Public Information Notices
Lebanon and the IMF
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On February 28, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Lebanon.1
Following the protracted civil war, a decade of large fiscal deficits, driven by the reconstruction and rehabilitation initiatives, led to an exceptional accumulation of government debt.
Macroeconomic conditions became particularly difficult in the spring of 2002, when the international reserve position reached its lowest level, but have since considerably improved. Market confidence was bolstered by the meeting held in Paris in November 2002, under the auspices of the French Government, to mobilize international financial assistance for Lebanon (Paris II). Available indicators suggest real GDP grew by about 2 percent in 2002 while inflation was 1.75 percent. Lebanon's real effective exchange rate appreciated over the past several years, as a result of the strengthening of the U.S. dollar (to which the exchange rate of the Lebanese pound is effectively pegged) vis-à-vis other major currencies; however, some of this appreciation has been reversed over the past year with the weakening of the U.S. dollar and the low inflation in Lebanon.
Significant progress has been made in improving the public finances since 2000. Following an adjustment of 5.2 percent in 2001, the overall fiscal deficit has been reduced from 19.4 percent of GDP in 2001 to 15.7 percent in 2002. The primary fiscal balance (which excludes interest payments) shifted from a deficit of 7.6 percent of GDP in 2000 to a surplus of 2.1 percent of GDP in 2002. Most of the adjustment in 2002 was achieved through higher revenue generated by the 10 percent VAT introduced with IMF technical assistance in February 2002, while expenditure has also been contained.
After a period of intense pressure in the foreign exchange market, confidence began to improve over the summer of 2002. Broad money demand picked up, and the balance of payments turned into a surplus, allowing the central bank to begin replenishing its reserves. Several factors contributed to this more favorable situation, notably renewed regional interest in Lebanon for portfolio and real estate investments, and as a tourist destination; the successful introduction of the VAT in February; the removal of Lebanon by the Financial Action Task Force from its list of noncooperating countries in the anti-money laundering initiative; and progress in the preparations for privatizations of the telecommunications, power, and water sectors.
Confidence was further boosted by the successful outcome of the Paris II meeting. At this conference, Lebanon received commitments totaling US$4.3 billion, of which US$3.1 billion was for budgetary support, to be fully disbursed by end-2003, and the remainder in project-related loans. The authorities' economic strategy for 2003, including the proposed budget, underpinned this improvement in confidence, which is evident in the behavior of monetary aggregates and interest rates. Broad money (M3) increased by 3.2 percent in December alone, which brought its 12-month growth rate to 7.6 percent (compared with 3.6 percent in the year through July). The share of dollar deposits in M3 declined to 64.2 percent in December, from a high of 69.8 percent in May 2002. The interest rate on two-year treasury bills fell from an effective 16.1 percent (which included a 2 percent premium then offered by the central bank in its swap operations) to 9.2 percent by late December, while the yield on the three-month bill declined from 11.2 percent to 7.0 percent in the last auction (held on January 9). The government is not currently issuing treasury bills, given its comfortable liquidity position.
The increased demand for the local currency, along with Paris II disbursements in December, allowed the central bank to increase its gross international reserves (excluding gold) to US$5.1 billion by end-December (from US$3.1 billion in June). Moreover, preliminary data indicates that the central bank accumulated another US$1.1 billion in gross reserves in January, benefiting from further Paris II-related and private inflows.
The central bank has recently issued a sizeable amount of certificates of deposits to sterilize inflows from abroad. Interest rates on 60-day CDs have nonetheless declined from 9.3 percent immediately after Paris II to 5.9 percent in late January. Interest rates on Lebanese pound and dollar deposits have also declined, by about 100 and 200 basis points, respectively. Lending rates have started to decline as well, albeit at a slower pace. Furthermore, spreads on Lebanese Government Eurobonds narrowed from 987 basis points before Paris II to 611 basis points at end-January, compared with a compression of about 41 basis points in the EMBI Global spread during the same period.
