|Confidence is higher, but vulnerabilities remain
|Heavy load of government debt exposes banking sector to systemic risks
EXECUTIVE SUMMARY IMF statement on Lebanon
Lebanon was able to weather the confidence shock created by Rafik Hariri's assassination in February 2005, although GDP growth slowed down considerably. The deposit base shrank by 4 percent in the first half of the year and dollarization shot up. By mid-year, monetary policy intervention and a peaceful exit from the political crisis had restored confidence. In the absence of new policy initiatives, the primary fiscal surplus dipped to 2 percent of GDP in 2005, and government debt rose to 175 percent of GDP. Part of the cost of financial stabilization in recent years, and again in 2005, has been absorbed by the Central Bank with a resulting increase in its losses.
Outlook and policy discussions
l Vulnerabilities remain very high and the events of 2005 weakened an already-fragile financial situation. The high concentration of government debt in the banks' balance sheets heightens systemic risks. Short-term liquidity conditions remain favorable, not least because of the ample regional liquidity. However, in the absence of adjustment, the large fiscal-financing need could create new pressures on international reserves.
l The authorities see a soft exit out of the debt overhang as the sole viable option and have prepared a program of fiscal adjustment, privatization and structural reforms. However, political instability has so far prevented Cabinet approval of the program.
l The staff's illustrative adjustment scenario, based on fiscal measures equivalent to 7 percent of GDP and privatization, would reduce the debt ratio to 133 percent by 2011. Concessional financial assistance would be needed to reduce the debt ratio further, and closer to a sustainable level. The authorities concurred with the overall size of the fiscal adjustment, but left open the issue of its phasing over the medium term. The scenario does not envisage exchange-rate changes or debt restructuring.
- Because Lebanon will continue to operate at very high levels of debt into the medium term, the strategy of gradual debt reduction through sustained fiscal adjustment is not without risks. Given the high exposure of Lebanon to financial shocks and political uncertainty, the government program should lock in a large upfront fiscal adjustment backed by vigorous privatization and reform.
- The exchange-rate peg remains the appropriate monetary anchor for Lebanon, and needs to be supported by a flexible interest-rate policy, a strengthened Central Bank balance sheet, and close policy coordination between the fiscal and monetary authorities. Financial stability relies crucially on depositor confidence, and continued close supervision of the banking sector should be another key element of the strategy.
1. Following the Paris II donor conference of November 2002, Fund staff intensified the frequency of surveillance at the behest of donors. The Paris II conference endorsed the authorities' exit strategy out of the high debt overhang, based on a package of fiscal adjustment, privatization and structural reforms. However, implementation of the strategy suffered numerous setbacks, and advice provided in the context of Fund surveillance has had limited success in steering policies in the direction of faster adjustment and reform, mainly because of domestic political gridlock and instability. While Lebanon weathered successfully the confidence shock created by Hariri's assassination in February 2005, the associated financial turmoil weakened what was an already fragile situation. The authorities see in the political transformation heralded by the June 2005 parliamentary elections an opportunity to relaunch a broad program of economic and institutional reform. Against this background, Article IV discussions focused on the macroeconomic risks ahead and a medium-term strategy to restore the financial health of the state and establish the foundations for strong economic growth.
II. BACKGROUND AND RECENT DEVELOPMENTS
2. Economic and financial developments since 2003 have been shaped by major changes in the political landscape. Policy initiatives were frozen during the political stalemate that prevailed prior to and following the extension of President Emile Lahoud's term in September 2004. Hariri's assassination led to the resignation of the government and plunged the country into a period of political and financial turbulence. Despite continued political assassinations and bombings, market confidence was gradually restored following the withdrawal of Syrian troops from Lebanon and the June parliamentary elections. Upon taking office in July, Prime Minister Fouad Siniora announced that the government would seek the support of the international community for an ambitious economic reform and adjustment program to be introduced by end-2005. Renewed political tensions - over relations with Syria, the legitimacy of the president, and UN calls for the disarmament of Hizbullah (one of the coalition partners in the government) - have caused repeated delays in the adoption of these plans.
3. Economic growth slowed down considerably in 2005. A surge in tourism and construction activity, and strong exports contributed to GDP growth of 6 percent in 2004. However, in the wake of the political crisis, private and public demand contracted in 2005, though export growth remained strong. In the event, real GDP is estimated to have grown by 1 percent, and inflation declined to 0.3 percent in 2005.
