subsidy and Oil Prices

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.1/ In 2010, transfers to EDL dropped 20 percent because of the use of natural gas as a substitute to gasoil, paid for with a lag of 6 months.

EdL’s production is both inefficient and insufficient to meet demand—reducing competitiveness and potential growth. Close to half of total electricity production costs are not recovered (15 percent in technical losses—due to transmission and distribution problems, as well as the use of fuel in two power plants designed to operate on natural gas; and about 30 percent in non-technical losses—from illegal connections/theft and uncollected bills).1 In addition, EdL currently has 2,019 MW of installed generating capacity, compared to a peak demand of 3,195 MW.2 Supply covers only some 18 hours per day on average, with frequent blackouts. Back-up private generators are extensively used, but at a cost that is three times the level of EdL tariffs. Seventy five percent of Lebanese firms identify electricity as a major constraint to business operations (compared to 52 percent in the MENA region).3

Reforms of the electricity sector have long been on the table, but progress has been scant. The 2011 “Policy Paper for the Electricity Sector” aimed at increasing production to 4,000 MW by 2014, with an estimated total cost of $6.5 billion, to be funded equally by the government and the private sector. The plan hinged on increasing generation, transmission and distribution infrastructure; diversifying fuel sources by converting most plants to natural gas; adopting a new tariff structure; and revising the legal framework (including ultimately EdL corporatization). Some progress was made to build a new power plant and rehabilitate existing ones, and launch a Liquefied Natural Gas Public-Private Partnership. Three private distribution service providers started operations; and two power barges were rented to supplement power production while power plants are being built. However, demand from refugees is estimated to equal roughly the electricity supplied by the barges, setting back expected supply improvements.

On current policies, transfers to EdL are expected to decline on the back of decreasing oil prices. These declines account for a large reduction in transfers (0.6 percent of GDP in the medium term), but as the experience in the late 2000s shows, they do not provide sustainable savings.

Transfers to EdL

(In percent of GDP, unless otherwise indicated)

article image
Sources: Lebanese authorities; and IMF staff estimates and projections.

Raising the average EdL tariff toward cost recovery levels would reduce transfers by an additional 0.8 percent of GDP—and in a more sustainable way. The Ministry of Energy and the EdL have prepared a proposal, with assistance from the World Bank, which would simplify the structure of tariffs and safeguard lower-end consumers (who generally have lower income). So far the proposal, while endorsed by various stakeholders, has not been acted upon. Switching to gas will also generate savings of 0.2 percent of GDP.

1 World Bank, 2012, “Republic of Lebanon, Electricity Sector Public Expenditure Review.”2 World Bank, 2013, “Economic and Social Impact Assessment of the Syrian Conflict,” (September 2013).3 World Bank Enterprise Survey: http://enterprisesurvey.org.

23. Putting the public debt on a sustainable downward path can only be achieved through strong fiscal consolidation. Lebanon managed to reduce its debt by an impressive 50 percent of GDP during 2007–12, from 180 percent of GDP at end-2006 to 134 percent of GDP at end-2012. The main drivers were high economic growth (9 percent on average over the period 2007–10), and, to a much lower extent, primary surpluses. With growth expected to return gradually to only 4 percent, staff noted that debt reduction has to come from sustained and large primary surpluses above the debt stabilizing level (Annex I). Fiscal adjustment should be complemented by structural reforms to rekindle private activity.

A01ufig12

Debt Dynamics Decomposition

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Source: IMF staff estimates and projections.

24. Staff recommended a fiscal adjustment strategy that is credible, balanced, and anchored in a multi-year framework. Staff noted that the salary scale adjustment debate had focused excessively on revenue measures, while the size and composition of spending should be addressed as well; the debate had also diverted attention away from the need for broader fiscal consolidation. More specifically, in staff’s view:

  • Passing a budget is a necessary initial step to anchor fiscal policy. Staff welcomed the ministry of finance’s renewed efforts to close earlier accounts, especially as a precondition for parliamentary consideration of a 2014 budget. A budget including all government spending and revenue plans—and their impact on deficit and debt—will help policymakers shift to a more comprehensive approach to fiscal policy.

  • The costs of the salary scale adjustment should be contained. At a minimum, salary increases should be phased in in installments and without retroactive payments, and based on clear performance measures. Staff also recommended factoring in all costs of the scale adjustment, including on pensions (Box 2). Measures to increase public sector productivity should be adopted; in this regard, staff recommended civil service reform, noting though that it would take time and political will to implement it.

