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Thursday 06, July 2017 by Nabilah Annuar

Reviving Lebanon

Despite geopolitical risks that continue to loom over the country, the formation of a new government gives renewed hope for the nation.

Following a 29 month presidential absence in the country, Lebanon came together and finally elected their president in October last year. Signalling a likely boost in economic sentiments, the election of President Michel Aoun is expected to restore executive power to the Lebanese government which could ease economic policymaking and restore some level of confidence.

Economy

For the fifth year in a row, Lebanon remains the largest host (on a per-capita basis) for displaced Syrians. According to the World Bank, the protracted Syrian conflict has continued to exacerbate the country’s vulnerabilities and remains an impediment to the return to potential growth. The situation has significantly strained already weak public finances in a situation of limited international assistance. Nevertheless, in 2016, Lebanon’s real GDP growth marginally accelerated to reach an estimated 1.8 per cent, from 1.3 per cent in 2015.

Lebanon’s traditional growth drivers—tourism, real estate, and construction—have received a significant blow and the IMF believes that a strong rebound is unlikely based on current trends. In the absence of a turnaround in confidence, or a resolution of the Syrian conflict, growth is unlikely to return to potential (four per cent) soon. Inflation also declined sharply in 2016 on the back of lower oil prices, but should return to trend (about two per cent) by 2017.

On the fiscal side, low oil prices have helped secure a primary surplus of 1.4 per cent of GDP in 2015, and the IMF projects a similar surplus (1.1 per cent) in 2016. Public debt is however high (138 per cent of GDP in 2015) and without decisive corrective action, Lebanon’s debt burden will increase further.

In the absence of fiscal reforms, an increase in tax revenues in 2016 from a marginally improving economy was unable to offset higher expenditures, leading to an increase in the overall fiscal deficit to an estimated 10 per cent of GDP and a small primary surplus at 0.1 per cent of GDP. With subdued GDP growth and high interest rates, such a surplus remains insufficient to prevent the debt-to-GDP ratio from continuing on its unsustainable path, reaching an elevated 157.5 per cent by end-2016.

According to the World Bank, on the external front, a pickup in imports of merchandize goods combined with deteriorating exports led to a worsening of the goods trade balance. Additionally, after being largely unaffected by lower oil prices in the past two years, remittances declined by 0.5 percentage points (pp) to 5.5 per cent of GDP in 2016 due to spending cuts in the GCC countries. As a result, the already sizable current account deficit is estimated to have widened to an estimated 21 per cent of GDP, which is among the largest in the world, exposing the country to significant financing risks.

As such, the economy is structurally and heavily dependent on capital inflows to finance its current account deficit. Faced with weaker capital inflows last year, Banque du Liban (BdL) financially engineered a swap that was able to boost its foreign exchange reserves and capitalisation in local currency at commercial banks. As a result, gross foreign exchange reserves at the central bank rose by 11.1 per cent by end-2016 to reach $34 billion after registering a decline of 5.4 per cent in 2015.

Risks

Security and political challenges continue to be Lebanon’s primary concerns. The World Bank suggests that should there be no further financial engineering by the central bank to boost capital inflows, Lebanon can once again be vulnerable to a slowdown in net foreign asset accumulation in the face of persistent and sizable fiscal and current account deficits. If financial engineering persists, then it will be subject to a combination of declining positive returns and increasing associated risks. As such, unless foreign currency financing needs are reduced, balance of payment pressures will re-emerge.

 

More generally, a frail macro-fiscal framework, underpinned by unsustainable debt ratios and persistent and sizable fiscal and current account deficits, exposes the country to significant refinancing risks, explained the World Bank. Attracting sufficient capital, and in particular deposits, to finance larger budgetary and current account deficits could prove challenging based on recent commercial banks’ deposit growth data.

Banking and finance

Lebanon’s banking system plays a critical role in securing sustained, broad-based economic growth. Noting IMF’s recent Financial Sector Assessment programme findings, the authorities’ close oversight of the financial system was commendable, but there is a need for continued vigilance. In particular, the IMF stressed the benefits of measures that would introduce forward-looking capital planning; strengthen regulation and supervision by, among others, aligning loan classification rules and sovereign risk weights with international good practise; and support liquidity risk management.

Outlook

Lebanon’s economic prospects over the medium term are highly affected by geopolitical and security conditions, which remain volatile. Potential growth is contingent on the resolution of the Syrian conflict in a manner that does not compromise the structure and stability of Lebanon, as well as on the resumption of the domestic political process. Based on this, the World Bank has forecasted growth to remain around 2.5 per-cent annually over the medium term.

In 2017, higher oil prices is expected to lead to an increase in government transfers to the loss-making public electricity company, likely inducing a small widening in the fiscal deficit. More expensive fuel imports will in addition further enlarge Lebanon’s import bill. A stronger real estate sector as well as a continued increase in tourist arrivals are expected to lead to a pickup in economic activity in 2017.

Following the conclusion of the IMF Executive Board’s Article IV consultation with Lebanon, the organisation stressed that a sustained and balanced fiscal adjustment is essential. Lebanon has healthy primary surpluses, but without further adjustment, Lebanon’s public debt burden will continue to rise, adding to existing vulnerabilities and ultimately crowding out essential public investment and social spending.

The IMF also urged the passage of a budget for 2017. They country needs immediate reform in the electricity sector, which remains a large drain on the budget and a key bottleneck to improved competitiveness and equity. The international organisation highlighted that there is significant scope to increase revenue equitably, including by improving compliance and broadening the tax base, starting with fuel taxation.

Monetary policy should remain geared to supporting the peg and although the BdL’s recent financial operation has successfully bolstered BdL’s gross international reserves and banks’ capital, it was not a sustainable solution to Lebanon’s funding needs. BdL should draw up medium-term strategy to improve its balance sheet.

The IMF also called for the authorities to advance structural reforms. In addition to electricity reform, they stressed the need for legislation to reinvigorate private investment, including in the oil and gas sector; and for better service provision and stronger safety nets.