Lebanon -- IMF Staff Visit - Concluding Statement
July 29, 2004
1. Over the last 10 days, the IMF mission has held technical and policy discussions with the Lebanese authorities. The findings of the mission will form the basis for the interim (semi-annual) report on Lebanon to be issued to the IMF Executive Board in September 2004. As always, the mission is grateful to the authorities for the openness and high quality of the discussions.
2. The economic and financial situation has continued to improve in 2004, although vulnerabilities remain. Fiscal performance has exceeded expectations, economic activity has picked up steam, and financing conditions have been favorable, owing to the benign global interest rate environment, and the redirection of capital flows from the region. Nonetheless, macroeconomic imbalances remain large and the economy continues to be vulnerable to adverse domestic and external shocks.
3. All indicators point to a significant acceleration in growth, which is projected to reach 5 percent for 2004. Strong export and tourism receipts, and a recovery in construction activity are the driving factors behind the strengthening recovery. The increase in growth also reflects a catch up effect from the adverse impact of the war in Iraq in 2003. A modest acceleration of inflation to about 3 percent is expected in 2004, owing to increases in import prices, mostly related to the depreciation of the Lebanese pound against the Euro, and higher fuel prices.
4. The external current account deficit is expected to decline to around 12 percent of GDP in 2004. Export growth has been impressive (29 percent in the first half of 2004), due in large part to a surge in exports to Iraq. Nonetheless the trade deficit is expected to widen in 2004 owing to strong import growth (31 percent in the first half of 2004), related to higher oil prices, as well as increased domestic demand. The widening of the trade deficit is offset by the surge in tourism receipts (about 20 percent in the first half of 2004), leaving the current account in a somewhat better position. At the macroeconomic level, the modest improvement in the current account reflects a substantial improvement in the government financial balance, and a worsening saving-investment balance of the private sector. The latter development stems from the adverse terms of trade shock related to oil prices and from the compression of private saving due to lower interest rates.
5. Sustained private capital inflows are financing the current account deficit. Although the surge of inflows recorded after Paris II is slowing down, the attractiveness of Lebanon as an investment destination continues to be boosted by confidence effects and geopolitical factors. Potential reversals in these same factors constitutes the major risk for the economy. In addition to deposit inflows into the banking system, Lebanon continues to attract large foreign direct investment ($2 billion net in 2003), mostly into the real estate sector. The level of international reserves has been stable at just over $10 billion, which the Banque du Liban (BdL) believes ensures confidence in the financial and foreign exchange markets.
6. Fueled by capital inflows, monetary growth remains strong at 12 percent over the 12 months ending June 2004. As financial inflows into Lebanon moderate, monetary growth is expected to slow down in the period ahead. The level of international reserves has helped reinforce confidence, although the pace of depositor inflows will also be affected by developments in international and domestic interest rates as well as regional political developments. Accordingly, the rate of growth of deposits is difficult to project with any degree of reliability. The banking system continues to be well capitalized, and the share of non-performing loans net of provisions has declined marginally to 12.2 percent at end-May 2004.
7. Budgetary performance to date has been much stronger than expected, thanks largely to solid revenue growth. The primary budget surplus for the first six months of 2004 has improved by about 1 percent of GDP over the same period of 2003. Revenue performance has been strong across the board, particularly in VAT receipts. Non-interest budgetary expenditure has also been well contained, although contingent liabilities related to the Electricité du Liban (EdL) losses have risen.
8. If recent trends are sustained, the primary budget surplus could well rise to 4 1/2 percent of GDP in 2004 (compared to 3.6 percent in 2003), notwithstanding the expected revenue losses due to the capping of gasoline prices. Because of the compression of interest charges, related to Paris II refinancing and low global interest rates, the overall fiscal balance could decline from 14.6 percent of GDP in 2003 to about 8 percent of GDP in 2004. Accordingly, a significant reduction in the debt-to-GDP ratio—the first since the civil war—is within reach in 2004.
II. Policies for 2004
9. The overarching policy objective for the short run is to consolidate recent gains and prepare the ground for stronger reform efforts in 2005:
- From 2001 to 2003, the authorities achieved an impressive degree of fiscal adjustment, with the primary fiscal balance improving by about 6 1/2 percentage points of GDP, with additional adjustment expected this year. In the second half of 2004, it will be important to maintain the resolve demonstrated in the first half of the year, in terms of expenditure discipline and revenue performance, in particular against pressures that may emerge in the pre-election period.
- The hard won gains on the budget front in 2004 are, however, being eroded by the heavy losses of EdL. While a satisfactory solution to the problems of EdL will require a broader political consensus than likely before the presidential election, EdL should be required to be more accountable on its financial situation, if necessary by providing it with the necessary financial expertise. Moreover, in as much as the operating losses ultimately accrue to the state, they should be recorded as budgetary support and not disguised as central bank loans. Total financial support to EdL from the government and the BdL amounted to 2.7 percent of GDP in 2003, and is expected to be another 2.2 percent of GDP in 2004.