4. Hariri's assassination and subsequent political crisis triggered significant financial turmoil and pressures on international reserves. In the two months that followed the assassination, some $2 billion in deposits were withdrawn and another $5 billion were converted into dollar deposits. The Central Bank absorbed some of the pressure through its international reserves, and also took action to counter financial pressures through: (i) swap operations, backed by higher interest rates and financial sweeteners, to lengthen the maturity of commercial banks' claims on government and the Central Bank; and (ii) the issuance of 10-year dollar CDs yielding 10 percent interest to attract and lock in some of the foreign assets of the commercial banks. In order to avoid a downgrading of banks' ratings and its possible impact on confidence, incentives provided to banks included upfront cash payments to shore up profits. A sharp rise in interest rates on Lebanese pound (LL) deposits eventually contributed to stabilize the situation, until the effects of the political crisis waned.
5. By mid-year, the financial situation had stabilized. Deposit inflows resumed at a high pace, accompanied by gradual de-dollarization. The $750 million Eurobond issue of October 2005 was heavily oversubscribed, notably by international investors; by mid-March 2006 Eurobond spreads had declined to a record low of 180 basis points, broadly in line with the global emerging market index. The stock market similarly picked up steam after the June parliamentary elections. Despite a sizeable correction in February 2006, by March the stock index was still 150 percent above its end-2004
level. Still, total capitalization remains small by emerging market standards (20 percent of GDP), with Solidere (the real-estate holding company which owns much of Downtown Beirut) accounting for over 60 percent of it, and banks for much of the rest.
6. The economic slowdown as well as buoyant exports helped narrow the current account deficit to an estimated 12.7 percent of GDP in 2005, notwithstanding higher oil prices and losses in tourism. The negative shock to the capital account in the first half of the year was more than offset by the recovery of FDI (Foreign Direct Investment) and portfolio inflows in the second half, and by end-2005 gross international reserves were back at their end-2004 level. Owing to very low domestic inflation,
the real effective exchange rate depreciated by 5 percent in 2005, despite the international appreciation of the dollar, to which the currency is pegged. Although labor costs tend to
be higher than in neighboring countries, recent gains in export-market shares do not
suggest the presence of an immediate competitiveness problem. From 2000 to 2005, Lebanon's global market share rose from 1.1 to 2.1 percent, and its regional (Middle East) market share grew from 18.4 to 36.1 percent.
7. In the absence of new policy initiatives to counter the adverse fiscal effects of rising oil prices and the economic slowdown, the primary surplus dipped to 2 percent of GDP in 2005 from 3 percent in 2004. Since the 2005 budget was only approved (ex-post) in February 2006, most expenditure categories were effectively frozen in nominal terms. However, this form of fiscal austerity was not enough to offset: (i) a one-time transfer (0.3 percent of GDP) to cover losses in the social security funds; (ii) growing subsidies to the state electricity company (EDL), whose financial losses are estimated at 3.2 percent of GDP in 2005; and (iii) revenue shortfalls attributable in large part to the cap on gasoline prices introduced in May 2004. Operational losses alone came to 1.9 percent of GDP.
8. The gradual lowering of the effective interest rate paid on government debt has contributed to a steady reduction in the overall fiscal deficit (to 8 percent in 2005). However, the maturing of the zero-interest loans received from banks in the context of Paris II and the scheduled repayment of below market financing from the Central Bank will tend to raise the effective interest rate in 2006. A near stabilization of the government debt ratio since 2002, was followed by another increase in 2005 owing to weak GDP growth, the settlement of arrears equivalent to 1.3 percent of GDP, and a new government prefinancing strategy.
9. The Central Bank has increased markedly its intermediation role since 2002, but at the expense of its financial strength. Its balance sheet has grown from $13 billion at end-2002 to $29 billion by end-2005, reflecting (below market) financing of the government and parallel sterilization operations as well as efforts to replenish international reserves. The expansion of the balance sheet has been accompanied by growing losses that reflect these operations, as well as: (i) the transfer to the government of unrealized capital gains on gold holdings; (ii) the high cost of long-term dollar debt issued in the first half of 2005; and (iii) the favorable conditions accorded to commercial banks to protect their profitability in 2005. Central Bank losses have not compromised monetary control.
