3. The IMF has supported these policies through a quarterly monitoring framework and two drawings under Emergency Post-Conflict Assistance (EPCA). All end-December 2008 quantitative indicative targets under the EPCA-supported program have been met, some of which with wide margins, underscoring that the program has been effective as a tool to support the authorities’ successful efforts to preserve macroeconomic and financial discipline in the increasingly challenging external environment.
4. These successes do not leave room for complacency, since difficult challenges lie ahead. The deepening global recession and the dysfunctional international credit markets make it even more urgent for Lebanon to address its still high underlying vulnerabilities, chief among them the very high level of public debt.
• Near term. It will be essential to reinforce the recent progress toward fiscal consolidation and to continue shoring up international reserves. At the same time, well-targeted social policies are needed to shield the impact of the expected economic slowdown on the most vulnerable groups of the Lebanese society. Continued donor support is also an essential ingredient to any successful policy strategy.
• Medium term. Lebanon needs to embark on an aggressive path of fiscal consolidation, in line with the policies laid out in the Paris III agenda. Fiscal consolidation, in turn, would reduce the cost of monetary stabilization.
II. Bracing for the Impact of the Global Recession
5. The impact of the global financial crisis on Lebanon has so far been muted. Deposit inflows took a short breather in the aftermath of the Lehman failure, but have resumed at a rapid pace since then. Deposit dollarization has been declining steadily, on the back of a growing interest differential in favor of the local currency, and because of continued confidence in the Lebanese financial system. There have been no pressures on the peg, which continues to serve as the lynchpin for Lebanon’s financial stability. The BdL has continued to accumulate international reserves at a swift pace. Eurobond spreads spiked after the Lehman failure, but have since come down markedly and are now below the emerging market average. The banking system has withstood the global financial crisis unscathed.
6. However, the global recession and especially the weakened economic outlook in the Gulf are likely to affect the Lebanese economy. Lower global liquidity and a pronounced global downturn, including in the Gulf region, are likely to affect remittances, tourism, foreign direct and portfolio investment, and deposit inflows. As a result, economic growth will likely drop to 3-4 percent in 2009, from over 8 percent in 2008. The external current account balance is likely to improve, helped by lower oil prices and slower economic growth, but capital inflows may weaken. As a result, commercial bank deposit growth may slow somewhat following the strong increase in 2008. Inflation has come down quickly from last year’s food and fuel price-induced spike and will likely remain subdued in the period ahead.
III. Successful Support by EPCA
7. Performance under EPCA has been broadly favorable, although there have been slippages in structural policies. The quantitative indicative end-December targets on international reserves, the primary fiscal balance, government borrowing from the BdL, and non-accumulation of domestic and external arrears have been met. The authorities have taken advantage of falling oil prices to restore gasoline excises (a welcome step in addition to the policy measures under EPCA). By contrast, the decline in oil prices has reduced the pressure to adjust electricity tariffs, resulting in the non-observance of the corresponding end-December monitorable action. Moreover, in light of the tight international capital markets, the government has postponed the privatization of the two mobile phone companies, so that the issuance of a request for applications, an end-March 2009 monitorable action, will not be met. In January 2009, the BdL has formally established an investment committee and drafted formal guidelines for foreign reserve management (end-December 2008 monitorable action). It has also adopted formal policies for the selection, appointment, and rotation of its external auditors, well ahead of the end-June 2009 target date. Overall, the mission shares the authorities’ belief that the EPCA-supported program has contributed to safeguard macroeconomic stability, and has laid the foundations for tackling Lebanon’s vulnerabilities.
IV. Priorities and Challenges in 2009
8. Going forward, the Lebanese economy and financial system are faced with three key risks.
• First, the global recession and slowdown in the Gulf will likely affect capital flows and economic activity in Lebanon. While a soft landing remains the most likely outcome, there is a significant downside risk.
• Second, government financing may be more difficult than anticipated. While under our baseline scenario, commercial banks would be sufficiently liquid to absorb the expansion of public debt inherent in the draft budget, a stronger fiscal expansion, higher interest rates on government debt, or slower deposit inflows could complicate government financing and require the preparation of contingency plans.
• Third, Lebanon remains exposed to political and security shocks that would adversely affect economic and financial conditions.
Given these risks—particularly when taken together—prudent fiscal and monetary policies, ongoing vigilance in financial supervision, and proactive contingency planning should top the policy agenda.
Reducing government financing risks
9. Despite substantially higher projected revenues relative to 2008, the draft 2009 budget implies a reduction in the primary fiscal surplus and a significant increase in financing requirements. Lower oil prices provide large gains (2.7 percent of GDP) through the recovery in gasoline excises and lower transfers to EdL. In addition, the budget envisages the introduction of rent collection on seashore properties, the collection of a 2 percent capital gains tax on a one-off revaluation of assets, the abolition of VAT refunds on exempted activities, and the option to increase the tax on interest income, together adding up to 0.5 percent of GDP in revenues. However, there have also been substantial expenditure pressures: the wage bill is slated to increase by 33 percent (2.1 percent of GDP), given one-off retroactive payments, substantial new hiring, and an adjustment in the salary scale; and there are ambitious plans to expand domestically-financed capital expenditure by around 0.9 percent of GDP compared to 2008. With the planned revision of electricity tariffs now shelved, the draft budget targets a primary balance (excluding grants) close to zero, compared to a surplus of 0.5 percent of GDP in 2008. With this, the overall deficit would increase to 12.3 percent of GDP, which would maintain the debt-to-GDP ratio at 162 percent of GDP. The authorities have indicated that, in the event of further spending pressures or revenue shortfalls, they would consider taking measures to prevent a further increase in the deficit and a rise in the debt-to-GDP ratio in 2009.
