Lebanon -- 2005 Article IV Consultation Discussions, Preliminary Conclusions of the IMF Mission
October 28, 2005
1. Momentous political changes in Lebanon have created a unique opportunity for sweeping economic, administrative and social reforms. Coming in the midst of such political transformations, the mission found that expectations of meaningful reform indeed run high. The mission held very constructive discussions with the authorities, as well as with representatives of the private sector and the labor unions, and would like to thank the authorities for their very kind hospitality and for their excellent cooperation at all levels.
2. While the political and financial shocks of 2005 have been weathered successfully, they have also aggravated what was an already weak financial situation for the public sector and for the economy more generally. As the authorities have stated, reforms should be centered around two mutually reinforcing objectives: (i) restoring the financial health of the state, and (ii) raising the growth of the economy. The challenges on the economic policy front are formidable. An exit from the large debt overhang will take strong and sustained efforts to reduce the government deficit, privatization to stimulate competition and revitalize growth, and institutional reforms to strengthen fiscal discipline and central bank independence. It is important that the cost of the reform be shared equitably, if the reforms are to be sustained. If backed by a large and highly concessional financing package from domestic creditors and external donors, the strategy could, in time, bring Lebanon back to a sustainable debt position. In this regard, the mission fully supports the authorities' intention to mobilize financial support from the international community.
3. Such a strategy is not without costs and risks, given that the debt ratio would remain very high well into the medium term. However, in the view of the mission, the cost of such adjustment is small by comparison with the potential economic and social impact of a financial crisis brought about by ever increasing financial imbalances.
4. Our remarks below are organized around the following themes:
• Economic and financial assessment
• The fiscal adjustment need
• The monetary policy framework and objectives
• The financial and banking system
• Structural reforms and growth
5. The ability of the economy and the financial system to ride out the confidence shock that followed the assassination of former Prime Minister Hariri attests, once again, to the resilience of the Lebanese financial system. There was no major run on the banks. Deposit outflows were limited to 5 percent of the deposit base, all of which have since been recovered. Dollarization of deposits shot up to 78 percent, but has since come down. The skillful handling of a difficult situation by the authorities, and the Banque du Liban in particular, helped avert what could have been a very destructive financial storm.
6. Deposits are, once again, growing, and the international reserves of the central bank are rising. Nonetheless, Lebanon has paid a large price for this shock in terms of foregone growth, higher domestic interest rates, and a weakened financial position of the state. GDP growth is estimated by the mission at around zero this year, with inflation stable at around 1 percent. Despite the economic slowdown, the external current account deficit is projected to remain high at around $4 billion (18 percent of GDP), reflecting the rise in oil prices and losses in tourism receipts. The regional external environment remains quite favorable for Lebanon, but significant structural and administrative reforms are needed to take full advantage of these opportunities and reduce the cost of doing business in Lebanon. This cost remains high by regional standards, with economic governance problems, administrative impediments and red tape cited as main impediments.
7. A number of facts illustrate the fragile state of the public finances and overall vulnerabilities. The government's debt ratio ($37 billion or 167 percent of GDP) remains on an upward path and, in the absence of fiscal adjustment, it would snowball, reaching 210 percent of GDP by 2010. On a per capita basis, government debt stands today at around $10,000 and rising, while the annual interest bill on this debt comes to nearly $600 dollars per person and absorbs almost half of government revenues. Meanwhile, about 40 percent of non-interest expenditures have to be covered by new borrowing. The fiscal situation has been further weakened by the growing gap between domestic energy prices (gasoline and electricity) faced by consumers and international oil prices. Additional fiscal risks arise from the adverse effect of rising international interest rates and, possibly, from large contingent liabilities, notably from the social security system. In a broader sense, the financial situation of the sovereign has also been affected by the costs borne by the central bank related to the carrying costs of international reserves, financial support to the government, and the exceptional measures taken to contain financial pressures earlier in 2005.
8. The banking sector has provided the financing needed to cover the fiscal deficit over the years, and continues to be Lebanon's main access channel to market financing. In this context, debt sustainability concerns are compounded by the very high exposure of the banking sector to the government and the central bank (together, 53 percent of assets), reliance on short term capital inflows for financing (essentially one-month deposits), and high dollarization (73 percent of the $55 billion deposit base). A gradual unwinding of sovereign exposure is likely to require both consolidation within the banking sector and a strategic shift by the stronger banks toward private sector lending.
