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Wednesday 25, July 2018 by Banker Middle East

Until debt do us part


Lebanon has inspired confidence among global investors; however, its new benefactors want to see their money put to work.

“Lebanon’s economy is known for its resilience,” Chris Jarvis, Advisor at the International Monetary Fund’s Middle East and Central Asia Department, noted following a visit to Lebanon. A country that lays claim to having one of the oldest civilisations in the world certainly knows how to weather shocks. Lebanon has always known how to make a comeback. Following a political crisis which saw its debt balloon to the largest in the Middle East, in April Lebanon convinced delegations from 41 nations to hand over an $11 billion aid package to overhaul the country’s ailing infrastructure and lift the economy’s faltering growth.

It was an extraordinary vote of confidence in a country that has made little progress on promised fiscal reforms. The pledges include $4 billion from the World Bank, $1.35 billion from the European Bank for Reconstruction and Development, and the renewal of a previously pledged $1 billion loan from Saudi Arabia. However, there is a catch. In return for their generosity, donors want Lebanon to stick to promised reforms including an overhaul of its legal frameworks, fiscal discipline and regulatory environment.

Lebanon’s new benefactors want to see the country commit to a fiscal consolidation plan that will tame its debt and soothe corruption. The conditions attached to the pledges may finally give Lebanon the motivation it needs to put its economy on a sustainable growth path. With the world watching, Lebanon can no longer get away with half-hearted efforts and empty promises. Ultimately, this is a golden opportunity for Lebanon to redeem its finances. 

“The funding presents a unique opportunity for Lebanon to affect a sustained boost to its economy, attract much-needed capital inflows, help stabilise financial and foreign exchange markets, and catalyse job creation,” the IMF said. “An essential component of this process is the adoption and implementation of a structural reform programme, including a strategy to lower the public debt-to-GDP ratio toward a more sustainable trajectory.”

This sentiment is echoed by financial watchdogs across the world. Moody’s stated the aid package is credit positive because “it supports the resumption of public investment, while incentivising fiscal reform implementation as a condition for disbursements.”

Fitch agrees that the conditionality attached to the funds will pressurise Lebanon to stick to fiscal reforms. For example, Lebanon has pledged to enact fiscal consolidation worth five per cent of GDP over five years through boosting tax collection and reducing transfers to the state electricity company, Electricite du Liban. This would give Lebanon a lot more financial wiggle room. Currently, Lebanon’s public finances and fiscal flexibility are constrained by high spending pressures, including large and rising interest payments and transfers to Electricite du Liban (which increased by more than 50 per cent in the first 10 months of 2017 on the back of higher oil prices).

Interest payments account for close to 50 per cent of general government revenues, according to S&P, the highest ratio among its rated sovereigns.

Even $11 billion falls short of making Lebanon’s task an easy one. Lebanon’s economic situation is underlined by high public debt, current account deficit, and urgent funding needs. The IMF estimates that public debt is above 150 per cent of GDP and will continue to rise rapidly. Lebanon’s financial wounds run deep. The civil war which began in 1975 forever scarred Lebanon’s economic infrastructure and snuffed out its position as a leading light on the Middle Eastern banking scene. When the war ended in 1990, Lebanon borrowed heavily to rebuild its war-torn physical and financial infrastructure. It saddled Lebanon’s government with a debt it has never been able to repay. Slowing deposit inflows combined with large external financing needs has been steadily draining foreign assets from the economy since 2011.

In 2017, the net foreign assets position accumulated a loss of $156 million, according to the World Bank. The country’s sovereign credit ratings paint a bleak picture. Moody’s downgraded Lebanon from B2 to B3 in August 2017, while Fitch and S&P have maintained their ratings at B-/B3 equivalent. S&P expects that continued deposit inflows to the financial system will be enough to support the Government’s borrowing requirements and the country’s external deficit over the next 12 months. However, the rating agency notes that the Lebanese Government’s debt servicing capacity depends largely on the domestic financial sector’s willingness and ability to add to its holdings of government debt, which in turn relies on bank deposit inflows, particularly from non-residents, and also on central bank financing.

After a temporary improvement in the fiscal deficit in 2017, S&P expects Lebanon to face rising deficits averaging close to 11 per cent of GDP over 2018- 2021. According to the IMF, overall fiscal balances will reach well above 10 per cent of GDP and public debt close to 180 per cent of GDP by 2023. S&P projects that the economy will grow by an average of 2.3 per cent over 2018-2021, from an estimated 1.6 per cent in 2017—far below real GDP growth of 9.2 per cent over 2007—2010.

However, increasingly challenging measures continue to be undertaken by Lebanon’s Central Bank to replenish its reserves. By end-2017, foreign exchange reserves were back at $42 billion, compared to $43 billion before the November Crisis and $39.6 billion at the end of 2016, according to World Bank data. Lebanon’s resilience continues to be tried and tested.

“Lebanon’s economic conditions remain challenging and regional spillovers continue to dominate the near-term outlook,” said Jarvis. “Lebanon has provided a safe haven for over a million Syrian refugees—estimated to be about a quarter of the population. Lebanon has received international assistance for its efforts and deserves continued support.”

Indeed, the number of Syrian refugees has pushed Lebanon’s population up by almost 25 per cent. Not only has this put a kink in one of Lebanon’s major trade routes, but any financial gains will have to stretch 25 per cent further.