  • Reforming electricity tariffs is key to reducing transfers to the EdL in a sustainable way. There have been proposals to simplify the tariff structure and increase its average level toward cost recovery, while protecting the lower-tier consumers (Box 4). However, vested interests and general lack of governance in the electricity sector have prevented progress. Staff endorsed the tariff reform, noting that its implementation is subject to cabinet’s decision and could therefore proceed regardless of the parliamentary schedule. In addition, ongoing projects to switch to cheaper generation should also be properly funded, monitored, and executed.

  • Staff sees scope to rebalance spending composition. Higher capital spending is needed to support growth and reduce infrastructure gaps, starting from planned projects in the electricity sector. Higher social spending, including through the National Poverty Targeting Program, would help reduce poverty and address social needs.

  • Revenue measures should be equitable and minimize distortions. Staff welcomed efforts to broaden tax bases, though regretted that the removal of the VAT exemption on gasoil was not being pursued. It advised against applying multiple VAT rates to avoid complicating tax administration. Instead, staff proposed a gradual increase of the overall VAT rate to 12 percent in 2015 and 15 percent in 2017, in line with past Fund advice; and noted the VAT’s sizeable tax base (consumption is about 90 percent of GDP), its efficiency, and ease of administration. Staff recommended avoiding double taxation.8 Finally, it called for limiting the reliance on fees and stamps, as they would likely generate low yields while complicating the tax system, noting that previous Fund advice had recommended their simplification.

25. Staff’s proposed adjustment would reverse the debt dynamics. The bulk of the adjustment would come from revenue—and particularly from the still under-tapped VAT potential—while spending would remain broadly unchanged as a share of GDP, though with a composition rebalanced in favor of higher capital and social spending. The primary position would turn into surplus as early as 2015, and reach 2½-3 percent of GDP over the medium term. There would be some growth dividends, as confidence effects—in an environment where good policy news have been limited—would drive a rebound in private investment, further enhanced in the medium term by higher-quality spending and electricity sector reform. Public debt would thus be put on a downward path, though would still remain above 130 percent of GDP by 2019.

Lebanon: Main Fiscal Indicators Under Staff’s Proposed Adjustment Scenario

(In percent of GDP; unless otherwised indicated)

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Sources: Lebanese authorities; and IMF staff estimates.

Includes various stamps and fees.

Includes social spending.

26. There is a need for a more transparent government financing framework. Last year, the government reached the cap on new foreign currency borrowing.9 Meanwhile, the gap between its foreign currency payments (including transfers to the EdL, and interest and some capital spending payments) and receipts (mainly profit transfers from the telecommunication company) has been widening. This reflects temporary factors (delays in transfers from Telecom), but also a structural deterioration (an increase in foreign currency payments). Thus, the government has been increasingly borrowing in foreign currency from the BdL in overdraft, which has reached $6.6 billion at end-April (about 14 percent of GDP). Staff welcomed the authorities’ effort to seek parliamentary approval to raise the cap on new foreign currency borrowing to reduce the government’s reliance on the BdL; it also recommended returning to regular and timely Telecom transfers to the budget.

27. Strong fiscal management should underpin adjustment. Staff welcomed ongoing capacity building at the ministry of finance. It reiterated the importance of adhering to a budget calendar and pursuing a medium-term budget framework; and noted the need for greater transparency of government spending and its funding. Staff also underlined the importance of strengthening cash management, in particular the transparency and timeliness of transfers to and from the budget. Finally, staff noted that strengthening revenue administration and combating reportedly pervasive tax evasion and corruption could generate considerable gains.

28. Windfalls from prospective gas resources are no substitute for adjustment. According to recent seismic surveys, Lebanon could benefit from offshore gas resources, though their size remains uncertain and production is not expected to begin before 2020 (Box 5). The bidding process for exploration is currently scheduled for August, after repeated delays. Staff underscored that gas resources represent an asset of the whole country; and that strong policies and institutions are needed to manage the related revenue stream in a sustainable and equitable way (Selected Issue Paper). The first step to manage gas resources properly is to define a fiscal regime that ensures a fair revenue share for the government while encouraging investors’ participation in exploration and production activities. Staff also called for a proper macro-fiscal anchor to ensure the sustainability of the gas revenue; and strong institutions to manage the gas wealth responsibly and transparently. In this context, it cautioned that discussions on a sovereign wealth fund are premature; and earmarking different revenue sources to specific uses would lead to fiscal fragmentation.