B. Fiscal Adjustment
9. A sustained strategy of deficit and debt reduction requires that efforts be based on durable reforms resulting in steady increases in the primary (non-interest) government surplus. In order to create a positive confidence effect, it would be important to reverse immediately the debt snowball effect and alter the explosive debt dynamics through a significant upfront fiscal adjustment. To that end, the mission considers that fiscal measures equivalent to about 2½ percent of GDP are required in 2006, followed by another 2 percentage points of GDP of adjustment each year in 2007 and 2008. In combination with privatization, such an ambitious adjustment would place the debt-to-GDP ratio on a downward path, although it would not be sufficient to reach sustainable debt levels. Considerable concessional financial assistance from abroad and a contribution from domestic creditors would be needed to bring the debt ratio closer to a sustainable level.
10. The magnitude of the adjustment required calls inevitably for both strong revenue and expenditure measures. The mission discussed with the authorities a wide range of options. On the expenditure side, weak transparency and accountability in government spending, combined with poor expenditure targeting, have undermined the efficiency of government spending. Accordingly, there should be scope for reducing non-productive spending, such as subsidies and badly targeted capital and current spending. Pension reform also appears urgent to correct looming imbalances in the system. However, expenditure reforms are likely to yield meaningful gains only over time, and revenue measures should necessarily be part of the initial package, if the debt dynamics are to be reversed. The VAT system remains the most effective tax instrument available to the authorities, and the taxation of gasoline could be revisited, as the state is not in a position to absorb future oil price shocks. In line with actions taken in other oil-importing countries, the cost to the economy of high energy can only be contained if its impact is passed on to consumers. At the same time, in order to spread more evenly and fairly the tax burden, the mission fully supports the authorities' objective of introducing a broader, more effective and more progressive income tax system by 2007, and to harmonize the taxation of investment income.
11. A core element of the adjustment strategy should be to restore the financial viability of the electricity sector. The dramatic jump in fuel prices has compounded existing problems of weak governance and production inefficiencies, as well as widespread theft and non-payment of electricity, part of which works de facto as a social redistribution system. The government's support for electricity (including servicing the debt of Electricité du Liban) will reach a staggering 4 percent of GDP this year, equivalent to education and health spending combined. Operating losses alone stand at around 2½ percent of GDP. The mission discussed various options being considered to address the structural problems of Electricité du Liban, at the level of its governance, fuel procurement, and improvements in production, transmission and distribution. The mission believes that determined and early action on this front would provide a strong signal of the government's willingness to tackle difficult issues. However, such structural reforms will at best cover a fraction of EdL's losses, the large part of which reflects today the high cost of fuel. The reform of the sector should aim at shifting, over time, the portion of EdL's losses which are due to the high cost of fuel to the users and away from taxpayers, with adequate compensation for the most vulnerable sections of society.
12. As noted above, the purpose of the reform program is not only to restore the financial viability of the state, but also, in the process, to improve the economy's growth and employment prospects. In this regard, the inevitable costs of adjustment should be counterbalanced by structural, administrative and institutional reforms aimed at improving the quality of government services, strengthening social safety nets and the targeting of social spending, and raising the productivity of capital spending. To that end, the mission also encourages the authorities to adopt institutional reforms to improve budgetary planning and execution, as well as transparency and accountability.
C. Monetary Policy Framework and Objectives
13. A clearer articulation of the country's international reserve objectives would help anchor interest rate policy and improve policy coordination between the fiscal and monetary authorities. By international comparison, gross international reserves are high in relation to GDP and imports, but low in relation to short-term external and foreign currency debt, as well as total deposits. In the Lebanese context, the presence of an ample liquidity buffer in the banking system as whole, and in the central bank in particular, plays a key role in maintaining confidence. In this regard, the exceptional pressures experienced in 2005 following Mr. Hariri's assassination can provide a useful guide to reserve adequacy and would suggest that the central bank's reserve position is again approaching an adequate level.
14. In turn, interest rate policy should respond flexibly and transparently to foreign exchange market conditions. Thus, for instance, capital inflows in excess of the country's financing and international reserve needs should trigger an easing of interest rates. During the exceptional events of 2005, the central bank had to take a number of ad-hoc measures to stabilize the situation. Looking ahead, and in a period of greater stability, the mission supports the central bank's intention to rely mainly on short-term transparent instruments of monetary control in a context of improved coordination with the fiscal authority.
15. The mission is of the view that a pegged exchange rate regime remains the appropriate monetary anchor at this time, particularly in the face of widespread dollarization and continued uncertainty. At the same time, giving up exchange rate flexibility as a policy instrument limits the ability of the economy to adjust in a timely manner to competitiveness gaps. Notwithstanding recent favorable export performance, the large external current account deficit suggests that gains in competitiveness would be needed over the medium term to sustain growth. This points to the importance of structural reforms to realize such gains.
