Mission Concluding Statement 

May 9, 2014

1. We wish to thank the authorities for receiving the mission during this challenging time. Our visit gave us an opportunity to meet with a broad range of counterparts, including Prime Minister Salam, Minister of Finance Khalil, Governor of the Banque du Liban Salame, members of Parliament, and representatives of the private sector, civil society, academia and the international community. We appreciate the hospitality and open discussions and are grateful for all the information made available to us. This statement lays out the mission’s assessment based on our discussions, and reflects on possible policy actions to pave the way for stronger, sustainable, and more equitable growth in the future.

2. The last two years have been exceptionally challenging for Lebanon. The Syria crisis has created unprecedented inflows of refugees, now estimated at about a quarter of the population. Security has been severely affected and local communities have been strained. Given the political impasse, the lack of reforms has amplified the macroeconomic imbalances. The fiscal position, in particular, has worsened, with adverse consequences for public debt. 2014 has come at a delicate juncture, with upcoming presidential and parliamentary elections. It is therefore important to urgently strengthen policies and make progress on key structural reforms.

A difficult environment

3. Macroeconomic conditions have deteriorated over the last two years, though signs of resilience remain:

- Economic growth has been low at 2 percent on average, significantly below pre-Syria crisis levels. Traditional drivers of growth—real estate-related activity, construction and tourism—have been impacted by the deteriorating security and increasing uncertainty. Inflation has been contained at an average of 4 percent, while the external current account deficit has remained large.

- Lebanon has been open to receiving large inflows of refugees, with profound impact on host communities. The refugees have settled throughout the country; and in some areas, the number of refugees is now larger than the Lebanese population. Unemployment and poverty have increased.

- Fiscal imbalances have widened. The primary fiscal position turned negative in 2012 and deteriorated further in 2013, reflecting spending pressures and revenue declines from weak economic activity, as well as policy decisions (such as the introduction of a VAT exemption on gasoline and the implementation of a cost of living adjustment for public sector wages). As a result, public debt reached 141 percent of GDP in 2013.

- The Banque du Liban (BdL) has been actively seeking to maintain stability. It has continued to finance the government and accumulate reserves—gross international reserves stood at a comfortable $35 billion at end-February. It has also supported credit to the private sector by providing low-cost funds to banks to on-lend to specific sectors.

- Foreign exchange and financial markets have been largely resilient. Deposits have continued to grow at 7-8 percent a year, while Eurobond spreads have moved in line with regional averages, and now stand at levels similar to end-2011. A successful Eurobond rollover/exchange was concluded in April. Standard & Poors has recently upgraded the outlook from negative to stable.

4. Tackling the refugee crisis requires strong international support. There has been substantial direct humanitarian assistance from the international community targeting Syrian refugees, reaching more than $800 million in 2013. Donor support for the budget and the Lebanese communities, however, was minimal despite repeated appeals, including in the context of the International Support Group for Lebanon and the multi-donor trust fund established by the World Bank. There are pressures on government spending reflecting strains on hospitals, schools, electricity, and other utilities and public services. Absent financial support from the international community, the needs of both the Lebanese communities and the refugees will not be met.

Policies for changing course

5. With large pressures weighing on the economy, there is an urgent need for strong policies. Growth is likely to remain at around 2 percent this year, reflecting significant domestic and regional risks. The limited policy space should be used to stop the current deterioration and start addressing the underlying weaknesses in public service provision, labor markets and social safety nets brought to the fore by the refugee crisis but predating it. These policies would send strong signals to the markets and donors to anchor confidence and mobilize financial support, paving the way for stronger and sustainable growth that benefits all.

6. Efforts should focus on three main fronts:

• Ensuring fiscal sustainability
• Preserving financial stability
• Implementing structural reforms for stronger growth.

Ensuring fiscal sustainability

7. Lebanon’s fiscal policy priority should be to put public debt on a sustainable downward path. As growth is projected to return gradually to a modest 4 percent over the medium term, debt reduction would have to come from sustained primary surpluses underpinned by strong and credible fiscal adjustment. Absent such adjustment, no other policy could reverse public debt dynamics in a sustainable way.

