S&P affirms Lebanon 'B-/B' ratings with a stable outlook
Lebanon continues to show modest progress in normalising its divided political system, as evidenced by the adoption of the new electoral law in June this year.
The stable outlook on Lebanon reflects S&P’s expectation that continued deposit inflows to the financial system will remain sufficient to support the government's borrowing requirement and the country's external deficit over the next 12 months.
S&P could lower its ratings on Lebanon if the political and economic situation deteriorated, leading to significant declines in deposit growth rates or foreign currency reserves. It could raise the ratings if Lebanon's policy-making framework became more predictable and effective, boosting economic activity significantly more than its current forecast and improving the sustainability of public finances.
According to S&P, 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 nonresidents, and also on central bank financing. This structural weakness constrains the ratings, as do Lebanon's divided political environment and regional tensions. These factors have, in turn, hindered economic outcomes and public finances, to which consistently large fiscal deficits, as well as high, and rising, public debt attest. Lebanon's general government debt, at an estimated 148 per cent of GDP in 2017, is the third highest among all sovereigns rated by S&P Global Ratings, after Japan and Greece.
The ratings are supported by Lebanon's external profile. The country's liquid external assets (that is, foreign currency reserves and financial sector assets held abroad) exceed total external debt. The ratings agency however anticipates a gradual worsening profile as non-resident deposit inflows (largely from the Lebanese diaspora) continue to finance the country's large twin deficits.
Flexibility and performance profile—very high debt burden, with debt-servicing capacity dependent on deposit inflows. S&P expects the general government debt burden to remain very high through 2020. Banking sector deposit growth in Lebanon will remain sufficient to support the government's debt-servicing capacity. Lebanon will remain in a narrow net foreign asset position over the ratings forecast horizon through 2020.
Domestic banks support government debt-servicing in two ways. First, they buy Lebanese government debt directly. Banking-system claims on the public sector account for about 17 per cent of total banking system assets or about one-half of total government debt. Second, Lebanese banks buy certificates of deposit issued by Banque du Liban (BdL), the central bank, which in turn buys government debt. As of year-end 2016, BdL held about 43 per cent of the government's outstanding treasury bills, which amounted to about 27 per cent of total government debt. Although S&P views the concentration of government financing from these sources as a structural weakness, at the current rating level these flows are an essential support.
The general government is expected to post a modest primary fiscal surplus and the broader deficit will stabilise at 8.5 per cent of GDP through 2020. On the one hand, the end of the political vacuum and slightly better economic activity should improve the government's revenues. Although the parliament has not approved a budget since 2005, it has recently ratified tax increases, which are expected to finance a public-sector pay rise. On the other hand, Lebanon's public finances and fiscal flexibility will remain constrained by structural expenditure pressures, including transfers to the electricity company, Electricite du Liban (about six per cent of general government expenditure in 2016). Interest payments accounted for close to 50 per cent of general government revenues in 2016. This is the highest ratio among all sovereigns it rates.
Net general government debt is forecast stabilise at around 131 per cent of GDP from 2018. At about 40 per cent of total government debt, S&P considers the proportion of foreign currency-denominated debt in the government's overall funding structure as high, particularly in the context of the relatively short average maturity of sovereign debt. However, S&P expects Lebanon's exchange rate peg to remain in place over the next few years and so, to some extent, view the foreign-exchange risk related to the government's debt as mitigated.
The ratings agency also expects the current account deficit to remain large, averaging about 19 per cent of GDP over 2017-2020. The improved domestic political situation and the firmer oil price will likely boost tourism and remittance inflows from the large Lebanese diaspora, particularly from those expatriates residing in the Gulf Cooperation Council (GCC) states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates). On the other hand, a higher import bill is expected, arising from both the rebound in oil prices and improving domestic demand.