16. Improvements in fiscal management should be accompanied by institutional reforms to reinforce the independence of the central bank as well as its transparency. The existing legal framework (the 1967 law on money and credit) establishes strict constraints on central bank financing of the government and public enterprises (such as EdL) and provides for some degree of central bank accountability and control. In practice, the provisions of the law have been overtaken by the financing difficulties faced by the public sector at different times. The mission takes note of the improved degree of cooperation that exists today between the monetary and fiscal authorities. It considers that consultation on the international reserve objectives and the government's financing strategy would improve the efficiency of financial policies and reinforce confidence. Eventually, institutional changes could be considered to provide explicit limits on central bank financing of the public sector, and, in parallel, to increase the transparency of central bank monetary operations.
17. Monetary policy independence and effectiveness also depend on strengthening the balance sheet of the central bank. Since 2002, the Banque du Liban has absorbed large financial costs related to: the cost of holding foreign exchange reserves due to the differential between domestic and international rates; the financial support provided by the central bank to the government since Paris II and the related sterilization operations; and the measures taken to support banks through the financial turmoil of early 2005. The reform plan should include actions to unwind some of these costly operations.
D. Financial Sector Reform
18. The reform strategy should be supported and accompanied by financial sector reforms aimed at preserving the financial soundness of the banking sector, providing capital to the private sector, attracting longer term capital to the country, and diversifying risks.
19. The banking sector was able to weather the financial turmoil of 2005 and remains both well capitalized and liquid. Profits for the system as a whole are moderate in relation to assets or equity, but there are considerable differences within the system, and the larger banks tend to be performing better with larger profit margins. The main systemic risk remains the exposure to sovereign risk and the large maturity mismatch. This latter risk is mitigated by the high level of liquidity of Lebanese banks, compared to international standards. The sovereign exposure creates systemic risks but is of course also the main source of bank profitability. The mutual dependence between the government and the banks cannot be corrected through regulatory means, but needs to be unwound over time through a change in financial and fiscal policies. In this context, further banking sector consolidation appears inevitable over the medium term, as only the most sophisticated and solid banks will be able to diversify their activities away from intermediating government debt. The mission supports the authorities' intention to further strengthen supervisory practices, including by considering an early adoption of pillars II and III of Basle II. It would also be important to provide legal protection to the staff working in the supervisory area.
20. The long standing imbalance between a very large banking sector and an underdeveloped capital market is both a reflection of the financial policy choices pursued since the 1990s and an impediment to better risk diversification and private investment. A well functioning capital market could provide the overleveraged private sector with a fresh infusion of working capital, help mobilize longer term financing from abroad, and support the privatization drive. Similarly, the development of a secondary market for fixed-income instruments, in conjunction with greater fiscal discipline, could contribute to financial stability and facilitate monetary policy management. The mission welcomes the importance attached by the authorities to further financial sector reforms, and encourages them to include specific measures in this area in their overall reform package, including the setting up of an independent securities regulator, the floating of shares of privatized companies on the Beirut stock exchange, and the removal of obstacles to the development of the insurance sector and other institutional investors, which could be active players in the stock market.
E. Structural Reforms and Private Sector Development
21. While restoring the financial health of the state is a precondition to sustain growth over the medium term, structural reforms have a key role to play in enhancing productivity and the economy's competitiveness. In a context where (i) extensive dollarization constrains the effectiveness of the exchange rate as an instrument of competitiveness adjustment, and (ii) fiscal adjustment will reduce the state's ability to contribute to aggregate demand, productivity growth becomes the key instrument to stimulate investment, create jobs and raise standards of living.
22. A reactivation of the privatization program should be a priority toward a more dynamic and competitive private sector. The authorities' strategy is, rightly, to see privatization as much as a structural reform measure as a financial operation. In the telecom sector, liberalization and the establishment of independent regulatory oversight are, in this regard, preconditions to the lowering of input costs for the economy, the creation of new services, and the generation of productivity gains in the enterprise sector more generally.
23. Although Lebanon's economy has a long tradition of private sector orientation, the public sector has increasingly encroached into private sector activities through direct control of enterprises and subsidies. The business climate is further hampered by the high cost of entry and exit and enforcement of contracts, and the lack of a proper competition policy. All business surveys also point to widespread corruption as a main impediment to investment. The mission is of the view that actions to address these problems would greatly enhance the overall effectiveness of the authorities' reform strategy.
F. Statistics, Technical Assistance, and Other Issues
24. Reliable statistics are key to effective policy making and analysis. Progress has been made to fill statistical gaps, but an acceleration of these efforts is needed to ensure that recent successes are sustained and to address remaining shortcomings in the coverage and quality of economic and social statistics. In this regard, the mission welcomes the authorities' intention to develop a statistical master plan with technical assistance from the World Bank and the IMF.