The most recent information on banking-sector performance suggests that bank profitability improved somewhat in 2002. Moreover, reflecting the recent deposit inflows, the foreign exchange cover for bank deposits has also improved. However, reflecting continued weak economic activity, nonperforming loans continued to rise, having reached about 27 percent of total loans at end-2002. Total provisioning against problem loans has remained at close to 70 percent.
The authorities' economic strategy for 2003, and the medium term, aims at reducing the government debt and its servicing cost, and restoring growth. The strategy includes further fiscal adjustment, large-scale privatization, burden sharing with the banking system, and external financial assistance on concessional terms. The government intends to use the counterpart of the privatization and Paris II related inflows to retire its debt. In line with this strategy, the approved 2003 budget is consistent with a primary surplus of 4.6 percent of GDP, and the government targets a steady increase in the primary surplus over the medium term, to 9 percent of GDP by 2007. The authorities expect proceeds from privatization and securitization in 2003-07 to total US$8.9 billion, and have made extensive preparations in the telecommunications, power, and water sectors. With respect to the Paris II commitments of direct budgetary support, US$390 million were disbursed in December 2002, US$600 million in January 2003, and US$1,250 million were disbursed in February and early March. The remainder would be disbursed in the second quarter (US$692 million) and later in the year.
The authorities have agreed with commercial banks on a scheme to reduce interest payments during the next two years, which has already started to be implemented. Under this scheme, commercial banks (which held about 60 percent of the government debt), will purchase zero-interest, two-year government securities in an amount equal to 10 percent of their deposit base as of October 31, 2002 (US$3.8 billion, after some exemptions). The subscriptions are to be made in five equal installments during January-May. Furthermore, in December 2002, the central bank cancelled US$1.8 billion worth of treasury bills against a reduction in the revaluation account for gold and foreign exchange. At the same time, most of the central bank's remaining holdings of government debt (treasury bills and Eurobonds), amounting to an additional US$1.8 billion, were exchanged for a 15-year Eurobond carrying a 4 percent coupon.
Executive Board Assessment
Directors welcomed the steps taken by the authorities over the past two years to address the country's serious macroeconomic imbalances and public debt burden which, in the aftermath of the reconstruction efforts in the wake of the 15-year civil war, increased sharply. The authorities' policy strategy, which is founded on strong country ownership, has focused on reducing the stock of debt and its servicing cost, with a view to enhancing confidence and laying the basis for private sector-led economic growth. Directors commended the authorities for their impressive efforts, which have begun to address—with the help of the international community—the country's severe public finance imbalances, producing a major turnaround in the primary fiscal balance, and improving economic and balance of payments performance, amid signs of improved confidence and renewed investor interest. Several Directors stressed that recent developments have significantly increased the chances of success of the authorities' strategy to reduce the vulnerabilities faced by the Lebanese economy. Directors cautioned that the way forward to strengthening economic viability in Lebanon remains long and arduous, requiring sustained efforts by the authorities, continued strong ownership, and the cooperation and support of the international community. Directors looked forward to the Fund and the authorities remaining constructively and productively engaged in helping the Lebanese economy to meet the challenges in the period ahead. They welcomed the request to Fund staff by Paris II participants to prepare six-monthly status reports, which will allow the international community to follow developments in Lebanon closely.
Directors expressed their appreciation for the leadership role of the President of France in convening the Paris II conference of the Friends of Lebanon in November 2002, and they welcomed the substantial progress that has already been made in mobilizing the resources committed at the conference. This, coupled with the continued adjustment and reform efforts, has set the stage for a further improvement in confidence, as evidenced by the strong deposit inflows into the banking system, a broad-based lowering of interest rates, and a marked recovery in official foreign exchange reserves. External assistance and the agreements with commercial banks and the Central Bank on a reduction of interest payments on government debt have contributed to a lowering of the interest cost and lengthening of the maturity profile of the government debt, and short-term rollover risks have receded.