S&P anticipates that non-resident deposit inflows will remain an important source of financing for Lebanon's large current account deficit, followed by foreign direct investment and capital account receipts, including donor inflows in response to the refugee crisis. The financial system is instrumental in intermediating the country's external financing requirement. Nearly one-fourth of Lebanese bank deposits are externally sourced, mostly from the country's diaspora. The banking system is highly dollarized, with about 60 per cent of system deposits and nearly 70 per cent of bank loans to the resident private sector denominated in foreign currency.
Non-resident deposits into Lebanon are sensitive to swings in confidence. However, S&P notes that in past episodes of volatility, such as after the 2005 assassination of Prime Minister Rafic Hariri and during the 2006 war with Israel, withdrawals lasted only a few weeks. In addition, they were in the low-single-digit percentages of total bank deposits and were more than compensated by returning inflows.
The research and ratings agency observed a general deceleration in non-resident deposits growth between the start of the war in Syria in 2011 and early 2016. Growth of non-resident deposits had further slowed to a low of 1.5 per cent annually in April 2016, compared with an average of 11 per cent in the first half of 2015. S&P believes that the political vacuum and, to a lesser extent, the economic slowdown in the GCC region explained this slowdown. Non-resident deposit growth subsequently recovered to eight per cent annually in June and these deposits are expected to increase by at least six per cent annually by the end of forecast horizon. BdL has been playing a material role in steering macroeconomic and financial policy. It encouraged foreign inflows back to the economy and increased central bank reserves, closing a large balance-of-payments gap, through a financial engineering operation conducted between May and August 2016. However, the need for such an operation highlights Lebanon's relative vulnerability to shocks in foreign currency inflows.
Institutional and economic profile—sectarian divide of society and state results in a tense political environment and high regional security risks. S&P views Lebanon's institutional and governance effectiveness as weak, reflecting both its highly divided domestic political system and the high-risk regional security environment. Spillovers from the war in Syria have weighed on Lebanon's economic growth. However, potential for an improvement in the domestic environment following the presidential election held in 2016.
S&P sees long-term constraints on Lebanon's institutional and economic profile, largely stemming from a divided political environment organised along confessional lines. However, a period of relative political stability is expected following the presidential election in October 2016, which broke the political deadlock that had lasted for more than two years. This should bode well for confidence and support economic growth, opined S&P. Also, in June 2017, the cabinet approved a new electoral law paving the way for legislative polls, which is expected to take place in May 2018. The law will introduce a proportional representation system for parliamentary elections and adjust the number of districts from which members of parliament are elected. The law aims to more correctly reflect the make-up of Lebanon's population. The country has not held parliamentary elections since 2009.
The ratings agency projects that the economy will grow on average by about three per cent in real terms over 2017-2020, supported by a gradual rebound in domestic consumption and services' exports. The government recently approved decrees needed for the organisation of the country's first offshore oil and gas exploration and production licencing; but S&P does not incorporate the effects of any potential discoveries into their economic or fiscal forecasts at this time. It expects growth to also be supported by the authorities' efforts to normalise relations with the GCC states, an important source of visitors to the country (including Lebanese expatriates based in those countries).
Although S&P projects real GDP to continue to grow on a headline basis, the trend growth in real GDP per capita (which S&P proxies by using 10-year weighted-average growth) will remain around negative two per cent in 2011-2020, which is below that of peers that have similar levels of development. This partly reflects the heavy burden imposed on Lebanon by the influx of refugees from the Syrian civil war. Registered refugees number about one million, according to the U.N. High Commission for Refugees, and are included in Lebanon's population data. Unofficial estimates range up to about two million, representing about one-third of the total population.
In S&P’s view, external security risks remain high. The Syrian crisis has entered its seventh year without a resolution in sight; and S&P expects that Lebanon's political, security, and economic trajectories will remain entwined with those of its larger neighbour. Risks to Lebanese banks being impacted by possible additional US sanctions against Hezbollah remain. Nevertheless, S&P does not expect the country's important banking industry to be destabilised in their base-case scenario.