Designing a Fiscal Framework for a Prospective Commodity Producer: Options for Lebanon

Lebanon might become a commodity producer over the next decade, with petroleum set to be an important source of government revenue. Recent seismic surveys suggest that Lebanon’s oil and gas resources could be in excess of 25 trillion cubic feet (tcf). While not particularly large by international standards, this estimate still points to the potential for a substantial revenue increase for many years (though not starting before 2020 at the earliest).

Changing status to a commodity producer introduces challenges to macro-fiscal management. High dependence on natural resources can result in high volatility of revenues and spending—typically higher than for non-commodity producers—with associated procyclicality. Indeed, spending in commodity producers during boom and bust commodity price episodes is found to be more procyclical than in non-commodity producers. In addition, resource revenue is exhaustible, raising issues of sustainability and intergenerational equity. This calls for smoothing government consumption over time, and avoiding the need for massive fiscal adjustment once resource wealth has been depleted.

To address these challenges, Lebanon’s fiscal framework needs to move on three fronts:

  • Fiscal regime. Appropriate laws and regulations defining the revenue potential from exploration and production of natural resources should be guided by a number of objectives and design principles:

    • The state should receive an appropriate share of the economic rents from exploiting natural resources.

    • The tax rules applying to the extractive industries should be set out clearly in legislation, to avoid negotiating project-specific fiscal arrangements.

    • The government’s take should adjust to price and cost fluctuations, to secure a larger profit share of the most profitable projects, but impose a lower tax burden in times of low profitability.

    • The fiscal regime should avoid distorting investment incentives and decisions, especially in the initial production stages, when governments typically favor early and dependable revenue.

    • Tax regimes should be competitive relative to those of other countries in attracting investment, taking account of the relative stage of exploration and discoveries and their expected characteristics. They should also be simple for taxpayers to comply with and the revenue authority to administer.

  • Macro-fiscal anchor. As Lebanon’s resource revenues are uncertain at this stage, the government should conservatively assume a short reserve horizon. Fiscal policy should therefore be guided by resource exhaustibility considerations, and anchored in a saving strategy for intergenerational equity reasons. The literature offers guidance on the formulation of fiscal policy in these circumstances (see Selected Issue Paper). Fiscal targets consistent with the Permanent Income Hypothesis (PIH)-based frameworks—whereby a constant share of revenue is consumed every year to preserve resource wealth—can be useful. Two related frameworks—based on the Modified Permanent Income Hypothesis and Fiscal Sustainability—allow for scaling up of expenditure to address specific needs (for example in human and physical investment), while still ensuring long-term fiscal sustainability. These frameworks may be relevant to Lebanon given its infrastructure gaps and social needs.

  • Institutions. Natural resource windfalls significantly complicate fiscal management, and therefore strong institutional arrangements are called for. A sound PFM system helps ensure, as part of the budget process, (i) a transparent and comprehensive presentation of oil revenue and the underlying non-oil fiscal position; (ii) a sustainable long-term fiscal strategy based on prudent revenue projections, realistic medium-term fiscal frameworks and a good budget classification; and (iii) transparent mechanisms for appraisal, selection, and prioritization of investment projects, to ensure that resource revenue is used to support long-term economic development. In addition, adopting a fiscal responsibility law could potentially strengthen fiscal discipline by anchoring fiscal decisions in a rule-based framework (see Selected Issue Paper).

Authorities’ views

29. The authorities acknowledged the need to revert the debt dynamics. But political uncertainty overshadows policy decisions and adjustment could only come over time.

30. The authorities reaffirmed their commitment to putting in place a budget for 2014. They noted that work on closing past accounts was almost complete, and agreed that passing a budget would send a strong signal.

31. There was a large degree of uncertainty regarding the parameters of the salary scale adjustment. The authorities also noted significant implementation uncertainties, in part related to the presidential vacuum, and felt than an early resolution was less likely.

32. The authorities felt confident that their proposed revenue measures would more than offset the salary increases. They stressed that sectors of the economy that had largely remained outside the tax net should share the adjustment burden. They disagreed, however, with the mission’s assessment that fees and stamps would generate only limited yield; and noted that a large and broad-based VAT increase could affect disproportionally the lower segments of the population, and would be politically difficult to implement.