8. Passing a budget for 2014 is a necessary and credible initial step to anchor fiscal policy. The last officially approved budget dates back to 2005. A sound budget—covering all government expenditure and revenue plans—would crystallize the government’s policy intentions and restore credibility in fiscal policy. There is a need to move away from the current fragmented approach to fiscal policymaking—as shown by the proposal on the salary scale adjustment for the public sector—and consider fiscal measures in the context of a comprehensive budgetary framework.

9. Measures underpinning fiscal consolidation should cover both revenue and spending, be anchored in a multi-year strategy, and support growth. The ongoing debate on the salary scale adjustment has diverted attention away from the budgetary strategy and the need for broader fiscal consolidation. In the view of the mission:

- The salary scale adjustment should be contained, with installments and no retroactive payments, and accompanied by civil service reform measures. Going forward, there is a need to adopt a salary adjustment system that is transparent (covering all employees and remuneration components); predictable (also for pension costs); and based on productivity and performance measures. The current debate should set the stage for a comprehensive civil service reform in the future.

- Electricity subsidies—and the electricity sector in general—need significant reform. Increasing power generation, improving transmission and distribution, strengthening collections, and enhancing the efficiency of Electricité du Liban (EdL) cannot be further delayed. Ongoing projects, including switching generation to natural gas, should be properly funded, executed and monitored. Electricity tariffs—unchanged since 1996, when global fuel prices were a fraction of current levels—should be gradually increased to cost-recovery levels while protecting lower-tier consumers.

- A shift in spending away from EdL subsidies into capital and social expenditure would support sustainable and inclusive growth. Capital spending has been unduly compressed and is inadequate to address infrastructure needs. Similarly, social safety nets and government support for the poor are insufficient. Targeted social spending, including through the National Poverty Targeting Program, should thus increase.

- A comprehensive revenue package should include reliable, non-distortionary, and equitable measures. It could include the introduction of a capital gains tax on real estate transactions; an increase in the withholding tax on interest income; the immediate removal of the VAT exemption on gasoline, followed later on by a gradual increase in the overall VAT rate and the corporate income tax rate; and an increase in excises on selected items. Measures with uncertain revenue impact (such as increasing fees and stamps) or one-offs should not be the core of the adjustment. Also, multiple VAT rates and measures with retroactive impact or that introduce double taxation should be avoided. These recommendations are in line with past Fund technical assistance.

10. Improvements in fiscal management should complement the proposed measures. Ongoing efforts to close the 2012 accounts should be concluded, so that the budget process can resume its course, as the budget is the main tool to promote government accountability; and be followed by the closure of the accounts since 1997. There is also scope for more transparency of government spending and its funding. In this context, we support the authorities’ effort to seek parliamentary approval for new borrowing in foreign currency to reduce the government’s reliance on the BdL. Finally, there is scope to broaden tax bases, particularly for the VAT and income taxes, strengthen revenue administration, and reduce tax evasion.

11. The prospective gas resources should not delay adjustment. These represent an asset of the whole country, which should be managed in a transparent, sustainable and equitable way. Experience in many countries shows that strong policies and institutions are needed to manage the related revenue responsibly. We therefore encourage the authorities to cooperate across institutions to define a sequenced strategy in this area, starting from the formulation of a transparent fiscal regime with taxation that ensures a fair share for the government.

Preserving financial stability

12. Foreign exchange reserves are adequate. Maintaining large reserve buffers relative to total deposits has served Lebanon well during times of uncertainty and is still warranted under the current uncertain environment. At the same time, the continued reserve accumulation and the associated sterilization costs have weighed on the BdL’s balance sheet; going forward, there is a need for an action plan to strengthen it.