- Actuarial imbalances in the social security system constitute another potential contingent liability for the government, that could destabilize public finances over the medium term. It is important in this regard to resist the temptation to shift the cost of unfunded mandates and future liabilities to the state. In the reform of the pension system now under consideration, any expansion of benefits for pensioners should be fully financed by adjustments in contributions.
- The cap on rising gasoline prices was motivated by valid social concerns, even though this is not a very efficient instrument to reach the most vulnerable segments of the population. Still, it would be important to recover the associated tax losses, and to restore the link to international prices once conditions permit.
- Debt exchange operations are presently under discussion to reduce the gross financing requirement of the government in 2005. The mission generally welcomes the use of debt management tools to smooth out the debt amortization profile of the government. The transparent and open manner in which the ministry of finance is planning to conduct the exchange should ensure the best possible terms for the government. Indeed, success should be measured by the terms at which the debt is exchanged, rather than the degree of participation rate of investors.
- Significant improvements have been made this year in government debt management, notably with the listing of Eurobonds on the Beirut stock exchange, the reduction in the frequency of T-bill auctions and the issuance of some paper at longer maturities. The availability of longer-term government paper is important as part of the effort to tap institutional investors and diversify the funding base of the government. The development of inflation-indexed bonds could also help expand the demand of contractual savings institutions for domestic paper, provided a reliable consumer price index is developed. However, the steepness of the yield curve should caution against moving too aggressively into longer maturities.
- While current liquidity conditions have supported a continued compression in interest rate spreads (vis-à-vis international rates), the choice of a fixed exchange rate regime requires a flexible management of interest rates. In order to avoid the need for abrupt, and possibly destabilizing, changes in the stance of monetary policy later on, interest rate policy needs to remain responsive to conditions in the foreign exchange market.
III. Medium-Term Outlook and Policies
10. Vulnerabilities related to the size of the public debt and the reliance on short-term bank deposits for its funding remain large. The mission's debt sustainability analysis shows that, in a context of rising global interest rates, policy inaction could again destabilize debt dynamics. Even with considerable adjustment, a range of adverse shocks could place the debt ratio on an upward path. Moreover, while the country's large deposit base has exhibited considerable buoyancy since Paris II, confidence factors are key to its stability. Still, the alignment of positive external conditions presently has enhanced the chances of making an orderly transition to lower debt ratios: a favorable external environment is boosting growth and Lebanon continues to attract capital at relatively low yields.
11. In line with the authorities' Paris II program, the debt reduction strategy should be articulated around three pillars: continued steady increases in the primary surplus, institutional reforms to enhance the credibility of policies, and structural reforms to improve competitiveness and growth. Improved cyclical conditions also would argue for front loading fiscal adjustment measures in 2005.
12. The exchange rate peg has been helpful in strengthening confidence and remains appropriate at the present juncture. Going forward, greater exchange rate flexibility, as part of a well-sequenced and comprehensive policy package of macroeconomic and structural policies, could increase the economy's resilience and adaptability to shocks.
13. Given the size of the fiscal adjustment needed over the medium term, the fiscal effort must rely as much on expenditure as on tax measures. A broad menu of fiscal reforms have been discussed and proposed in recent years, and the mission fully supports the intention to put forth a number of these measures in the 2005 budget.
14. Increases in tax rates must inevitably be part of the medium term strategy, but efforts should also be placed on broadening the tax base to ensure a more equitable distribution of the tax burden. Much progress is being registered on the latter front and on supporting administrative reforms, notably with the broadening coverage of the DASS (deduction at source on wages and salaries), the completion of a draft tax procedures code and the planned establishment of a large taxpayer unit at the beginning of 2005. The mission also encourages implementation of the professional tax. More generally, Lebanon has a potentially large untapped tax base, which should be addressed through the adoption of a general income tax. A precondition to the successful expansion of the tax base is a reform of the tax administration to improve its effectiveness and its relationship with taxpayers. The successful examples of the VAT administration, the Cadastre and customs are illustrative of the benefits of administrative reforms in terms of strengthened compliance.
15. Expenditure restraint should be replaced by expenditure rationalization as the main instrument of adjustment. This would ensure that scarce resources are allocated to where they are most effective, thereby limiting the contractionary effects of adjustment on demand. In this regard, the mission welcomes the emphasis placed by the government on reforming the public pension system (and aligning it with the private pension system), slimming down the civil service, strengthening recruitment standards for civil servants, phasing out transfers to non-productive state-owned enterprises, and improving capital spending based on the ongoing review of public investment. A social safety net needs to be put in place to protect the most vulnerable groups from the effects of some of the reforms to be implemented.