10. The heightened external, political, and financing risks call for a more ambitious fiscal target. The substantially higher government net financing requirement inherent in the draft budget, together with the tight international credit markets, could imply the need for more than doubling the new financing from commercial banks, at a time of a projected slowdown in deposit growth. The unchanged debt-to-GDP ratio could signal a pause in the so far successful strategy of debt reduction. Moreover, much of the increase in the wage bill will raise spending permanently, whereas the likely reduction in transfers to EdL reflects volatile oil prices, exposing the fiscal position to further risk. These developments underscore that there is no room for countercyclical fiscal policy. The mission believes that a primary surplus of around 2 percent of GDP would be desirable. This target would avoid an increase in required net financing as percent of GDP and keep the trend of a reduction in the debt-to-GDP ratio intact, signaling that fiscal policy continues to be oriented toward consolidation.
11. Cautious budget implementation and fiscal consolidation measures after the elections should help achieve a higher-than-budgeted primary surplus. The political circumstances, the likely slowdown in economic activity, and the soaring wage bill will make it difficult to make continued headway toward fiscal consolidation. Nonetheless, given the heightened risks, the mission suggests that any revenue overperformance should be saved and that any shortfall in capital expenditures should be preserved to safeguard the EPCA targets, support confidence, and pre-empt possible financing bottlenecks. In case agreement on a budget can not be reached, alternative fiscal measures, including expenditure restraint, would be needed to compensate for those revenue measures envisaged in the budget. Following the elections, the new government should consider swift adoption of the fiscal consolidation measures included in the Paris III policy package.
12. Given the expected economic slowdown, the government’s draft anti-crisis action plan is welcomed. This plan includes an acceleration and reprioritization of infrastructure spending within existing expenditure ceilings by the Council for Development and Reconstruction, an expansion of interest subsidies for LL-denominated bank lending to the corporate sector, various measures to improve the business climate, and incentive programs to support job creation. Care should be taken to avoid additional expenditure pressures from these programs. The mission believes that a targeted redirecting of expenditures would have been a more effective means to address the social effects of the anticipated economic slowdown than the planned generalized expansion of the wage bill. Thus, the mission encourages the authorities to continue their efforts to develop, with World Bank assistance, a system for targeted social assistance and a social sector strategy.
13. The financing of the increased fiscal deficit will be affected by the seizure in international capital markets. Given the ongoing global financial deleveraging, financing prospects in international markets are severely impaired. At the same time, domestic commercial banks, the main source of government financing, will likely experience a slowdown of deposit inflows, given the global recession and the economic slowdown in the Gulf. Nonetheless, our baseline scenario suggests that, with an assumed slowdown of deposit growth to around 10 percent this year from over 15 percent in 2008, market financing in both LL and U.S. dollars should remain comfortable, even with little rollover from external financing sources. The Eurobond exchange currently under way is an important and proactive first step towards securing the necessary financing and buttressing confidence. Parliamentary authorization is needed for the government to tap the market for its additional foreign exchange borrowing requirement.
14. Contingency plans are essential in case government financing becomes tight. The risk that election-related political uncertainty and the unfolding of the global crisis translate into a more substantial drop in deposit inflows cannot be ruled out, which could complicate government financing. We have discussed with the authorities the elements of contingency plans for that case, which entail a combination of fiscal adjustment, a lower pace of reserve accumulation, higher interest rates, and the mobilization of additional support from the international community.
15. Some progress is under way in structural fiscal reforms. Parliament approved the tax procedure code by end 2008 but several associated regulations are still pending. A cash management unit was established by end 2008 and is implementing a pilot project on monthly payment forecasts in collaboration with three line ministries. The authorities indicated that the draft Global Income Tax bill would be submitted to the Council of Ministers by end-March and soon thereafter to Parliament, implying a minor delay in the corresponding end-March monitorable action. The ministry of finance is also in the early stages of a new project to restructure the tax administration.
Strengthening further the international reserve buffer
16. Given the various risks to the Lebanese economy, there is not much scope for lowering domestic interest rates in the near term. A growing interest differential and continued confidence have been the key drivers of strong deposit inflows, even during the international financial crisis. While local currency interest rates have already declined somewhat, we support a cautious approach to interest rate policy for the period ahead. Interest rates should be gradually reduced further only once there is more evidence that deposit growth will indeed be holding up at comfortable rates. This approach should contribute to further building international reserves at the BdL, a key factor to safeguard confidence in the midst of the global crisis and in the run-up to the June parliamentary elections.