Directors observed that, notwithstanding these positive developments, reducing the risks the economy is exposed to and restoring debt sustainability remain a priority task. They expressed broad support for the authorities' ambitious debt strategy, which seeks to reduce the stock of government debt and reduce its cost over the medium term, through additional fiscal adjustment, large-scale privatization, concessional external financing, and the debt arrangements with the domestic banking system. Directors noted that, if fully realized and sustained over the medium term, the authorities' strategy can be expected to lead to a substantial decline in the government debt ratio. The stock of debt will, however, remain high for many years to come, and prospects for achieving debt sustainability highly sensitive to adverse shocks and macroeconomic developments, including growth. To minimize these risks, Directors agreed, will require continued strong efforts to improve the debt dynamics, along with wide ranging structural reforms aimed at sustainable higher growth.
Directors stressed that a continued strong fiscal stance will be essential in 2003 and over the medium term. They welcomed, in this context, the further improvement in the primary surplus embedded in the 2003 budget. They also commended the steps taken to enhance public revenue, including the successful introduction of the VAT, the recent adoption of the new tax on interest income, and the planned establishment of a large taxpayer unit. Going forward, Directors urged the authorities to specify early on—and to bring forward as necessary—the additional measures that will be needed to ensure further fiscal adjustments that the authorities aim to achieve in future years, while carefully taking into account their possible impact on growth prospects. They underscored the importance of measures on the expenditure side, including to rationalize public employment and the wage and pension bill, and reallocate budgetary resources to enhance the social safety net. On the revenue side, Directors encouraged the authorities to introduce a comprehensive income tax and to give consideration to an increase in the VAT rate at the appropriate time. They also highlighted the importance of ensuring the financial viability of the National Social Security Fund, whose surplus has declined in the last two years.
Directors noted that early and substantial progress in implementing the authorities' highly ambitious privatization program will be key to enhancing the credibility of the strategy of lowering the public debt ratio. Directors welcomed the progress made in keeping the privatization program broadly on track so far through key important enabling legislative steps and the managerial improvements and restructuring actions in the electricity company (EdL). They noted, however, that the auctioning of the cellular network licenses has been somewhat delayed and that privatization in other sectors might take more time than initially envisaged. Directors therefore saw a need for the authorities to further intensify their efforts to ensure full and timely implementation of the privatization program, and underscored that transparency will be key to sustain investor confidence and public support throughout the process. A number of Directors cautioned that the planned securitization of certain government revenues would adversely affect budgetary revenue over the medium term and, possibly, increase the government's borrowing costs. They encouraged the authorities to keep this policy under review.
Directors welcomed the substantial reduction in interest rates, made possible by the recent improvement in confidence and the inflows of external assistance. They noted that the absorption of such large external inflows entails challenges for the monetary authorities, and that, in particular, the retirement of local currency debt might require the Banque du Liban (BdL) to continue to undertake large-scale sterilization operations. Directors welcomed the significant actions taken by the authorities to strengthen prudential supervision of the banking system, but urged continued strong vigilance in view of the rising trend in nonperforming loans, and the exposure to government debt and exchange rate risk. They commended the authorities for the strong progress made in enhancing their capacity to combat money laundering and the financing of terrorism.
Directors welcomed the indication that the impact of measures to alleviate the debt burden on the income position of the BdL and commercial banks appears manageable, while stressing the need for continued close monitoring, including with respect to their impact on the overall health of the banking system. They were encouraged that the debt arrangement with the domestic banks had emerged from a negotiated agreement. Directors looked forward to further efforts to extend debt maturities and smooth debt service obligations over the medium term while reducing the foreign currency component of debt.
Directors underscored the importance of developing a coherent medium-term strategy to strengthen and diversify Lebanon's growth base. They welcomed the recent progress in further liberalizing Lebanon's already open trade regime, noting that this has been instrumental for reaching the association agreement with the EU, and should facilitate Lebanon's accession process to the WTO.
Directors welcomed Lebanon's decision to participate in the General Data Dissemination System, and they encouraged the authorities to continue to make efforts to fill the gaps that still hamper economic analysis and policymaking.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT