Lebanon: Staff Report for the 2016 Article IV Consultation
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
24 Jan 2017
eISBN:
9781475570618
Language:
English
Keywords:
ISCR; CR; Lebanon; government; Lebanese pound; refugee; support refugee; international community; reform agenda; asset quality; investment climate; Commercial banks; Global; FX liquidity
Download PDF (904.8 KB)

Following an extended impasse, Lebanon has a new president and a new prime minister, paving the way for a number of political changes. When formed, the new government will face a challenging policy environment. The Syrian crisis continues to dominate Lebanon's economic outlook, and the associated influx of refugees (about a quarter of the population) has few, if any, international parallels. GDP growth is still subdued and Lebanon's debt burden is rising, despite modest primary surpluses. Moreover, the economy remains vulnerable to shifts in deposit inflows, which have slowed notably since last year's Article IV consultation. Most recently, the Banque du Liban (BdL) engaged in a sizable financial operation that has (among other objectives) helped restore international reserves.

Abstract

Following an extended impasse, Lebanon has a new president and a new prime minister, paving the way for a number of political changes. When formed, the new government will face a challenging policy environment. The Syrian crisis continues to dominate Lebanon's economic outlook, and the associated influx of refugees (about a quarter of the population) has few, if any, international parallels. GDP growth is still subdued and Lebanon's debt burden is rising, despite modest primary surpluses. Moreover, the economy remains vulnerable to shifts in deposit inflows, which have slowed notably since last year's Article IV consultation. Most recently, the Banque du Liban (BdL) engaged in a sizable financial operation that has (among other objectives) helped restore international reserves.

Context

1. This Article IV consultation took place at a time of major change. Following a 2½ year impasse, parliament elected a president on October 31; a few days later, a new prime minister was appointed, with a mandate to form a new cabinet. Consultations are still ongoing, but agreement is expected relatively swiftly, as solutions are needed quickly to address Lebanon’s macroeconomic challenges.

A01ufig1

Real GDP, 1995-2015

(In percent growth)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: National authorities and IMF staff calculations.

2. Spillovers from the Syrian crisis have profoundly affected Lebanon. Now in its sixth year, the Syrian crisis continues to dominate Lebanon’s outlook. The most immediate impact has been decelerating economic growth, coupled with an unparalleled inflow of refugees, now estimated at around one third of local population—the highest per capita count in the world.

3. The economy’s funding needs continue to grow. Historically, the economy has managed to sustain large imbalances and weather significant shocks, owing to its macro-financial structure—where banks channel deposit inflows from foreign investors and Lebanon’s diaspora to cover Lebanon’s sizable budget- and current-account deficits. But starting in mid-2015, inflows started to decelerate, prompting the Banque du Liban (BdL) to undertake a complex and sizable financial operation over the summer of 2016.

4. In the current uncertain environment, the priority is to reestablish the credibility of the policymaking framework, with particular focus on three key areas:

  • Restoring fiscal sustainability. The growth of public debt (above 140 percent of GDP) needs to stop immediately. Fiscal discipline will underpin confidence and support financial stability (including by reducing Lebanon’s reliance on inflows).

  • Anchoring financial stability. The exchange rate peg is the appropriate nominal anchor and the BdL needs to stand ready to increase interest rates if necessary. There is also a need to continue to monitor and mitigate risks in the banking sector.

  • Promoting sustainable and inclusive growth. Addressing Lebanon’s infrastructure deficit—a result of protracted under-investment and exacerbated by the refugee presence—requires implementing reforms to address the economy’s bottlenecks, such as electricity provision.

5. The international community must play a key role. Lebanon’s response to the refugee crisis is a testament to both its generosity and resilience. Recent initiatives to match identified needs with donor funding need to proceed swiftly, as Lebanon requires and deserves significant support.

An Increasingly Challenging Environment

6. Despite regional tensions and the conflict in Syria, security conditions in Lebanon have held up well. Such an achievement is all the more remarkable in light of the number of Syrian refugees within the country—estimates place them at around 1–1½ million (Box 1 and Selected Issues Paper on Refugee Issues).

7. There has been growing international recognition that the refugee crisis is a global problem, requiring a global response. At the London Conference on “Supporting Syria and the Region” in February 2016, the authorities presented a new plan to address the costs of the crisis (see also Box 7 below). The plan calls for $11 billion over 2016–20, comprised of both grants ($5 billion) and loans ($6 billion). Its proposals are ambitious, and seek not only to offset the increasing toll of the refugee presence, but also to help restart job-rich growth that can benefit both host communities and refugees. To date, however, funding has remained short of estimated needs.

8. Growth remains low. Lebanon is in a protracted period of low growth of 1–2 percent, well short of potential. We estimate that growth was about 1 percent in 2015, and project a similar outcome in 2016 (below the authorities’ estimate of 2 percent, though in line with most market forecasts).1 Lebanon’s traditional growth drivers—tourism, real estate, and construction—have all taken a blow, and a strong rebound is unlikely absent an improvement in political and security conditions. While lower oil prices have supported domestic demand and lowered fiscal costs, their overall impact is more mixed (Box 2 and Selected Issues Paper on Remittances). Inflation declined sharply in 2015, to an average of -3.7 percent, reflecting lower oil prices and a stronger U.S. dollar.

9. The fiscal situation is increasingly challenging. Tax revenues as a share of GDP continue to decline (see below), while interest payments have moved upward in line with public debt. A small primary surplus of 1.4 percent of GDP in 2015 was not sufficient to offset the impact of slowing nominal output growth and higher interest payments. As a result, public debt increased by 5 percentage points in 2015, to 138 percent of GDP.

10. Banks remain the economy’s chief source of funding. With assets over 350 percent of GDP, banks hold over half of Lebanon’s T-bills and Eurobonds (total sovereign exposures make up 61 percent of total bank assets). Banks, in turn, are funded primarily by deposits (including from non-residents), with generally a short-term maturity and high degree of concentration (Box 3). To further strengthen banking-sector resilience, the authorities requested a Financial Sector Assessment Program (FSAP) in the spring of 2016.

A01ufig2

Composition of Commercial Banks’ Assets

(In percent of total)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: BdL

Dealing with the Impact of the Refugees

The Syrian crisis, now entering its sixth year, has been very costly. According to the United Nations High Commission for Refugees (UNHCR), the number of Syrian refugees in Lebanon is now more than 1.4 million. Accommodating such an outsize presence has come at a substantial cost. The authorities estimate direct budget costs at around $400 million per year. And estimates of indirect costs exceed $2½ billion in terms of the erosion of public services (World Bank, 2013).

The impact of refugees: From theory…

The discussion on how to address an inflow of refugees has parallels in a number of other host countries. According to standard economic theory, in the short run, new migrants with access to the labor market will tend to lower incumbents’ wages, reflecting a lower capital labor ratio. The influx will also reduce the number of employed incumbents—some will be induced to exit the labor market. But there are also winners. Returns to capital actually increase, as the extra labor makes capital more productive (along with other complementary factors, such as skilled labor or land). Over the long run, however, these effects are unwound, as higher returns prompt higher investment and higher capital stock. Indeed, with constant returns to scale, the capital labor ratio will ultimately revert to the initial steady state, bringing back wages to their original level.

The key message from standard theory is that a modern economy is not a zero-sum game, as the number of jobs is not fixed. Instead, the economy will eventually respond to immigration by scaling up production in line with the new labor force. Market rigidities may shape the pace of adjustment, and flexible, investment-friendly economies will adjust more rapidly than economies with less flexible markets. But ultimately, economies are generally able to accommodate an addition of new workers.

…to the Lebanese reality

Key features of the Lebanese economy may confound the (benign) predictions of standard models.

  • Firstly, the length of adjustment will depend on the investment climate—the easier it is to scale up the capital stock, the more quickly the economy will move to the new steady state. In advanced economies this scaling up generally takes place in a few years (Dadush, 2014). But Lebanon’s investment climate has significant shortcomings, given poor infrastructure and low public investment.

  • Secondly, the nature of Lebanon’s labor market may exacerbate the impact of Syrian refugees. Studies from advanced economies tend to downplay the impact of unskilled immigration, noting that native wages generally remain unchanged, and finding that many incumbents often move to occupations where local knowledge and linguistic ability offer a comparative advantage (IMF, 2016). The Lebanese market is perhaps less accommodating. Data are scarce, but estimates suggest that almost half of the workforce is employed in the informal sector, and so is likely to compete directly with new refugees. Moreover, these workers are not covered by any social safety net, making them particularly vulnerable. Early estimates suggest that unskilled wages in some areas have fallen by as much as 50 percent (ILO, 2014), potentially tipping as many as 170,000 residents below the poverty line (World Bank, 2013)—although it is unclear how many of these represent existing Syrian migrants.

  • Thirdly, current studies may not be applicable to Lebanon given the scale of immigration in Lebanon over a short period. Most empirical studies investigate relatively moderate increases in the labor force (and available jobs). Given the scale of the refugee presence, the size of Lebanon’s labor shock may have outstripped some of its potentially beneficial impacts had the shock been smaller.

  • Finally, standard models are silent on the role of unpriced factors, such as public goods and infrastructure. Implicitly, these are scaled up in line with the capital stock by the local authorities. But given Lebanon’s political situation, and its limited fiscal space, this cannot be taken for granted. Furthermore, there may be negative externalities owing to an overburdening of existing public goods.

Sources: Uri Dadush, 2014, “The Effect of Low-Skilled Labor Migration on the Host Economy.” KNOMAD Working Paper 1.ILO, 2014, “Assessment of the Impact of Syrian refugees in Lebanon and their Employment Profile.”IMF, 2016, “The Refugee Surge in Europe: Economic Challenges” SDN/16/02World Bank, 2013, “Lebanon: Economic and Social Assessment of the Syrian Conflict.”

Impact of the Oil Price Decline on Lebanon—A Mixed Picture

While a sharp decline in oil prices is seemingly a positive shock for an oil importer country like Lebanon, on balance its net effects are more mixed. The magnitude of positive and negative impacts is uncertain and critically depends on the pass-through of global prices into domestic retail prices. In that respect, Lebanon has one of the highest pass-through in the region—gasoline pump prices have declined by 49 percent since their peak in April 2012. Yet, Lebanon’s strong ties with (now weaker) regional oil exporters—a key source of external demand and funding—make the assessment more nuanced and may offset some of the positive direct impacts of lower oil prices.1

A01ubx1fig3

World Oil Price vs. Price of Regular Unleaded Gasoline

(Index: January2014 = 100)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: IMF Middle East and Central Asia REO

The oil price shock has affected the Lebanese economy through various channels.

  • Higher consumption: Consumers react to the effective income boost of lower oil prices. However, absence of micro-data at the household level makes it difficult to estimate such impact.

  • Lower import costs: Oil imports become cheaper, though according to staff estimates the price elasticity of oil demand is relatively low. Thus the import decline owing to lower oil prices is very modestly offset by increased consumption of oil volumes.

  • Better fiscal position: The primary impact on the budget is on the spending side, as the sensitivity of public revenue to changes in oil prices is small (excises and VAT on gasoline—gasoil is fully not taxed—are the only taxes directly related to oil). However, the electricity company EdL has been producing electricity from fuel oil at a loss, requiring larger government transfers. These used to average about 4 percent of GDP (around $2 billion) prior to the oil shock in mid-2014. EdL transfers declined to 2.8 percent of GDP in 2015 (and projected at 1.5 percent of GDP in 2016).

A01ufig4

Growth in Trade Deficit vs. Oil Price Movement

(percent, Y-o-Y)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

  • Lower deposits/remittances and FDI to Lebanon: A sizable share of the Lebanese diaspora lives in GCC countries and other oil producers in West Africa; remittance inflows from these countries have declined. More generally, less money is expected to come from these countries given their tighter liquidity conditions, either through property buying (FDI) or deposits from both Lebanese and foreign investors. There could thus be repercussions for the Lebanese real estate market as well as banks’ liquidity—with possible spillover into the fiscal sector given the government’s large funding needs.

  • Lower exports: The GCC countries are Lebanon’s key export market for goods (along with Iraq and Syria), accounting for over 40 percent of Lebanon’s share of goods exports. Lower exports will partially offset lower oil imports. However, if the marginal propensity to consume out of savings from lower oil prices is high, higher non-oil imports may also offset some of the benefits from lower oil imports.

  • Lower tourism: A large amount of (high-end) tourists have typically come from GCC countries, though their numbers have started to decline significantly with the onset of the Syria crisis. The oil price decline will likely not help their numbers to recover to pre-crisis levels.

1 Our assessment is in line with previous findings (on the upsides of high oil prices for Lebanon) in Kyobe, A. and A. Sadikov, 2012, “The Price of Oil and the Lebanese Economy: A Blessing in Disguise?” IMF Country Report No. 12/40.

11. Deposit inflows have slowed. In the past, foreign-deposit inflows (between $8–12 billion per year) have been a key sign of confidence. Deposit growth has eased over the past couple of years, particularly since mid-2015. And notwithstanding a recovery over the summer (in part triggered by the BdL’s actions, see below), by early-November 2016, year-to-date growth was $6 billion—or 4.7 percent growth on an annualized basis. The slowdown is likely explained by various factors including tighter liquidity conditions in GCC countries (a key source of deposits for Lebanon) and increased risk premia on Lebanese financial assets.

A01ufig5

Y/Y Change in Commercial Bank Deposits

(In USD billions)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: Banque du Liban

12. Lebanon’s external position remains challenging. The current account deficit is estimated to have narrowed by 7 percentage points to 18.2 percent of GDP in 2015 (though data are subject to frequent revisions). This decline is largely explained by lower oil prices, rather than by a contraction in non-oil imports. But goods-and-services exports continue to decline, owing to the impact of regional conflict on key trading partners and routes. Despite the improved current account, slowing financial inflows has prompted a contraction in Lebanon’s Net Foreign Assets (NFA) position, at least through mid-2016.

A01ufig6

Net Foreign Assets

(In USD billions, annual change)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: BdLandIMF staff calculations

13. As a result, the BdL has taken steps to shore up its reserves. With easing deposit inflows, gross reserves fell over 2015–16 to reach $35.1 billion in May 2016, a decline of 10.1 percent from a peak in May 2015. In response, in mid-2016 the BdL engaged in a sizable financial operation with a number of components and counterparts (Box 4).

14. The operation has had a number of implications. It has: (i) strengthened BdL’s gross foreign exchange buffers, to $40.6 billion by end-October; (ii) reversed the cumulative decline in Lebanon’s NFA position (to a cumulative $555 million by end-September, from -$1.4 billion through end-July); (iii) improved the capital buffers of banks; and (iv) reduced local-currency funding costs for the government and private sector. At the same time, the operation also created significant Lebanese pound liquidity (equivalent to one third of GDP); sizably reduced banks’ FX liquidity held abroad; narrowed the spread between LL and USD deposit rates, adding to dollarization risk; and increased the FX liabilities of the BdL (and related carry costs), thus affecting the BdL’s balance sheet.

A01ufig7

BdL FX Assets, 2008-2016

(In USD billions)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

15. Appetite for Lebanese external debt has softened. Eurobond yields have increased by almost 70 bps over the past 12 months, compared to an average drop of around 70 bps for other emerging markets. Spreads have thus increased, to over 500 bps and 250 bps vis-à-vis U.S. Treasuries and emerging-market instruments, respectively.

A01ufig8

5-Year Spreads vs US Treasuries 1/

(In basis points)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

1/ Lebanese seriesuse BVALvaluesprovided by Bloomberg.Source: Bloomberg

16. The country’s credit ratings reflect Lebanon’s challenges. Moody’s downgraded Lebanon from B1 to B2 in December 2014; and Fitch downgraded Lebanon to B- in July 2016. S&P, on the other hand, has kept its B- rating since November 2013, though it upgraded the outlook from negative to stable in 2016. Rating agencies’ assessments continue to focus on the bank-sovereign nexus, slowing deposit growth and reserves, domestic political uncertainties, and rising fiscal difficulties.

A01ufig10

Lebanon’s Credit Ratings

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

17. There has been limited progress on structural reform.2 Laws on anti-money laundering and combating the financing of terrorism (AML/CFT) were passed in November 2015; and more recently, legislation on tax transparency and exchange of information was also passed.3 But over the past few years, parliament has met rarely and key legislative initiatives remain pending: legislation on developing Lebanon’s offshore gas fields has yet to pass, along with similarly delayed electricity- and safety-net reforms.

Deposit Concentration and Deposit Growth

Deposits in Lebanese banks are highly concentrated. For the domestic banking system at end-2015, it is estimated that 16,000 accounts (less than 1 percent of all deposit accounts) held 50 percent of total deposits, while 1,600 accounts (less than 0.1 percent of all accounts) held 20 percent of total deposits. Classified by bucket sizes, 84.6 percent of total deposits are in accounts with balances greater than $100,000, 50.2 percent in accounts with balances greater than $1 million, and 3.7 percent of deposits in accounts with balances greater than $100 million. The concentration is higher in foreign currency than LL accounts.

A01ufig11

Deposit Concentration

(In percent)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: BCC and IMF staff calculations.

Large accounts have been a key driver of deposit growth.

  • Between end-2008 and end-2015, deposits in “smaller accounts” (< $1 million) have grown by 55 percent, whereas deposits in “large accounts” (> $1 million) have grown by 185 percent.

  • Much of the slowdown in deposit growth in 2015 can be attributed to large depositors. While, in recent years, accounts with balances greater than $1 million had grown by about 12–14 percent per year, in 2015, their growth rate declined to about 5.8 percent, driving much of the decline in deposit growth observed in 2015.

Given the size of the large deposits, the share of nonresident deposits may be larger than commonly believed.

A01ufig12

Deposits in Accounts, by Balance Amount

(In USD billions)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: BCC and IMF staff calculations.
A01ufig13

YoY Growth in Deposits (June-to-June) by Size Buckets

(In percent)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: BCC and IMF staff calculations.

The BdL’s Financial Operation

In June 2016, the BdL engaged in a financial operation to strengthen its foreign exchange reserves, among other objectives. As of May 2016, the BdL gross reserves had declined y/y by 10.1 percent or $3.9 billion and stood at $35.1 billion, reflecting lower foreign exchange (FX) inflows and the economy’s large FX funding needs. The operation consisted of various steps and targeted various objectives:

  • BdL’s purchase of newly-issued Eurobonds from the Ministry of Finance ($2 billion). In the last week of May 2016, the BdL swapped Lebanese pound (LL) government debt for the new Eurobonds with the MoF. This helped reduce public debt service costs and lengthen the public debt maturity structure.

  • BdL’s sale of Eurobonds and other FX securities to the banks ($13 billion according to staff estimates). Starting in June, the BdL invited banks to buy the newly-acquired Eurobonds and FX-denominated long-term CDs. The BdL gross FX reserves increased to $40.6 billion by end-October; and the consolidated NFA position turned positive in September, to a cumulative $555 million.

  • Banks’ sales of LL instruments to the BdL and strengthening of banks’ capital position. Banks were offered sizable incentives to participate in the operation. For each purchase of FX securities, banks were eligible to discount an equivalent amount of LL T-Bills or CDs to the BdL at a zero percent, and split equally the income with the BdL.1 The BdL instructed banks to retain all the income from the transaction as provisions in LL for a prospective implementation of IFRS 9 accounting rules in 2018 (by creating a 2 percent general provision against the loan book and a graduated increase in the Capital Adequacy Ratio from 12 percent to 15 percent by 2018). The discount of T-bills and CDs at zero percent is akin to a money-financed capital injection (without any equity stake in return; according to staff estimates, equivalent to 10 percent of GDP), which helped strengthen banks’ capital buffers.

Banks used various approaches to attract foreign currency. They sold Eurobonds to foreign clients at prevailing rates and drew down their own FX liquidity—in part by repatriating funds from correspondent banks. A few banks also passed on part of their income to high net-worth depositors, by offering very attractive rates on sizable deposits. As a result, annualized deposit growth rate increased from 3.5 percent at end-May to 4.7 percent by early-November.

Banks are now facing sizable excess LL liquidity. As of mid-October, the operation had resulted in sizable liquidity (equivalent to a third of GDP, some of which is being mopped up and already been invested in newly-issued LL T-Bills). The BdL has taken various steps to reduce this liquidity further, and thus mitigate possible dollarization risks: (i) it is issuing long-maturity term deposits (of 5 years or more) at rates slightly below the prevailing LL rates, provided that participating banks subscribe 14 percent of any placement with the BdL in 5-year, 5-percent government bonds; and (ii) it has asked banks to extend additional LL lending (though in the current economic climate, asset quality may be affected in the future).

At the same time, the banks’ internal FX liquidity position has weakened. Before the operation, banks’ FX liquidity held abroad had declined from a peak of $18 billion in June 2011 to $10.4 billion by May 2016; by end-August, it was below $8.5 billion, increasing banks’ reliance on the BdL for FX liquidity. Lower FX liquidity has led to increased FX deposit rates, narrowing the spread between LL and FX deposit rates and reducing the attractiveness of LL deposits. Moreover, since the incentives offered by banks to depositors focused on giving them one-off upfront income (instead of higher interest rates), prospects for keeping the new inflows in the system remain uncertain.

Finally, the operation also had an impact on BdL’s balance sheet. It added to the foreign exchange liabilities of the BdL and the associated carry costs.

1 For example, a bank discounting a security with face value of LL 100 with 8 percent coupon and remaining maturity of 10 years received upfront LL 140 (that is, LL 100 principal plus an immediate income of 40, equal to half of the LL 80 it would have ultimately received (over time) if the security had been held to maturity.

Outlook and Risks

18. Under the baseline, growth will likely remain subdued—too low to address Lebanon’s macroeconomic imbalances and social challenges. We assume that the impact of the Syrian conflict will remain broadly unchanged over the forecast horizon, depressing domestic confidence and leaving a (modest) global recovery as Lebanon’s chief growth driver over the medium term.4 Thus, Lebanon’s output gap will remain open even toward the end of the projection period. As oil prices normalize, inflation is expected to return to trend (around 2 percent) by early 2017.

19. And without a change in sentiment, the economy’s funding base will remain soft. Taking into account the BdL’s financial operation, deposit inflows will likely total about $8 billion in 2016, up from about $7 billion in 2015. But with the operation now closed, and under an (unchanged-policy) baseline assumption no adjustment and reform, inflows are projected to return to the levels seen in the early half of the year—short of the levels needed to fund the economy over the medium term.5

20. Upside potential is significant. With the election of a president, Lebanon now has the opportunity to move beyond its recent political impasse. It is too early to project the likely impact of a new political settlement, as key milestones will likely require time to be met. But the prospect of a government able to tackle the country’s long-pending reform agenda could have a material impact on confidence and growth, boosting inflows, supporting financial stability, and helping Lebanon’s debt dynamics. Similarly, Lebanon’s outlook is linked closely to developments in Syria. In the event of an early resolution, Lebanon would be uniquely placed to benefit from the reconstruction effort, as well as from the reestablishment of trade and an improvement in regional investor confidence.

21. But sizable vulnerabilities and risks remain (see Risk Assessment Matrix):

  • Deposit inflows could decelerate further. The willingness and ability of depositors to fund Lebanon cannot be taken for granted, especially with the prospect of tighter regional and global financial conditions, and in light of shifting geopolitical tensions. The concentration of deposits, short-term maturity structure, and share of nonresident depositors in the Lebanese banking system all add to Lebanon’s vulnerability (Box 3).

  • Growth could weaken further. Lower growth would compound Lebanon’s adverse debt dynamics and imbalances, and ultimately impair banks’ asset quality.

  • Fiscal imbalances could widen. Increased spending pressure, or continued inertia, would increase public debt, possibly leading to financing pressures and lower investor confidence. This could, in turn, spread into the macro-financial sphere—triggering lower deposits, higher financing costs, deteriorating bank finances, and falling reserves.

Lebanon: Risk Assessment Matrix1

article image

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Authorities’ Views

22. The authorities broadly agreed with staff’s assessment of risks. They noted the significance of regional political developments in shaping Lebanon’s outlook, highlighting in particular the impact of the Syrian conflict. They also shared staff’s assessment regarding the importance of continued deposit inflows, underscoring that regional competition for funds had become more intense. But they noted that much of the recent slowdown in activity had resulted from the prolonged political impasse in Lebanon, and that the formation of a new government would likely result in a substantial turnaround in confidence, investment, and growth.

Policy: Action Needed to Anchor Confidence

23. With limited policy change, domestic and external vulnerabilities have deepened. Lower growth and a larger debt burden have increased the adjustment needed to stabilize Lebanon’s debt dynamics; and if slow deposit inflows persist, Lebanon’s external position might weaken. On this basis, our estimates and projections paint a less sanguine picture compared to just one year ago.

A01ufig15

2016 Outlook: IMF Staff Projections

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

24. As Lebanon’s outlook is growing less benign, only coordinated policy actions can anchor confidence. Lebanon’s macrofinancial structure rests on the banking sector’s ability to attract continued inflows, while maintaining confidence in the peg. As fiscal sustainability, depositor confidence, financial stability, and exchange rate credibility are all tightly interconnected, the policy response to address Lebanon’s challenges must include various policy areas.

25. In this context, corrective measures are urgently needed.

  • Over the short term, the key challenge will be to preserve the confidence of foreign investors, by articulating a credible policy mix that starts to address fiscal imbalances as a matter of urgency, while also strengthening the resilience of Lebanon’s banking sector.

  • Over the longer term, social stability and shared prosperity require job-rich, sustainable growth.

26. The 2016 consultation thus focused on three key themes: (i) starting the process of fiscal adjustment immediately; (ii) standing ready to increase interest rates to support financial inflows, if needed; while safeguarding financial stability; and (iii) laying the ground for higher-quality and more inclusive growth.

A. No Substitute for Fiscal Consolidation

27. Lebanon needs to make major progress in lowering the public debt burden. Over 2005–10, public debt dropped by 5 percentage points of GDP per year on average, owing to high growth and sustained primary surpluses. But as real growth decelerated in 2011, this impetus weakened; and by 2015, the debt ratio started to increase again.

A01ufig17

Growth and Fiscal Indicators, 2000-2021

(Percent)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: National authorities and IMF staffcalculations

28. Low growth is a primary driver of Lebanon’s adverse debt dynamics, but not the only one. The drop in tax revenue of 4 percentage points of GDP in just four years suggests that other factors are at play, including tax policy changes (such as reductions in fuel taxation in 2011–12) and deteriorating compliance (see Selected Issues Paper on Revenue Mobilization). Meanwhile, wages, interest payments and transfers to Electricité du Liban (EdL) accounted for close to 70 percent of total expenditure in 2015. Capital spending has narrowed to about 1 percent of GDP, significantly below levels in comparator countries;6 and social spending remains inadequate to address Lebanon’s needs.

A01ufig16

Drivers of Debt Dynamics

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: IMF staff calculations.

29. Under current policies, debt dynamics will deteriorate further. In the baseline scenario, low oil prices will help secure sustained primary surpluses of about 1½ percent of GDP. Nonetheless, higher interest rates and subdued nominal growth will push public debt to 160 percent of GDP by 2021—almost 20 percentage points higher than today (Annex II).7 At the same time, spending rigidities will increase, with the interest bill projected to exceed 11 percent of GDP by 2021, or about 60 percent of total revenue. Fiscal risks may add further pressure, including sizable pension liabilities,8 demands to adjust public wages,9 a potential increase in oil prices, and a possible softening in investor appetite for Lebanese debt.

A01ufig18

Composition of Spending

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: National authorities and IMF staffcalculations

30. Fiscal adjustment is essential. And while adjustment at a time of low growth makes policy trade-offs particularly acute, protracted inaction will prohibitively increase the size and cost of adjustment needed in the future (Box 5).

Fiscal Adjustment and Growth Trade-Offs

Fiscal policy affects growth via many channels, mainly by tax and expenditure policies. However, there is only limited consensus in the literature on the size and durability of fiscal impact on growth. The empirical evidence suggests that the size of the impact may depend on the type of fiscal instrument used, the state of the business cycle, degree of trade openness, and type of the exchange rate regime, among other factors. While the empirical evidence is extensive for advanced economies, much less is known about the impact of fiscal policies in MENAP countries.

A01bx5ufig19

Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source:IMF staff calculations.

Assuming the composition and size of the proposed upfront adjustment, growth is expected to be temporarily reduced by 0.8 and 0.4 percentage points in 2017 and 2018. Based on the framework to quantify the size and persistence of fiscal multipliers by Cerisola and others (2015),1 elimination of a transfer to EdL has only a temporary effect on growth, while the impact of the proposed tax measures is expected to last for two years.

While the impact of lower growth on debt dynamics is negligible, postponing the adjustment by two years increases debt-to-GDP ratio by about 10 percentage points of GDP. These estimates are subject to large uncertainty. Nevertheless, assuming more lasting and negative impact of the proposed tax measures on growth, is unlikely to affect debt dynamics as negatively as its postponed implementation.

A01bx5ufig20

Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: Ministry of Finance and IMF staff calculations.
1 Cerisola M., A. Abdallah, V. Davies, and M. Fischer, 2015, “Assessing The Impact of Fiscal Shocks On Output in MENAP Countries”, Technical Notes and Manuals, IMF.

31. The amount of adjustment needs to be sufficient to immediately halt further debt increases. A primary balance of 4 percent of GDP would be sufficient to stabilize debt, requiring an upfront adjustment of about 3 percent of GDP—if sustained, such an adjustment would place debt on a downward path within 5–6 years. Debt would then slowly decline to 133 percent of GDP by 2030. While such a surplus might seem large compared to the experience of other countries, in the case of Lebanon it needs to be viewed against high budget deficits and mounting funding needs and interest bills.

32. There is no substitute for upfront adjustment. Neither donor assistance, resolution of the Syrian conflict, nor any prospective revenue from oil and gas would, in itself, sustainably resolve Lebanon’s debt dynamics.

  • Donor assistance. Assuming grants increase over 2017–21, each year by between $400 million and $1 billion (about 0.5 to 1.9 percent of GDP, in line with the authorities’ grant requests at the London conference), the impact on Lebanon’s debt to GDP trajectory would be small.

  • Resolution of the Syrian conflict. Lebanon stands to gain significantly from Syria’s reconstruction effort when the conflict ends. But even under a favorable scenario—with the Syrian conflict ending by end-2017, Lebanon’s output gap closing immediately, and economic output rising by the equivalent of 10 percent of Syrian GDP—the positive impact on growth will not be sufficient for debt sustainability.

  • Oil and gas resources. The size and income from Lebanon’s off-shore resources are uncertain. And given that exploration has not yet started, it could take several years before the government would start receiving revenue.

A01ufig21

Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Note: Grants would be dispersed between 2017 and 2020.Sources: Ministry of Finance and IMFstaffcalculations.
A01ufig22

Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Sources: Ministry of Finance and IMFstaffcalculations.

Key recommendations

33. Our proposed adjustment package combines revenue and spending measures (see Table below). The package needs to be adopted in its entirety to achieve the targeted primary adjustment:

  • Passing a credible budget—the first in a more than decade—remains a critical priority. In this context, the Minister of Finance’s recent efforts to submit a 2017 budget to cabinet are praiseworthy, and passing a budget would provide a tangible sign of reform commitment. Ongoing work to close accounts since 1993 needs to continue in parallel with the passing of a budget.10

  • Long-standing revenue measures need to be implemented. 11 These include: (i) an increase in the corporate income tax rate (from 15 to 17 percent); (ii) the introduction of a capital gains tax on real estate; (iii) an increase in the rate on interest income tax (from 5 to 7 percent, though timing may depend on deposit behavior); (iv) an increase in the VAT rate from 10 to at least 11 percent; (v) an increase in tobacco excises; and (vi) new stamp duties and fees.

  • Increasing fuel taxation is overdue. Low retail prices provide a unique opportunity. The VAT on diesel (suspended in 2011) needs to be restored and gasoline excises (significantly lowered in 2012) need to be increased to earlier levels, also to start containing negative externalities of high fuel consumption. The impact of such measures needs to be compensated by strengthening the social safety net (see below).

  • There is scope to increase tax compliance. Tax collection is only 50 percent of estimated capacity (Box 6 and Selected Issues Paper on Revenue Mobilization). Ongoing efforts in this area to further promote electronic tax declaration, among others, need to be strengthened. Although the capacity of tax administration has increased by 120 staff in 2016, the needs are estimated to be five times higher.

Impact of Proposed Fiscal Measures on Budget Balance

(In percent of GDP)

article image

  • Average electricity tariffs need to be increased to reduce (and eventually eliminate) transfers to Electricité du Liban. Current proposals to link tariffs to new additional capacity, while protecting lower-end consumers, are welcome, as they should allow for an improvement in service without worsening the fiscal situation. But these are a first step only. Improved service from EdL will help reduce the average household energy bill, and so provide scope for further tariff increases in the future, with the goal of eliminating the EdL subsidy altogether.

VAT—A Good Candidate for Revenue Mobilization in Lebanon

There is need and scope to mobilize tax revenues in Lebanon, especially given the country’s fiscal position. Tax revenue performance in Lebanon is weak and has been driving the drop in public revenues since 2010; and remains below the regional average.

Central Government Revenue, 2010 -2015 (percent of GDP)

article image
Source: National authorities and IMF staff calculations.

Lebanon’s tax effort (the ratio of actual tax revenue to capacity—the maximum tax revenue a country can ideally achieve) is lower than in similar MCD countries. Based on Fenochietto and Pessino (2013),1 Lebanon’s tax effort is only 50 percent, indicating, tax revenues might be doubled to around 30 percent of GDP at maximum effort. This compares to an average of 60 percent for similar MCD countries and a world average of about 70 percent.

VAT is typically a good candidate for revenue mobilization. It is one of the least distortive taxes with generally the highest share in total tax revenue. As the structure of the Lebanese economy is oriented towards private consumption and a high share of imports, the potential gains from mobilizing VAT revenues are significant.

A01ufig23
Source: IMF staff calculations

A VAT gap analysis points to significant VAT erosion over time.2 This analysis measures the overall gap between actual VAT receipts and receipts under a perfectly enforced VAT levied on all consumption.3 In turn, this gap can be disentangled into two components: (i) the compliance gap, which estimates the impact of imperfect compliance within the current tax system; and (ii) the policy gap, which calculates the deviation of current tax rules from the benchmark tax levied on all consumption. For Lebanon, the overall VAT gap was estimated at around 7.4 percent of GDP in 2013; up from 6.1 percent in 2009. The compliance gap of 3.3 percent of GDP has been stable over time. The policy gap is continuously rising to 4.0 percent of GDP—very close to actual VAT collected in 2013. The substantial part of the policy gap is a consequence of discretionary policy decisions—mainly the VAT exemption of gasoil in March 2012.

VAT Tax Gap (percent of GDP)

article image
Source: National authorities and IMF staff calculations.

Policy simulation suggest there is room to improve fiscal performance and debt dynamics over the medium term assuming only incomplete and gradual elimination of the VAT gap. Assuming a gradually elimination of a 50 percent of the compliance gap and a partial elimination of the policy gap—representing tax expenditure—that would happen over the next five years, the primary balance would increase from 1.1 percent to 5.2 percent of GDP, the overall balance would improve from -8.1 to -5.6 percent of GDP and the public debt would stabilize at about 150 percent of GDP in 2021. Therefore, this analysis suggests that even a partial elimination of the VAT gap can lead to a significant improvement in fiscal performance.

A01ufig24

Public Debt - VAT Gap Reduced (Percent of GDP)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: National authorities and IMF staff calculations.
1 Fenochietto, R. and C. Pessino, 2013, “Understanding Countries’ Tax Effort,” IMF Working Paper 13/244, (Washington: International Monetary Fund).2 Source: Revenue Administration Gap Analysis Program—The Value-Added Tax Gap (2016).3 Source: Current Challenges in Revenue Mobilization: Improving Tax Compliance (2015).

  • A long-standing salary scale adjustment for the public sector poses challenges. If passed, its budgetary costs need to be fully offset to preserve the targeted fiscal adjustment (for example by considering broadening the VAT tax base and increasing VAT rates); at a minimum, salary increases should be phased in without retroactive payments; and should ideally be linked to measures to strengthen productivity and rationalize public sector employment growth.

  • The National Poverty Targeting Program (NPTP) needs to be strengthened. The NPTP is an essential part of Lebanon’s (nascent) social safety net, and provides support to households living in extreme poverty. The program is funded in part by grants from the World Bank and UNDP, but a proposal for additional government funding is currently waiting for the ministry of finance’s approval, which should be granted as a matter of priority.

34. Over time, as adjustment takes hold and as growth recovers, public investment and social spending need to be increased. Rebalancing spending was a key focus of last year’s consultation, and bears repeating.

35. An appropriate oil and gas framework is needed. Legislation on an exploration and fiscal regime for the oil and gas sector needs to be passed. A formal engagement with the Extractive Industries Transparency Initiative (EITI) would signal a commitment to transparency and accountability.

Authorities’ Views

36. The authorities are aware of the importance of front-loaded fiscal adjustment and the costs of delay. They acknowledged that debt-service costs pose a problem for sustainability, while also crowding out needed spending. Although a number of measures—including stricter implementation of spending ceilings as well as tax proposals—were presented in the draft 2016 budget, a number of additional measures are expected to be approved and implemented once a new government is formed. At the same time, the authorities noted that, in the post-electoral environment, spending pressures might intensify, especially if additional hiring in the public sector continues.

37. The proposed salary scale adjustment remains a sensitive issue. The authorities are aware of the need to combine salary increases with reforms in the public sector employment, especially to eliminate distortions in the wage structure across different public administration sectors. They noted that public sector employees are entitled to the (long-delayed) salary increases, also to secure a more decent living for public servants and to mitigate corruption in the public sector.

38. There was broad agreement on the design and implementation of the adjustment proposed by staff. While agreeing on the tax measures, the authorities were of the view that improvements in tax compliance and collections should precede increases in tax rates. They also agreed that EdL transfers should be reduced and eventually eliminated, though they noted some disappointment at the lack of progress on proposals to change the tariff structure.

39. The authorities reiterated that the international community needs to provide additional assistance, especially direct budget support. They stressed the global public good afforded by Lebanon’s hosting such a large refugee presence. And they requested that the international community provide additional funding, not only as humanitarian aid, but also in the form of budget support. They also noted that, while funding in some areas had increased, the lack of longer-term commitments makes the provision and scaling up of critical services particularly challenging, as effective interventions will span over a number of years—in the case of education, for example, the authorities noted that they cannot educate children for one year and suspend their education the next for lack of funding.

B. Preserving Confidence in Lebanon’s Financial System

Using Interest Rates to Secure Buffers

40. The BdL is bearing much of the burden of economic policy. It has effectively operated as a policy maker of last resort—playing a critical role in preserving stability and supporting Lebanon’s exchange rate peg (Lebanon’s key nominal anchor). In this context, while the BdL’s recent financial operation has helped offset a decline in reserves, it cannot offer a sustainable solution to Lebanon’s funding needs. Absent an improvement in depositor sentiment, the BdL will need to attract fresh inflows, which may require higher interest rates. To date, the BdL has not yet raised rates owing to concerns about public debt dynamics and growth. But a policy change will be unavoidable if deposit growth does not improve.

41. The timing and extent of any potential change in interest rates will depend on Lebanon’s fiscal stance.

  • Fiscal adjustment would help reduce the government’s financing requirements, especially in foreign exchange. The BdL has been providing foreign exchange to the government through an overdraft facility12—allowing the government to draw foreign exchange resources beyond the ceiling set by law on its (non BdL) foreign currency borrowing. In the context of softening deposit inflows, funding the government’s foreign currency needs might place added strain on reserves.

  • Fiscal adjustment would also pave the way for more market-determined interest rates. The BdL has sometimes helped finance the government by offering long-term instruments to banks and channeling the proceeds to cover shortfalls in both the T-bill market and the Eurobonds market. As a result, T-Bill yields have remained largely unchanged since 2012, muting their role as a key market signal. Finally, the BdL also has adopted a range of quasi-fiscal initiatives to channel subsidized credit to support the economy, particularly to the real estate sector ($4.4 billion over 2013–16).

Key recommendations

  • Monetary policy needs to remain geared to supporting the exchange rate peg.

    • If deposit growth were to soften, rather than relying on a repeat of its recent operation, the BdL would instead need to use interest rates as a more direct and easily communicated policy tool to secure foreign exchange inflows. In this regard, the BdL also needs to communicate the size and scope of its recent operation to reduce market uncertainty.13

    • While an interest rate increase would have an impact on debt service for both the private and public sector and increase banks’ cost of funding, such costs should be cast against the implications of the recent BdL operation.

    • Given the size of their reserve buffers (which remain adequate, Annex III), the authorities have some freedom to choose the pace and timing of any interest rate move.

  • Steps to absorb excess liquidity need to be accompanied by efforts to encourage banks to improve their net foreign asset position. The BdL needs to continue to sterilize the excess Lebanese pound liquidity created by the financial operation, while remaining vigilant to ensure that new lending does not undermine asset quality. Going forward, as financing needs are reduced, banks need to be encouraged to rebuild their foreign exchange liquidity buffers abroad—taking into account rollover and dollarization risks.

  • As fiscal adjustment takes hold over time, the BdL would need to withdraw from T-Bill and Eurobond auctions and encourage banks to participate directly. As an incentive, it would gradually reduce the attractiveness of placements with the BdL, paving the way for more flexible and market-based yields on government instruments. Overall, this will encourage greater fiscal discipline.

  • As conditions normalize, the BdL also needs to withdraw from quasi-fiscal schemes. It would need to allow old subsidized credit schemes to expire, while refraining from adding new ones. Looking forward, there is a need to strengthen the BdL’s balance sheet, as its income position has been impacted by repeated policy interventions.

Authorities’ views

42. In the authorities’ view, the financial operation has met several objectives and has helped preserve financial stability. The BdL emphasized the following seven objectives: strengthening BdL’s foreign currency assets, enhancing the capital base of banks, increasing liquidity in local currency, improving the government debt profile by reducing the cost of borrowing, improving the balance of payments, targeting positive inflation rate, and improving the country’s rating and outlook. They pointed to steps being taken to sterilize the excess (local-currency) liquidity created by the operation, and underscored that the operation had boosted confidence. In their view, staff’s assessment of the operation was rather negative, and the market needed time to absorb the operation’s implications. The authorities continued to view interest rate tools as excessively costly to the economy, and felt that the financial operation was the best option at hand given the various constraints and pressures faced at the time it was undertaken.

Preserving Confidence in the Banking System

43. Lebanon’s resilience hinges on the continued health of its macro-financial structure. The FSAP findings (see Financial Sector Stability Assessment (FSSA) report) suggest that the country’s challenging economic environment and the government’s growing funding needs are having an impact on banks. Moreover, while regulatory capital requirements exceed the minimum levels set under the Third Basel Accord, banks’ capital buffers are modest in light of their significant exposure to local-currency sovereign debt and foreign-currency BdL instruments.

  • Sovereign exposure. Risk weights are not in line with international standards.14 In the event of a sovereign downgrade to a rating below “B-” and a corresponding increase in risk-weights for all FX-denominated instruments to 150 percent—as per Basel’s standardized approach—the impact would be a reduction of regulatory capital by an estimated 6 percentage points.

  • Interest rate risk. Banks are primarily funded via short-term deposits and have a large portion of their investments in long-term sovereign instruments, pointing to interest rate risk.

  • Asset quality. Despite a slowdown in the real economy, reported nonperforming loans (NPLs) have remained relatively stable over past five years, at 10.4 percent by end-June 2016.15 Banks are also significantly exposed to Lebanon’s softening real estate sector—either directly in the form of housing loans and loans to developers, or indirectly in the form of loans to corporates, in turn collateralized by real estate.

  • Foreign currency liquidity needs. A large share of banks’ foreign currency assets (e.g., long-term deposits with the BdL) cannot be immediately pledged in the interbank market to raise liquidity, suggesting that large liquidity shocks might quickly involve the BdL as lender of last resort. And net foreign assets of banks have declined. At present, 1 percent of deposits (or $1.6 billion) represents 4 percent of BdL’s gross reserves, highlighting the systemic importance of sufficient liquidity buffers.

A01ufig25

Banks’ Net Foreign Asset/(Liability) Position

(In USD billions)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: BdL.

44. Assessment of compliance with the Basel Core Principles (BCP) found that the supervisor is well respected, though continued progress is needed in a number of areas. The Banking Control Commission’s (BCC) deserves credit for raising supervisory standards; at the same time, the supervisory approach does not yet support a clear view on the risk profile and systemic relevance of individual banks. In addition, the ongoing BCC supervisory review of capital needs to reflect banks’ risk profile. The FSAP also found that the loan classification rules currently are not aligned with international best practice.

Key recommendations

45. The authorities have put in place a number of actions in line with the FSSA’s main recommendations. The recent announcement by BCC to implement a graduated increase of the capital adequacy ratio to 15 percent (from 12 percent) by 2018 is welcome. In addition:

  • There is a need for forward-looking capital planning. Over the longer run, banks will need to engage in forward-looking capital planning reflecting their risk profile and linked to a multi-factor stress testing. In this context, the supervisory review of capital planning is welcome. In addition, the risk weight on BdL foreign-currency exposure needs to be aligned with the Basel Accord, allowing for a reduction in sovereign exposure over the medium term, and incentivizing banks to diversify their liquidity holdings as they strengthen their net foreign asset position.

  • Continued efforts to strengthen banking regulation and supervision are needed. As per the BCP assessment, there is a need to align the regulatory treatment of restructured loans with international good practice and to stay vigilant on asset quality, including by monitoring loan-loss migrations at the bank level. The authorities also need to put in place a systematic reporting system on the funding structure and liquidity risk profile.

  • The Anti Money Laundering (AML)/Combating Financing of Terrorism (CFT) framework needs to be strengthened further. While progress has been made since the last full assessment of Lebanon’s AML/CFT framework in 2009—including through legislative steps taken in November 2015—some gaps remain. In line with the FSSA recommendations, the authorities need to better align AML/CFT supervision with current ML/TF risks; and need to continue to keep a close focus on the risk of withdrawal of correspondent banking relationships.

Authorities’ views

46. The authorities provided several clarifications on capital adequacy. First, they noted that the BdL places banks’ foreign currency deposits with foreign central banks and prime banks whose credit assessment is BBB and above. Hence, the risk weight of banks’ exposure to the BdL with regard to placements in foreign currency (50 percent) should be considered in the context of their exposure to foreign central banks and prime banks. Second, the BCC regularly conducts scenario analyses, including to analyze the potential impact of a downgrade of Lebanon’s sovereign rating to a level below B-. Such analyses indicate that a downgrade to CCC+ would not cause all banks to breach minimum required capital ratios. Lastly, the new regime of a graduated increase in the capital adequacy ratio to 15 percent from 12 percent will protect against risks mentioned above.

47. The authorities disagreed with the BCP assessment of problem assets and the provisioning and quality of banks’ loan portfolios, and the assessment of the AML/CFT framework. They stated that the applicable regulatory framework prescribes the criteria for supervisory loan classification and sets the framework for following up on all loans, with special care taken for loans classified as Class 3 or worse, noting that the BCC reviews a large sample of credit portfolios, covering at least 50 percent of the total banks’ loan portfolios, through its missions. Finally, they underscored that they are fully compliant with AML/CFT rules according to Financial Action Task Force (FATF) and MENA FATF.

C. Lebanon’s Only Enduring Solution: Investment, Jobs, and Growth

48. There cannot be enduring and inclusive growth without structural reform. The traditional drivers of growth have not provided the high-quality, job-rich growth needed. Indeed, Lebanon’s employment growth elasticity is one of the lowest in the region (at least for Lebanese nationals), and job creation has not kept up with the economy’s growing labor force–now expanded by the refugee influx.16

49. Lebanon’s current account deficit suggests an underlying competitiveness problem, even factoring in the Syria crisis. The sharp increase in the deficit is attributable, in part, to the disruption of trade relationships and elevated regional uncertainty. Nonetheless, even abstracting from the impact of Syria, the external balance is weaker than suggested by fundamentals, pointing to an underlying problem with productivity and competitiveness (see Annex III).17 If Lebanon is to transition to a stronger, more sustainable growth path, action is needed to boost productivity, fight corruption, and address the cost of doing business.18

A01ufig26

Lebanon. Competitiveness Rank, 2011-15

(Rank out of 144)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

Source: World Economic Forum,

50. The need for electricity reform is a long-standing priority. The electricity sector has not only been widely identified as Lebanon’s most pressing bottleneck, but it also remains a major drain on the budget. Indeed, over 2006–14 the government transferred an average of 4½ percent of GDP each year to EdL, representing over 40 percent of the current debt stock. The World Bank has long been active in promoting electricity reform. But progress has been hindered by, political disagreements within the government.

51. Lebanon’s stock of human capital remains a key untapped resource. Lebanon enjoys a steady stream of well-educated labor market entrants (see Selected Issues Paper on Human Capital and the Knowledge Economy), but has typically had difficulty matching these entrants with suitable job opportunities. The net result has been an ongoing “brain drain”—adding to the strength of Lebanon’s diaspora, but limiting the scope for domestic development. The BdL has launched a new financing program (under BdL Circular 331) to help boost startup investment in the knowledge economy, aimed at stemming the drain of Lebanon’s talented youth, and jumpstarting the development of a local high-tech sector.

52. The knowledge economy is a promising source of growth, but challenges remain. Access to cheaper financing has helped kick-start the sector, though there are limits to what the BdL can do on its own. For Lebanon to realize the full potential of its human capital, various stakeholders need to work together to create a conducive institutional and business climate, starting from strengthening infrastructure—frequent electricity outages and slow internet speeds are a major hindrance for firms.

53. Lebanon’s capital markets have the potential for development. The Capital Markets Authority (CMA) is now operational and a new trading platform is paving the way for market initiatives. But successful development will require a further strengthening of Lebanon’s regulatory and institutional framework. And as markets grow, the CMA needs to strike a balance between innovation and investor protection, shifting the nature of its oversight towards monitoring, risk-based supervision of intermediaries, and market surveillance.

54. But investment and growth are not just long-term needs. Lebanon’s refugee presence has added to Lebanon’s infrastructure gap and has intensified the need for reform. As a matter of policy, Lebanon has long affirmed that it is not a country of asylum or resettlement, and that the Syrian refugees cannot expect to stay in Lebanon permanently. Nonetheless, as a large number of refugees is likely to remain in Lebanon over the medium term, there is a need to shift them away from a protracted cycle of short-term humanitarian aid. In this context, there is an immediate need for increased investment (especially in infrastructure) and job-rich growth.19 But this requires sustained and forward-looking support from the international community, starting with the authorities’ proposal at the 2016 London conference (Box 7).

The 2016 London Conference

At the London Conference in February 2016, the authorities presented a new plan to address the costs of the refugee crisis. Noting that Lebanon is, by necessity, providing a critical universal public good, the plan calls for substantial international assistance—$11 billion over 2016–20, including both grants ($5 billion) and loans ($6 billion). The plan’s proposals are wide-ranging and ambitious, covering budget support, concessional financing, and direct assistance to local municipalities and the school system.

The key thrust of the proposal is an effort to stimulate growth and employment through a targeted series of investment initiatives. It focuses not only on high-priority infrastructure needs, but also on the maintenance of key public services (education, municipal services, etc.). In essence, it targets some of Lebanon’s investment bottlenecks directly, helping the economy scale up to meet its new employment needs. The authorities project that these interventions could create 300,000–350,000 jobs, of which 60 percent would accrue to Syrian refugees. Also, the authorities would encourage job creation in labor-intensive sectors through the Subsidized Temporary Employment Programme (STEP), which provides incentives for small- and medium-sized enterprises to invest and expand their workforce. It is estimated that this would generate a further 100,000 jobs, again shared between local residents and Syrian refugees.

A01ufig27

Syrian Refugees in the Labor Force

(2014)

Citation: IMF Staff Country Reports 2017, 019; 10.5089/9781475570618.002.A001

1/ UN Department of Economic and Social Affairs(UNDESA)Source: ILO and IMF staff calculations

But despite the potential benefits of the authorities’ plan, incorporating Syrian refugees into the labor market is potentially controversial. As a matter of policy, Lebanon has long maintained that it is not a country of asylum, a final destination for refugees, or a country of resettlement. The permanent integration of Syrian refugees, therefore, is not viewed as a viable solution; and any measure that discourages the ultimate repatriation of the refugees is arguably problematic. In this context, according to Decree 197 (December 2014) Syrians can only work legally in the agricultural, construction, and domestic service sectors. And even for these sectors, the financial and administrative requirements for establishing legal residency are often prohibitive for a large portion of vulnerable Syrian households. Many refugees enter the labor market illegally, but the insecurity and inefficiencies associated with the informal sector represent a significant burden—not only in humanitarian terms, but also in terms of the labor market’s ability to adjust quickly and flexibly. Expanding refugee access to stable sources of livelihood has clear humanitarian and security benefits; but it also allows the refugee community to contribute to local growth and development. Moreover, the impact on repatriation incentives is unclear. International experience suggests that self-reliant refugees, who have been able to enhance their skills while in exile, are often able to return to their origin country more rapidly (World Bank, 2015).1

1 World Bank, 2015, “Sustainable Refugee Return.” GPFD Issues Note August 2015.

Key recommendations

55. While the adoption of a far-reaching reform agenda will depend on political consensus, small steps in a few select areas could have a significant impact on confidence. In staff’s view, the following measures are perhaps the most pressing:

  • Electricity reforms. Lower oil prices are not a reliable source of sustained budget savings, and, ultimately, electricity transfers need to be reduced to zero. In this context, low oil prices present an opportunity to start the process of bringing tariffs up to cost-recovery levels—though in a way that protects more vulnerable consumers. Recent proposals to link the tariff structure to the expansion of capacity are promising and need to be adopted quickly, as they allow for increased production (and lower production costs) without increasing transfers from the budget.