10. The banking sector continues to record profits but remains vulnerable, with claims on government and the Central Bank accounting for over 50 percent of assets. The capital adequacy ratio was 22 percent as of mid-2005, although this high ratio reflects in large part the low-risk weighting applied to government paper. Banks took advantage of abundant excess liquidity in the region in 2005 to raise capital. Profitability rose by about 13 percent in 2005, buttressed by the cash premium paid by the Central Bank to rollover maturing government paper. Still, on average, the return on equity is low by international standards - although higher for the larger banks. Banks remain highly liquid, with a net liquid to total asset ratio of 45 percent, and hold nearly $10 billion in liquid assets abroad. Lending has stagnated, in part because of widespread over-leveraging in the private sector. The quality of the loan portfolio has stabilized at a ratio of nonperforming loans to total loans of 10 percent (net of provisions).
11. Only moderate progress has been made on the structural reform agenda since 2004. Most public-sector reforms have been of an administrative nature, with a number of legislative reforms pending in Parliament (Box 1). The EU Association Agreement will come into effect on April 1, 2006.
III. OUTLOOK AND POLICY DISCUSSIONS
12. Despite the recovery of confidence, the macroeconomic and financial picture is still one of high vulnerabilities. Underlying financial imbalances have grown. The government debt ratio has edged up again, and, with some of the financial benefits of Paris II coming to an end, the interest bill is expected to start rising. Moreover, the financial standing of the sovereign (Central Bank and government) has deteriorated at a much faster rate, owing to the fact that the Central Bank has absorbed in its balance sheet many of the fiscal costs of financial stabilization. On the positive side, liquidity conditions have improved markedly since mid-2005, in terms of international reserve coverage, commercial banks' liquidity, and access to market financing. Although Lebanon is well placed to continue capturing some of the portfolio outflows from Gulf Cooperation Council countries (over $100 billion in 2005), delays in fiscal adjustment will cause the fiscal financing need to rise with possible new pressures on international reserves.
13. Discussions were organized around the four main pillars of the authorities' program: (i) fiscal adjustment and debt management; (ii) monetary and
exchange rate policies; (iii) the role of the financial sector;
and (iv) the growth and social agendas. In the absence of a detailed government program, discussions were informed by an "unchanged policies" (baseline) scenario and an illustrative "adjustment" scenario developed by Fund staff. The
latter draws from policy proposals discussed with the authorities since the last Article IV consultation.
A. Medium-Term Scenarios and Debt Sustainability Analysis
14. The government's solvency problem is illustrated in the staff's baseline scenario, which shows that under unchanged policies the debt ratio would rise steadily to over 210 percent of GDP by 2011. The
scenario assumes a vicious circle of growing debt, rising interest-rate spreads, and weak economic growth. It is difficult to predict where the breaking point lies, but it is clear that such growing financing needs cannot be filled indefinitely by ever increasing capital inflows.
15. In the staff's illustrative adjustment scenario, an ambitious fiscal effort and privatization reduce the debt ratio to 133 percent of GDP by 2011. The scenario is based on: (i) fiscal effort of about 7 percent of GDP (much of it front loaded in the first three years); and (ii) partial privatization of the telecom sector in 2006-07, yielding receipts of 19 percent of GDP. The scenario excludes exchange rate adjustment, debt restructuring and concessional financing.
16. The illustrative adjustment scenario is predicated on a mix of (mainly upfront) revenue and (phased) expenditure measures, as detailed in the table below. The revenue effort (4.3 percent of GDP) comes from an upfront increase in the VAT rate from 10 to 15 percent, reform of the income-tax system (including an increase of interest-income taxation), and a phased increase in gasoline excises back to their 2003 level. The expenditure compression is assumed to take place over time in line with structural reforms in the public pension system, civil service and wage policy, and the electricity sector. An expansion of capital spending, which has taken the brunt of the adjustment to date, is assumed to offset in part the above budgetary gains.
17. The authorities took a slightly more optimistic view of interest rate and growth prospects than the staff. The staff's adjustment scenario assumes that interest rates could remain roughly unchanged from their present level, despite a projected increase in IBOR. This further narrowing of spreads (by 110 basis points for LL deposits, and 60 basis points for dollar deposits) reflects confidence gains and a lesser financing need. The authorities were of the view that interest rates could dec-line further. As for GDP growth, the authorities expected a stronger rebound in 2006 than the 3 percent growth projected by staff.
The Daily Star