“While we project that real GDP will continue to increase on a headline basis, we estimate that trend growth in real GDP per capita will remain around negative 1.2 per cent over 2012-2021, which is below that of peers with similar levels of development,” said S&P. “This partly reflects the heavy burden imposed on Lebanon by the influx of refugees from the Syrian civil war. We also expect external security risks to remain high. The Syrian crisis has entered its seventh year, and Lebanon’s political, security, and economic trajectories will remain entwined with those of its larger neighbour.”

Lebanon’s traditional growth drivers—tourism, real estate and construction—are forecast to remain weak as long as the Syrian conflict continues. This has, understandably, put a strain on Lebanon’s creaky public services.

The quality of Lebanon’s infrastructure is amongst the poorest regionally and globally, according to the World Bank. In fact, out of 137 countries, Lebanon ranks 130 in quality of overall infrastructure. This has been induced by low public spending on infrastructure, a consequence of the county’s debt burden as well as the longterm absence of a budget.

“The authorities can also promote sustainable growth through structural reforms, including by taking steps to improve the business climate,” said Jarvis. “There is a need to improve the institutional framework before undertaking large investment projects, and to assess the risks and potential fiscal costs arising from any public-private partnership projects.”

Large infrastructure spending plans only heighten the need to improve fiscal sustainability, especially given large infrastructure spending plans. The outgoing parliament approved the 2018 budget in late March, targeting a deficit of 8.5 per cent of forecast GDP. This would be smaller than the budgeted 2017 deficit, but 0.8 percentage points larger than the actual 2017 deficit and would not reverse the rise in government debt/GDP.

However, Fitch pointed out that these two fiscal measures are both longstanding aims on which little progress has been made, and it is still unclear how they will be delivered. Without fiscal reform that lowers government borrowing needs, Banque du Liban, the Central Bank, will undertake further unconventional financial operations to maintain deposit inflows into the banking system, foreign exchange reserves, and confidence in the currency’s dollar peg.

In a further test of the country’s resilience, Lebanon must achieve fiscal sustainability against of a backdrop of political uncertainty. The presidential elections in October 2016, which broke the political deadlock that had lasted more than two years, and the formation of a new government in December 2016, promised a period of relative stability.

However, the surprise resignation of Lebanese Prime Minister Saad Hariri from Saudi Arabia in November 2017 illustrates the fragility of the political and geopolitical landscape. Hariri’s return to Lebanon and the retraction of his resignation in December 2017 stabilised the domestic political situation somewhat. It also led the different political factions to cooperate to a certain extent and agree on a dissociation policy in relation to regional conflicts, although, S&P says, its impact is questionable. It was hoped that May’s election, the country’s first in 10 years, would smooth the path for political progress; however, the result did little to fundamentally shift the political status quo or ease the country’s fiscal challenges.

Incumbent Prime Minister Saad Hariri’s position has been weakened, however, he is still the most likely candidate to form a new government. “The result underscores that policymaking will remain constrained by Lebanon’s sectarian-based political system and highlights that Lebanon could be dragged further into Iranrelated tensions,” Fitch warned. The immediate challenge is to form a new coalition government within a reasonable timeframe. “We do not anticipate a return to the political paralysis of 2014-2016, but a repeat of the five months of negotiations that followed the 2009 election would prevent effective policymaking for much of 2018. The quicker the process, the more supportive it will be for financial inflows,” Fitch said.

However, rising tensions between Saudi Arabia and Iran, as well as Israel and Hezbullah, along with continued conflict in Syria, will likely derail any push for material policy reforms and weigh on economic growth in the near term, S&P warned.

In the meantime, the country’s finances remain in a precarious position. In January, Moody’s lowered its Macro Profile for Lebanon’s banking system to “Very Weak +”. This followed Moody’s decision to change its assessment of the country’s susceptibility to event risk to ‘High --’ from ‘Moderate +’ and its assessment of institutional strength to ‘Low --’ from ‘Low’.

“After years of deterioration, the operating environment is stabilising,” said Alexios Philippides, an Assistant Vice President at Moody’s. “However, economic output will continue to be constrained by deteriorating basic infrastructure and businesses will defer investment decisions until there is further clarity on the political situation.”

Therefore, the rating agency expects modest credit growth of six per cent over the outlook period, similar to 2016, driven by the Central Bank’s support packages. The lower assessment of Lebanon’s institutional strength is a result of lower World Bank World Wide Governance Indicators for rule of law and control of corruption.

The difficult domestic political environment has led Lebanon’s ranking on the Worldwide Governance Indicators to deteriorate and its competitiveness to weaken. The Government’s high and increasing debt burden and reliance on the banking system to finance its large budget deficit render domestic banks susceptible to sovereign event risk and increased financial risks, Moody’s said.

Total banking system assets equalled over four times GDP at the end of 2016, one of the highest levels globally, driven by banks’ large sovereign exposures. Private-sector credit, at around 110 per cent of GDP as of the end of 2016, is also considered to be high compared with other emerging markets.

“To preserve confidence there is an urgent need to place the economy on a sustainable path and halt the rise in public debt,” said Jarvis. “Front-loaded fiscal adjustment is needed based on revenue measures, increasing tax compliance, increasing fuel taxation, and rebalanced spending, including by reducing costly electricity transfers.”

Lebanon’s new government has its work cut out. While the world has offered its support, circumstances appear to be against it. Hizbollah has entrenched its political position at the same time as the US and Saudi Arabia are moving to counter Iran and conflict rages on in Syria. Lebanon will have to find increasingly creative solutions to stop any spill overs from souring its donors’ generous mood.