16. The growth in contingent government liabilities also needs to be brought under control, foremost among them the losses of EdL. While structural improvements in production and collection can gradually reduce these losses, at current and projected oil prices the gap is unlikely to be closed without adjustments in tariffs or outright subsidies. Accordingly, the pattern of open-ended transfers should be replaced by a time-bound restructuring program.
17. Contingent liabilities from the continued losses in the health and family allowance arms of the social security system also need to be addressed. The current imbalances should be closed as soon as possible by adjustment in contribution rates and benefits. In the health insurance fund, saving should also be possible by reforming the delivery of services.
18. Institutional reforms are also needed on the budgetary side, to increase transparency and accountability and improve budget planning and execution. The IMF fiscal transparency report that is to be prepared by the IMF in September, in conjunction with the World Bank's Country Financial Accountability Assessment, will be another occasion for identifying needs in this area. The mission considers that adoption of an organic budget law could be the right instrument to address current gaps in the legislation. As a complement, adoption of a fiscal responsibility law could also strengthen the medium-term orientation of policies, provided there is a broad commitment to reform in the country.
Monetary and fiscal policy coordination
19. The establishment of improved institutional mechanisms to facilitate coordination between the central bank and the ministry of finance would enable a clearer assignment of operational responsibilities and lower the overall cost of financial policies. The need for policy coordination is dictated by the linkages between the level of international reserves, the level of interest rates, and the level of sovereign borrowing in the market. The actions of the central bank and the ministry of finance in the financial markets should be complementary and directed at common objectives. Already, coordination has improved with the decision this year to refrain from using direct central bank financing at below market rates, and the decision to issue T-bills in excess of the government's immediate liquidity needs to help absorb liquidity. To avoid the risk of policy reversals in the future, increase credibility, and enhance the policy response to market signals, coordination should be supported by strengthened institutional arrangements. These would also allow the central bank to guide interest rates through its control over short-term rates, while leaving longer maturities to the treasury.
20. The stalled privatization program should be revitalized as soon as possible. A liberalization of the telecom sector under effective regulatory oversight is a precondition to successful privatization. In this regard, the nomination of the regulatory commission and the establishment of the mobile and fixed line operators as incorporated businesses should be completed as soon as possible, followed by privatization. There is also a potential synergy between privatization and capital market development, that could be exploited through an initial public offering, which could boost investor interest in privatized assets with positive spillover for the economy as a whole. Corporatization of EdL and its privatization should follow, although this will require considerable work in terms of clarifying the financial and operational situation of EdL.
21. The reliance on the large deposit base to finance government deficits has insulated Lebanon from some of the pressures experienced by other emerging markets, although it has also exposed the country to larger interest rate and rollover risks due to the short maturity of bank deposits. The dominant role played by banks in intermediating the debt creates a close nexus between financial stability and debt sustainability. While deficit reduction and privatization are essential to the reduction of these systemic vulnerabilities, financial and banking sector reforms also play a role by strengthening the balance sheet of banks and diversifying the governments funding base.
22. In coordination with the central bank, the Banking Control Commission (BCC), has taken a proactive stance in monitoring and mitigating risks in the banking sector. New regulations have recently been issued to: (i) provide a general framework for risk management consistent with Basle II; and (ii) encourage further foreign-currency asset diversification. Based on IMF technical assistance, and with the collaboration of the central bank, the BCC is also upgrading its financial risk monitoring capacity, including through the refinement of an Early Warning System for the financial sector.
23. The development of capital markets is crucial to tap into pools of longer term financing. Investor demand for longer-term financial assets in the economy depends on the soundness of the macroeconomic situation. However, it is also being hindered by gaps in the legal and institutional structures, which the authorities should address quickly. In particular, the lack of adequate regulation and supervision for capital markets constitutes a barrier to: (i) the development of long-term collective investment schemes, such as investment funds; (ii) the success of future privatization, by limiting the participation of potential investors; and (iii) private sector growth, due to the overleveraged position of enterprises in Lebanon.
24. WTO membership will provide an additional boost to the outward orientation of Lebanon, as an open economy fully integrated in the world trade system. In this regard, the mission takes note of the progress in negotiations with WTO, and welcomes plans to enact all of the supporting domestic legislation in time to allow for accession in 2005.
IV. Statistics and transparency
25. Statistical coverage is improving, but remaining gaps need to be addressed. The mission looks forward to the completion of the national accounts by year end, and welcomes ongoing improvements in balance of payments statistics. Improved production, labor market and price statistics, including consumer prices, are crucial to sound policy making. An action plan is needed for the upgrade of statistical systems and for the collection of a full set of standard economic indicators. The authorities are encouraged to make use of the IMF data quality ROSC exercise, to mobilize attention around remaining statistical reporting deficiencies relative to international standards and norms.
26. The mission welcomes ongoing efforts toward greater transparency. In particular, it takes note of the increased use of the ministry of finance's and the central bank's websites to provide statistics, analysis and information to the public. The authorities are encouraged to broaden this effort.