B. Maintaining Reserves and Activating Market Signals

Discussions centered on the role played by the BdL in maintaining stability, and the need for high reserves and lower government financing by the BdL.

33. The exchange rate peg is the nominal anchor for Lebanon. Staff acknowledged the key role the peg has been playing as lynchpin of financial stability, given the government’s high debt and debt service in foreign currency, and substantial household and corporate currency mismatches from the large credit dollarization. Strong and supportive policies are needed to underpin the continued viability of the peg.

34. Maintaining high reserves is warranted given large risks and vulnerabilities. Official foreign exchange reserves are adequate, at 110 percent of the reserve metric at end-2013. The reserve coverage is larger—at 147 percent—if commercial banks’ estimated foreign liquid net assets are considered as an additional buffer in case of deposit outflows. Staff underscored the need to maintain high reserves, but noted that reserve accumulation and the associated sterilization costs have weakened the BdL’s balance sheet. With bank deposits expected to remain the main source of reserves, a deposit growth rate of about 8 percent would be sufficient to broadly maintain the reserve coverage while meeting fiscal and external financing needs under current policies. Going forward, there is a need for a strategy to gradually strengthen the BdL’s balance sheet.

A01ufig13

Reserve Adequacy

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

1/ Includes nonresident deposits.Source: IMF staff estimates.

35. Staff called for lower government financing by the BdL. Banks have continued to shy away from T-bills with maturity shorter than 7 years—offered in the regular auctions. To mop up banks’ pound liquidity and keep T-bill rates unchanged, the BdL has increasingly offered long-term deposits—of 7-year or higher maturity—with yields generally matching T-bills with similar maturities, and channeled this liquidity to cover demand shortfalls in the T-bill auctions.10 In a positive step to encourage banks to reduce deposits with the BdL and invest in government paper instead, the BdL has recently reduced by 26 basis points the interest rate it pays on banks’ deposits. Staff encouraged the BdL to go one step further and gradually withdraw from T-bill auctions. It noted though that rate cuts on BdL’s instruments might only have a marginal effect on the T-bill market, and T-bill rates will likely have to rise to attract more bank participation in the auctions if fiscal imbalances are not addressed.

A01ufig14

Pound Liquidity and T-bill Holdings

(In trillions of Lebanese pounds)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.

36. Ending the fiscal dominance and activating market signals require a reduction of vulnerabilities. Staff underlined that lower government financing by the BdL can only be sustained if combined with fiscal restraint—key to ensuring a sustainable reduction in government’s large debt and financing needs. To allow the interest rates to reflect market conditions and enhance the transparency of government financing, staff also recommended regularizing the issuances of T-bills with maturities longer than 7 years and making the T-bill auction process more transparent, including by providing more detailed auction results.

37. Staff cautioned against the adverse effects of a rise in global interest rates. In this context, it again recommended maintaining a high level of reserves to signal commitment to macro-financial stability. It also called for strengthening banks’ capital buffers to absorb potential losses from an increase in funding costs and a decline in Eurobond prices.

Authorities’ views

38. There was agreement on the importance of maintaining high reserves. The authorities felt comfortable with the current level of reserves. While they acknowledged the costs of maintaining high reserves in an environment of low global rates, they felt there was no alternative in the near term. They noted that in the medium term the BdL’s balance sheet will benefit from larger remuneration on reserves driven by higher global rates.

39. The authorities broadly shared staff’s position on government financing and interest rates, but pointed to limited policy alternatives in the current environment. They underlined the need to stay vigilant and underpin monetary policy changes by strong fiscal consolidation. They remained open to further gradual changes in BdL rates if and when conditions permit, while noting that increases in T-bill rates would likely raise financing costs for the private sector, as lending rates are generally linked to short-term T-bill rates. The T-bill auction system was already transparent, in their view, and recent progress was made on debt management coordination between the BdL and the ministry of finance.11 Finally, they felt that banks’ capital buffers were sufficient and valuation effects from a rise in global rates likely limited, as most Eurobonds are held to maturity.

C. Strengthening the Financial System

The resilience of the banking sector in the current challenging environment and the authorities’ plans to develop capital markets were the focus of discussions.

40. Banks have so far been resilient, but the environment is increasingly challenging. Regional instability has halted banks’ expansion in neighboring countries, and opportunities for credit to the private sector are currently limited. Nonperforming loans (NPLs) have slightly increased over the past year, but remain low. Loans under watch have increased though and the use of overdraft facilities is widespread. Provisioning on NPLs has decreased. Banks’ profitability has deteriorated, with an average return on assets now of about 1 percent. Liquidity buffers, including large deposits with the BdL, are strong. Banks’ already high exposure to the sovereign has continued to increase.

A01ufig15

Banking Sector Stability Map

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Source: IMF staff calculations.Note: Away from center signifies higher risks.

41. Capital buffers should be further strengthened given banks’ large exposure to the sovereign. The BdL requires by end-2015 an additional capital buffer of 1.5 percent on top of the Basel III minimum plus a 2.5 percent conservation buffer. Staff welcomed this measure, though urged the authorities to have a consistent approach to banks’ exposures to the government and the central bank in accordance with the Basel capital adequacy framework.12

42. Staff called for an improvement of loan classification and restructuring rules. The increase in loans under watch and the widespread use of overdrafts warrant tighter rules guiding the classification of NPLs and the restructuring of loans, including re-aging of overdrafts and arrears. While the authorities are monitoring banks’ credit exposures to neighboring countries, staff nonetheless encouraged them to stay vigilant for signs of further asset deterioration, both domestically and abroad. Staff took note of the positive steps to enhance supervision by establishing supervisory colleges to strengthen the cross-border supervision of the largest banks.

A01ufig16

Bank Asset Level and Composition

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Lebanese authorities; and IMF staff estimates.

43. Staff encouraged progress on the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) regime. A better understanding of the source of deposits and adequate identification of beneficial owners would allow more effective monitoring of transactions and strengthening of risk-based supervision—necessary to enhance the integrity of the financial sector. In this context, staff called also for strengthening the AML/CFT regime, including by taking the necessary legislative steps to bring the existing AML law and other related legislation in line with the revised international standards.

44. Over time, there might be scope to encourage banks to reconsider their business model, which currently revolves around channeling deposits to the public sector. Staff estimates that a deposit growth rate of about 8 percent would cover the economy’s financing needs while keeping reserves high. Banks should thus avoid returning to the double-digit deposit growth rate experienced in previous years, which would generate high sterilization costs for the BdL. In this context, banks could lower deposit spreads (relative to international rates) to help slow deposit growth—if and when needed. At the same time, staff saw a need to reduce over time banks’ reliance on the sovereign. Banks might have to consider downsizing their balance sheets if public financing needs decline significantly and regional opportunities remain limited.

45. Preliminary steps to develop capital markets are welcome. While the banking sector is almost fourfold the size of GDP, the insurance sector and the stock market remain underdeveloped (Selected Issue Paper). The newly established Capital Markets Authority (CMA) issued its first regulations in June 2013; the transfer of part of supervision from the BdL to the CMA is under way. Staff welcomed progress, noting that developing capital markets to complement the banking sector could promote growth, but cautioned that tight regulation and supervision of the financial system are essential to avoid excessive risk taking.

Authorities’ views

46. The authorities felt that staff’s assessment underplayed ongoing progress in the prudential framework. They stressed both the high quality of banks’ capital (mostly core Tier 1) and the strict bank capital requirements, which go beyond the Basel III minimum. The authorities justified the different weighting system on the basis of BdL’s conservative investment strategy for the international reserves. They also emphasized the efforts made to assess capital adequacy with respect to banks’ cross-border exposures through ongoing stress tests. They considered that Lebanon’s AML/CFT regime is in practice fully compliant with international standards, while noting that Lebanon’s financial intelligence unit, the Special Investigation Commission, is actively cooperating with its foreign counterparts. Finally, they regretted that banks had become overly-cautious by refusing to open accounts to some foreign nationals instead of classifying them as high-risk for increased scrutiny.

47. A few success stories would allow the stock market to take off. The authorities acknowledged that the development of capital markets might be held back by current conditions; though they were confident that it could take off if a few large companies (e.g., Telecom) were to be listed.

D. Structural Reforms for Stronger and More Equitable Growth

Advancing structural reforms is key to raising Lebanon’s growth potential and improving labor market and social conditions.

48. Reviving the economy and achieving strong, sustainable, and inclusive growth are key challenges. The sectors that have traditionally been the main drivers of growth—real estate, construction, and tourism—are particularly exposed to security and political conditions. In addition, the refugee crisis has amplified economic and social challenges. There is also a widespread perception that past episodes of high growth have disproportionally benefitted selected sectors or groups, and future growth would need to be more inclusive, create jobs, and make significant inroads to reducing poverty.

49. Staff underscored the need to advance structural reforms to strengthen the economy and enhance its resilience to shocks. It noted that Lebanon might have lost some competitiveness, and the pending wage increase could pose additional problems. Staff called for measures to lower the cost of doing business, improve services—in particular electricity provision—and promote jobs, while also strengthening social safety nets. Given the currency peg, pushing structural reforms forward is essential to improving competitiveness and growth, and correcting the moderate real exchange rate misalignment (Box 6). Higher and more robust growth would also reduce Lebanon’s exposure to shocks and help restore debt sustainability.

A01ufig17

Deterioration in Competitiveness

(Index out of 7, rescaled to 100)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Source: World Economic Forum, Global Competitiveness Indicators.

50. There is an urgent need to strengthen electricity provision and lower its cost. As noted above, transfers to EdL absorb a sizeable share of government resources, and inefficient and inadequate electricity provision adds to the cost of doing business. Staff viewed increases in average electricity tariffs as the main measure to sustainably address these problems (Box 4)—though noting that the associated social impact should be properly mitigated. A more reliable service by EdL would price out expensive private generators, even after tariff increases, and contribute to more efficiency in the economy at large. Staff also called for improving transmission and distribution systems to reduce inefficiencies and minimize losses due to theft and inadequate collections. Finally, it recommended improving governance of the energy sector, as past reform attempts were stalled by vested interests and a lack of political resolve; and expressed disappointment that the debate on the salary scale adjustment had missed an opportunity to put electricity tariff increases and the reform of the sector on the agenda.

51. More efforts are needed to improve labor markets and support job creation. Lebanon’s ability to create jobs for new labor market entrants has been traditionally inadequate, resulting in high unemployment and emigration of highly-educated people. The refugee crisis has added to these pressures, by increasing the labor force but also shifting the economy toward lower-productivity sectors as most refugees are lower-skilled (Box 1). This de-skilling process could become even more pronounced if the refugee crisis continues. Improving economic prospects could help retain higher-skilled workers and move to higher-productivity sectors. There is also an immediate need to tackle poverty. Cash-for-work programs, micro-finance initiatives, and local economic development plans for the most affected communities are among possible options. Over time, modernizing labor market legislation and improving compliance with labor laws would limit the informal labor market.

52. Increased private sector participation in infrastructure investment could lift Lebanon’s growth potential. The framework law for Public Private Partnerships (PPPs) has been awaiting parliament approval; its passage would clarify the legal framework and pave the way for better governance and transparency of public projects.

Authorities’ views

53. The authorities agreed on the importance of structural reforms. Given the government’s budget constraint, they saw potential from increased private sector participation in infrastructure projects—though some noted that at times this had happened in the context of a weak regulatory environment and little cabinet oversight. They acknowledged though that a number of structural reforms had long been on the agenda, and current political conditions might not permit advancing it.

Real Exchange Rate Assessment

Lebanon’s CPI-based real effective exchange rate (REER) has appreciated slightly since 2011. This reflects appreciation of the nominal effective exchange rate, while the relative CPI inflation has remained broadly stable. Over a longer horizon, the REER has appreciated by about 9 percent from the level in 2008, a year in which the REER hit a trough, reflecting nominal effective exchange rate appreciation.

A01ufig18

CPI-Based Effective Exchange Rates

(Index, 2005 = 100)

Citation: IMF Staff Country Reports 2014, 237; 10.5089/9781484368282.002.A001

Sources: Information Notice System; and IMF staff estimates.

Lebanon’s external current account deficit has remained large and is expected to improve only gradually over the medium term. The deficit is estimated at 12¾ percent of GDP in 2013. Goods exports and tourism-related receipts have declined on account of disruptions to transit routes and heightened domestic and regional uncertainty; however, these effects were offset by increases in the number of nonresident Syrians in Lebanon—unregistered Syrian refugees are treated as nonresidents for balance of payments statistics purposes—and increased humanitarian aid flows. The current account deficit is projected to narrow to about 10½ percent of GDP over the medium term, as exports of goods and services recover with subsiding uncertainty.