  • Fostering the knowledge economy. In terms of funding, revisiting the scale of incentives to avoid too much money chasing too few ideas could be beneficial. Finalizing and implementing capital market regulation, and the preparation and adoption of a capital market development plan could also help. But more fundamentally, there is a need to put in place a supporting ecosystem for the knowledge economy, starting from reliable and robust internet connectivity and electricity.

  • Facilitating donor support. The framework for channeling funds through the government needs to be improved. As short-term measures:

  • There is need to expedite the disbursement of donor money from budgetary transit accounts, as currently procedures remain slow.20

  • The coordination framework launched after the London Conference, to better coordinate with the international community, needs to be elevated to a high-level forum to discuss strategic issues.

  • Pending legislation. The framework law for Public Private Partnerships—awaiting parliamentary approval for three years—could help mobilize private sector resources for infrastructure investment, though with due attention to possible fiscal risks. Similarly, an agreement with the European Union regarding simplified rules-of-origin for Lebanese exports has been negotiated but is yet to be ratified.

Authorities’ Views

56. The authorities agreed broadly with staff’s diagnosis and priorities, but stressed that the slow pace of reform in the past had been a symptom of Lebanon’s protracted political impasse. The election of a president was an encouraging first step, and following the formation of a new government, action on the reform agenda could potentially proceed very swiftly. The authorities agreed in particular with the pressing need for electricity reform, and noted that a tariff structure that allowed an expansion of generating capacity would be key in bringing down overall production costs.

57. The authorities also underscored that Lebanon’s reform agenda was closely linked to the refugee presence, and that additional donor funding would be critical. Lebanon’s infrastructure deficit has widened sharply owing to the added demands of the refugee community. So far, most donor support had come in the form of short-term humanitarian assistance but even this was short of actual needs. Longer-term funding—either in the form of budget support to reduce the government’s cost of borrowing, or concessional finance for infrastructure spending—has not yet materialized. While grateful for the support received so far, they urged the international community to step up their support as a matter of urgency.

D. Data Issues

58. Data quality remains weak. There has been a general deterioration in the provision of data. Fiscal data are reported with long and increasing lags; national accounts compilation suffers from serious shortcomings; and balance of payments statistics are subject to frequent and sizable revisions. The Central Administration of Statistics (CAS) and the External Sector Section of the BdL are aware of existing problems and are working to improve data quality. But progress has been slow and uneven.

Key recommendation

  • The authorities need to address data gaps. At a minimum, the timeliness of fiscal data need to be improved; IIP data need to be finalized and published; and collaboration between CAS and other institutions needs to be strengthened.

Staff Appraisal

59. Lebanon finds itself at a critical juncture. The recent presidential election and the appointment of a new prime minister with a mandate to form a new government bode well for a revamping of Lebanon’s policymaking framework. Lack of adjustment and reform in the past has reflected internal and regional political fissures, rather than a lack of capacity.

60. The Syria shock has been both profound and long-lasting. The costs of regional conflicts have been significant; growth has stalled; and Lebanon’s already-strained infrastructure and services have struggled to cope with refugee inflows. Despite all this, Lebanon has endured and its response to the crisis is a testament to both its generosity and resilience.

61. Yet, the need for adjustment and reform pre-dates the Syrian crisis. Lebanon entered it with a long-standing need for reform and with large infrastructure gaps—chief among all, in the electricity sector. The budget was also burdened with significant spending rigidities, mainly related to salaries, debt service and transfers to EdL. High growth rates masked all these factors prior to the crisis, but once growth dissipated, they have come to weigh heavily on fiscal performance.

62. The economy faces rising vulnerabilities. Staff estimates and projections are less benign compared to last year’s Article IV consultation, especially on public debt dynamics. And a new development—the slowdown in financial inflows—has come at a time when the economy’s funding needs remain sizeable, and when liquidity conditions have tightened in many of Lebanon’s traditional sources of funding, namely regional oil exporters. As a result, Lebanon’s foreign exchange reserves dropped for the first time in eleven years in 2015, and the decline continued into mid-2016, prompting the BdL to take action.

63. The BdL’s recent financial operation has been a stop-gap measure, but cannot sustainably resolve Lebanon’s funding needs. The BdL has continued its efforts to support financial stability and the exchange rate peg, which remains the appropriate nominal anchor. As in previous episodes, the BdL has deployed unconventional measures. While the operation bolstered BdL’s gross international reserves and banks’ capital, it has also resulted in a large injection of local currency liquidity and erosion of banks’ foreign currency buffers, which now need to be addressed; and has affected the BdL’s balance sheet. In addition, as in other countries, it is important for the BdL to communicate the size and scope of its unconventional measures in a timely manner.

64. Going forward, the policy agenda needs to decisively address Lebanon’s pressure points. Fiscal adjustment is essential—large enough to halt Lebanon’s adverse debt dynamics, and with a composition that broadens the tax burden (starting from fuel taxation) while seeking to rebalance the spending mix toward more efficient programs and better social safety nets. Neither large donor funding, temporarily higher growth, nor prospective gas revenue can permanently substitute for fiscal adjustment. Passing a credible budget remains a critical priority and would signal a strong commitment to discipline. Fiscal adjustment would also reduce the government’s reliance on bank funding and would, in turn, reduce the need for ongoing financial inflows—ultimately relieving pressure on the BdL and allowing it to use interest rate policy more flexibly going forward.

65. Financial stability has been a pillar of sustained confidence. The banking system is renowned for its resilience—though the system now faces a more challenging macroeconomic environment, growing exposure to the sovereign, lower foreign currency liquidity buffers abroad, significant interest-rate risk, and greater international scrutiny. The Banking Control Commission is proactively vigilant. Its efforts need to be complemented by measures to introduce forward-looking capital planning; strengthen regulation and supervision by, among others, aligning loan classification rules and sovereign risk weights with international good practice; and support liquidity risk management. Finally, the AML/CFT frameworks need to be strengthened further.

66. Higher, more sustainable, and more inclusive growth can provide a lasting solution. Current growth rates are insufficient to address Lebanon’s employment or social needs, and even in the past, higher growth rates have often failed to generate sufficient job opportunities. But Lebanon has a wide range of resources at its disposal, including an innovative and resilient business sector, and an enviable pool of high-quality human talent. Unlocking this potential will require reinvigorating Lebanon’s structural reform agenda to address key infrastructure bottlenecks, also to improve competitiveness. But beyond the longer-term need for a more balanced growth path, job-rich investment is urgently needed now, particularly in light of large-scale refugee presence. The authorities’ ambitious proposal at the London Conference to boost employment and growth deserves attention and international support.

67. In this context, the international community needs to play a stronger role. Lebanon has received significant assistance, but largely for humanitarian purposes and below estimated needs. Funding volatility also undermines the effectiveness of spending programs. Larger and more stable support to help Lebanon address the costs of the Syrian crisis is both needed and warranted.

68. Data gaps need to be addressed. Progress continues to be made in many areas; stronger cooperation among agencies and high-level support for the Central Administration of Statistics would help strengthen data compilation and dissemination. The Fund stands ready to assist, including through our Middle East Technical Assistance Center.

69. Staff propose that the next Article IV consultation take place on the standard 12-month cycle.

Table 1.

Lebanon: Selected Economic Indicators, 2013–21

(Population: est. 4.5 million; 2014) (Per capita GDP: est. US$11,112; 2014) (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 2a.

Lebanon: Central Government Overall Deficit and Financing: 2013–21

(In percent of GDP, unless otherwise indicated)

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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 2b.

Lebanon: Central Government Overall Deficit and Financing: 2013–21

(In billions of Lebanese pounds, unless otherwise indicated)

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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: Balance of Payments, 2013–21

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

Excluding official budgetary transfers.

From 2009: includes new data source for real estate investment.

Excluding budgetary loan disbursements.

Net of non-deposit foreign liabilities.

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

Excludes Lebanese Eurobonds and encumbered reserves.

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