13. Monetary policy should pave the way for increased interest rate flexibility over time. The BdL has recently reduced by 26 basis points the interest rates it pays on banks’ deposits—a welcome step to encourage banks to reduce their excess pound reserves with the BdL and invest in government paper instead. The BdL should build on this recent step and gradually withdraw from T-bill auctions, which would be facilitated by fiscal consolidation over time. Providing more detailed auction results would enhance the transparency of the T-bill auction process. Such actions would lead to interest rates that better reflect the cost of funding the government.

14. Banks should maintain large liquidity and strengthen capital buffers. Banks have been largely resilient despite the difficult environment. Regional instability has halted their expansion in neighboring countries, and opportunities for credit to the private sector are currently limited. Nonperforming loans have marginally increased and profitability ratios have declined. Still, liquidity buffers remain large and the quality of capital is high. Capital buffers should be re-assessed in relation to the large exposure to the sovereign in accordance with Basel III. The BdL requires by end-2015 an additional capital buffer of 1.5 percent on top of the Basel III minimum plus the 2.5 percent conservation buffer. Finally, there is a need to improve loan classification and restructuring; stay vigilant for signs of further asset deterioration; and further strengthen the AML/CFT regime, in particular by approving the pending amendments to the existing AML/CFT law and the new related draft laws.

15. Preliminary steps to develop capital markets are welcome. The newly established Capital Market Authority (CMA) issued its first regulations last year, and the transfer of supervision from the BdL to the CMA is under way. Developing capital markets to complement the banking sector could promote growth. Proper regulation and tight supervision of the financial system are essential to avoid excessive risk taking.

Implementing structural reforms for stronger growth

16. Improving competitiveness will unlock Lebanon’s growth potential. There are signs that Lebanon is losing competitiveness; its exports performance—affected also by Syria-related trade disruptions—has not kept up with competitors. Lowering the cost of doing business, improving the business environment, and increasing productivity (including in the public sector) could boost competitiveness and make exports and import-competing sectors a stronger engine of growth.

17. Inefficient and insufficient electricity provision is a major impediment to growth. The EdL currently generates electricity at a loss; its production does not cover demand, which is ultimately met through expensive private generators. Plans to strengthen generation capacity, switch to natural gas and increase electricity tariffs should be implemented without further delay, and complemented by improvements in transmission and distribution. Such steps would lower the cost of doing business, free up budgetary resources for capital spending, and promote stronger and sustainable growth by addressing supply-side constraints.

18. There is also scope for private sector participation in infrastructure investment. Enacting a framework law for Public Private Partnerships (PPPs)—awaiting parliament approval—would clarify the legal framework and pave the way for improving governance and transparency of public projects. Telecommunications, transportation and water are promising sectors for PPPs.

19. The massive influx of refugees has revealed underlying weaknesses in Lebanon’s labor market. The unemployment rate is estimated to have doubled to about 20 percent, reflecting a dramatic increase in the labor supply from the refugee influx. The impact, however, is particularly felt on lower-skilled Lebanese workers, as the vast majority of refugees seek employment in these segments. The immediate priority is to address these unemployment pressures—for example through cash-for-work programs, microfinance initiatives, and local economic development plans for the most affected communities. Going forward, there is a broader need to modernize labor market legislation and improve compliance with labor laws.

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20. Timely and reliable data and clear communication are crucial for higher accountability and stronger governance. The Central Administration of Statistics (CAS) has continued to improve its data collection and dissemination—as shown by the recent release of a new Consumer Price Index. However, national accounts, balance of payments statistics and social and labor market indicators remain weak in terms of coverage, quality, and timeliness. In addition, increasing delays in releasing fiscal data should be addressed. Adequate funding and high-level support for CAS, along with enhanced cooperation with other agencies, will help improve statistics. Better data will also underpin much needed communication and monitoring of economic plans, and therefore contribute to their overall transparency and effectiveness.

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¹ An International Monetary Fund (IMF) mission visited Lebanon during April 23-May 7, 2014 to hold discussions for the 2014 Article IV consultation.