The extent of the REER misalignment is assessed using Consultative Group on Exchange Rate (CGER)-type methodologies. Two standard approaches—the macroeconomic balance (MB) and external sustainability (ES)—are estimated using a new toolkit.1, 2

Lebanon’s exchange rate appears to be moderately overvalued. The assessment is in line with the finding at the time of the last Article IV consultation.

Real Exchange Rate Overvaluation Estimates Using CGER Approaches 1/

(In percent of GDP, unless indicated otherwise)

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Source: IMF staff estimates.

Using a current account elasticity of 0.32.

  • MB approach. The estimated current account norm is -9.7 percent of GDP and the underlying current account balance is 10.4 percent of GDP. The REER is estimated to be overvalued by 2.2 percent.

  • The ES approach. The current account balance that would stabilize Lebanon’s net external asset position (NEAP) at its estimated end-2012 level of -122 percent of GDP is 7.2 percent of GDP. This would imply a REER overvaluation of 9.8 percent.3

Structural reforms are needed to improve competitiveness. While temporary factors underline current weak export performance, no significant improvements in competitiveness can be expected absent structural reforms to reduce the cost of doing business and boost productivity.

1 The toolkit was developed to facilitate external assessments for countries that are not included in the Consultative Group on Exchange Rate Issues (CGER) sample; it applies the same analytical approaches as those proposed by the CGER, but to a larger panel spanning emerging and developing countries, including Lebanon, unlike in earlier assessments. Additional methodological information can be found at http://www.imf.org/external/pubs/ft/dp/2014/dp1401.pdf.2 A third approach commonly used—the Equilibrium Real Exchange Rate (ERER)—could not be applied as it relies on labor productivity data, which are not available for Lebanon. If employment is approximated by a fixed share of the population, the ERER estimation would suggest that the REER is undervalued by about 1½ percent.3 While adjusting for multilateral consistency would produce a larger REER overvaluation than suggested by these estimates, the sizeable discrepancy between the two sets of estimates calls into question the validity of this adjustment.

E. Data Issues

54. The quality of statistics is improving, but further steps are needed. The Central Administration of Statistics (CAS) released a new CPI index in March with Fund assistance;13 the production of national accounts was transferred to CAS from the prime minister’s office, and quarterly national accounts are under preparation. Staff also noted ongoing efforts to improve balance of payments statistics and plans to release international investment position data; and encouraged the authorities to address the longer delays recently experienced in the release of fiscal data. Adequate and stable funding and high-level support for CAS, along with enhanced cooperation with other agencies, will help further improve statistics. Finally, staff called for better data to underpin much needed communication and monitoring of government’s economic plans, thus contributing to their overall transparency and effectiveness; and to strengthen surveillance.

Authorities’ views

55. There was some frustration at the challenges involved in data compilation. Technical staff—at CAS and other institutions—underscored the inadequate cooperation from other institutions in providing timely inputs; and thought that policymakers need a better appreciation of the importance of reliable statistics.

Staff Appraisal

56. Lebanon’s renowned resilience is being severely tested. When the Syria crisis erupted in 2011, the economy was already in downturn after four years of strong growth and impressive reduction in public debt. Lebanon has since remained shackled to spillovers from the Syria crisis and political paralysis. Growth has sharply decelerated, the primary fiscal balance has turned into deficit, and public debt has been on an upward trend. The massive refugee population is straining economic and social structures. Unemployment and poverty have increased.

57. The outlook remains weak without decisive action. Strong regional and domestic headwinds will continue to weigh on the economy. Persistent imbalances expose Lebanon to large downside risks. Absent strong policies and reforms, potential growth will remain subdued.

58. A comprehensive, balanced, and multi-year fiscal strategy is key for achieving a sustainable debt reduction. In this context, there is a need to stop urgently the fiscal deterioration and reestablish primary surpluses. Fiscal adjustment should include both revenue and spending measures, and tilt the composition of spending away from EdL transfers into capital and social outlays. It should also include broadening the tax base and strengthening revenue collections, also by combating evasion and corruption. The authorities’ plan to pass a budget is a welcome first step in this direction.

59. The budgetary impact of the proposed salary scale adjustment should be contained. The ongoing debate on salary increases has detracted attention from the need for broader fiscal consolidation. At a minimum, any salary adjustment should be implemented in installments, with no retroactive payments, and in conjunction with productivity-enhancing measures.

60. Stronger fiscal management should support fiscal consolidation. Resuming a regular budget calendar would promote government accountability and enhance the transparency of government spending and its funding. In this context, seeking parliamentary approval for new borrowing in foreign currency would help reduce the government’s reliance on the BdL.

61. Prospective gas resources are not a substitute for adjustment. There has been excessive focus on how to use rather than properly manage these resources. It is essential to set up a transparent fiscal framework and supporting institutions to manage the related revenue transparently and equitably.

62. Monetary policy should remain geared to supporting the peg. The peg has served well as nominal anchor for the economy, and the BdL should continue to maintain high reserves. As fiscal consolidation gains ground, the BdL should gradually withdraw from T-bill auctions. Increasing over time the flexibility of T-bill rates and the transparency of T-bill auctions would lead to interest rates that better reflect the cost of funding the government and to better allocation of banks’ assets—without jeopardizing financial stability.

63. BdL’s balance sheet needs to be strengthened. Reserve accumulation, government financing and quasi-fiscal credit schemes to support the economy—and the associated sterilization costs—have all taken a toll on the BdL’s finances. Going forward, there is a need for a strategy to improve them.

64. Continued efforts to enhance bank regulation and supervision are critical. Capital buffers should be strengthened, given banks’ large exposure to the sovereign; loan classification and restructuring rules improved; and the AML/CFT framework further enhanced—to bring it in line with international standards—by taking necessary legislative steps and strengthening related risk-based banking supervision. Proper regulation and supervision of the financial system are also key to avoiding excessive risk taking and fostering a balanced development of capital markets.

65. Progress on structural reforms would unlock Lebanon’s growth potential and address social inequalities. Given the recent loss in competitiveness and the moderately overvalued real exchange rate, there is a need to lower the cost of doing business. Electricity sector reform, in particular, could yield immediate benefits. Plans to strengthen generation capacity, switch to natural gas, and increase average electricity tariffs toward cost recovery levels—while protecting more vulnerable consumers—should be implemented without further delay. Social safety nets should be strengthened and unemployment reduced.

66. Tackling the extremely large refugee crisis requires strong international support. Absent additional support, the needs of both the Lebanese communities and the refugees will not be met. Sound government policies—including a concerted policy framework to deal with refugee issues and a commitment to fiscal discipline—will send credible signals to donors and will also help mobilize the needed budget support.

67. Despite ongoing progress, data remain inadequate in some areas. Reliable and timely statistics are necessary for effectiveness, transparency and accountability of policymaking. High-level support for CAS and cooperation across institutions will help secure continued progress.

68. Staff proposes to hold the next Article IV consultation on the standard 12-month cycle.

Lebanon—Risk Assessment Matrix1

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The Risk Assessment Matrix (RAM) shows events that occur materially after the baseline path (the scenario most likely to materialize in the view of the IMF staff). The likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” indicates a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks at the time of the discussions with the authorities.

Table 1.

Lebanon: Selected Economic Indicators, 2011–19

(Population: est. 4.4 million; 2012)

(Per capita GDP: est. US$9,609; 2012)

(Quota: SDR 266 million, 0.11 percent of total)

(Poverty rate: 28 percent; 2004-05)

(Unemployment: 11.0 percent; 2011) 1/

(Main products and exports: services, jewelry)

(Key export markets: UAE, Saudi Arabia, Switzerland)

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Sources: Lebanese authorities; and IMF staff estimates.

According to a labor force survey conducted by the World Bank in April 2011. The latest official unemployment rate is 9.7 percent in 2007.

Defined as currency in circulation plus resident and nonresident deposits.

Includes nonresident deposits.

Excluding gold and encumbered assets.

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

Table 2.

Lebanon: Central Government Overall Deficit and Financing, 2011–19

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

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

Includes wages, salaries, related benefits, and pensions.

Excludes principal and interest payments paid on behalf of Électricité du Liban (EdL).

Includes transfers to the National Social Security Fund, hospitals, municipalities, Higher Relief Committee, Displaced Fund, Council of the South, bread subsidy, and the interest subsidy.

Table 3.

Lebanon: Central Government Overall Deficit and Financing, 2011–19

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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.

Includes wages, salaries, related benefits, and pensions.

Excludes principal and interest payments paid on behalf of Électricité du Liban.

Includes transfers to the National Social Security Fund, hospitals, municipalities, Higher Relief Committee, Displaced Fund, Council of the South, bread subsidy, and the interest subsidy.