17. Safeguarding the peg continues to be key for financial stability. Maintenance of the peg is essential given the large currency mismatches of the government, corporate and household sectors related to the still widespread dollarization and the government’s high debt and debt service obligations in foreign currency. Moreover, although the recent strength of the U.S. dollar has led to some real appreciation of the Lebanese pound, the real effective exchange rate remains broadly in line with fundamentals. In the medium term, more decisive progress in structural reforms, including the energy and telecom sectors, is needed to boost productivity and support the long-run viability of the peg.
The banking sector remains key for Lebanon’s financial stability
18. The banking sector has been little affected by the global financial crisis and remains highly profitable. Banks source 90 percent of their non-equity funding from deposits, which has served them well in recent months when global wholesale funding has dried up. Moreover, proactive regulation and supervision by the BdL and the Banking Control Commission (BCC) have strictly limited banks’ engagement in structured products and real estate speculation. Lebanese banks have also had very little exposure to foreign financial institutions that have failed in the context of the global financial crisis. Recent stress-testing by the BCC suggests that even under a number of shock scenarios banks remain well-capitalized, and the enhanced monitoring of commercial bank operations outside Lebanon is welcomed.
19. However, significant underlying vulnerabilities remain, suggesting the need for continued vigilance in bank supervision. Banks carry a large maturity mismatch, since their loan portfolio and holdings of public debt are largely funded from short-term deposits. They also carry a substantial indirect currency exposure from foreign exchange lending to the government and the domestic private sector. Moreover, given their substantial holdings of foreign assets, banks could still be affected by the global financial crisis going forward. They could also be exposed to higher non-performing loans in Lebanon and the region in light of the projected economic slowdown. Given these vulnerabilities, banking supervision needs to remain vigilant. In order to provide an additional cushion to the banking sector, the BdL has recommended that commercial banks limit dividend payments to 25 percent of 2008 profits. The bank merger law, once implemented, would provide the BdL with a useful toolkit in case a bank might face difficulties. This should be accompanied by the extension of legal protection to bank supervisors, in line with international best practices. Over the medium term, reforming the deposit insurance system would also be a welcome measure.
V. A Medium-Term Plan to Tackle Vulnerabilities
20. The high public debt-to-GDP ratio remains the key vulnerability. While this ratio has fallen markedly since 2006, it remains among the highest in the world. Lebanon should thus adhere to a decisive path of fiscal consolidation to maintain the debt on a gradual path toward the restoration of sustainability.
21. The Paris III policy agenda provides a useful anchor for the debt reduction strategy. Actions taken by the government to modernize and expand the telecom sector are welcome, as the sector has the potential to become a more buoyant driver of growth. In that respect, privatization of the mobile phone providers as soon as market conditions allow remains an important further step to reinvigorate economic growth and to reduce the debt. Since the losses of EdL still absorb too large an amount of budgetary resources, it remains a pressing priority to reform the energy sector which would help increase its efficiency and reduce debt. Despite the fall in international oil prices, current electricity tariffs still imply a significant untargeted subsidy, underscoring the need for a tariff revision. A gradual increase in the VAT rate from 10 to15 percent, the introduction of the global income tax, and cuts in non-essential expenditures would also contribute to the necessary fiscal tightening.
22. Timely and flexible disbursement of Paris III pledges is another important element of this strategy. Welcome progress has been made in the disbursement of these pledges, but disbursements have fallen short of expectations and have not been fully aligned with the goal of debt reduction. The mission supports the authorities’ request that donors provide as much budgetary support as possible, or at least align their disbursements to the government’s existing spending priorities.
23. Even with an ambitious debt reduction strategy, Lebanon will remain vulnerable to shocks for many years. With full implementation of the strategy, primary surpluses (excluding grants) could reach 5.5 percent of GDP over the medium term, and with this, government debt could decline to around 136 percent of GDP by 2014. However, substantial risks remain: higher interest rates, lower economic growth, or delays in policy implementation could imply a renewed increase in the debt-to-GDP ratio and correspondingly lead to heightened financing risks. In parallel to the reduction in the level of debt, the composition of the debt portfolio should be gradually shifted toward local currency-denominated liabilities in order to reduce over time the government’s large currency mismatch.
24. Over the medium term, the BdL’s balance sheet should be strengthened. The accumulation of international reserves by the BdL has been essential to strengthen confidence and safeguard macroeconomic stability. The decline in international interest rates has, however, highlighted the costs of this policy. To ensure sufficient inflows to finance the large government deficit, the BdL has to maintain relatively high domestic interest rates through the sale of its securities, which hurt its financial position and complicate debt dynamics. Looking forward, the mission believes the BdL should consider shifting towards using its large t-bill portfolio as the main tool for sterilizing excess liquidity. This would lower the sterilization cost for the BdL and support fiscal discipline by making the cost of government financing more transparent. Over the medium term, the continued improvement of the economy’s financial situation and de-dollarization will help strengthen the BdL’s balance sheet. Privatization of the assets held by the central bank once market conditions permit will also help its financial balance, while contributing to the government’s growth agenda.