• 6 pages
• Confidential
• September 22, 2009

An International Monetary Fund mission visited Lebanon September 10-18, 2009 to discuss developments through end-June 2009 under the authorities’ program supported by Emergency Post-Conflict Assistance (EPCA) and the outlook for 2009. The mission met with the Minister of Finance, the Governor of the Banque du Liban (BdL), and other high-ranking officials. The mission is grateful for the open and constructive dialogue, the warm hospitality, and the excellent cooperation.

A. Strong economic and financial performance in line with EPCA objectives

Lebanon is starting to reap the benefits of prudent macroeconomic policies. The two key objectives of EPCA—reducing the government debt-to-GDP ratio and strengthening international reserves—were clearly met, buoying confidence and economic activity despite the difficult international environment and recent delays in forming a government.

The most recent cyclical indicators point to ongoing strength in economic activity. The global financial crisis and recession has had only a limited impact on the Lebanese economy. Merchandise exports, which account for only a small share of the economy, have clearly been negatively affected by lower external demand, but construction activity appears to hold up well, and tourism and financial services continue to expand almost unabated. The limited data available do not suggest a sharp drop in remittances inflows. As a result, economic growth is likely to be stronger than projected at the time of our last visit: real GDP could grow at around 7 percent this year (instead of 4 percent). Inflation has dropped and, under the peg, is likely to remain subdued, given the benign inflation outlook in trading partners.

Sustained growth and fiscal discipline in line with EPCA targets have allowed for a further reduction in the government debt-to-GDP ratio. Buoyant tax revenues in light of sustained economic growth and improved efficiency in tax collection have helped to widen the primary surplus despite increased expenditure pressures. Continued fiscal discipline paired with the favorable macroeconomic situation has led the debt-to-GDP ratio to drop from 160 percent at end-2008 to 153 percent at end-June 2009. With this, the ratio has dropped by 27 percentage points since 2006, though it remains among the highest in the world.

Financial indicators point to ongoing strength in the banking sector and the balance of payments. Commercial bank deposits are continuing to grow at about 20 percent year-on-year and deposit dollarization has dropped, helped by ongoing confidence and attractive domestic interest rates. As a result, the BdL has continued to accumulate international reserves at a fast pace: at $24.8 billion (end-August), reserves have doubled over the last 18 months. In part thanks to prudent banking sector supervision, banks have virtually not been affected by the global financial crisis and have remained profitable and well-capitalized. Eurobond and Credit Default Swap spreads have moderated, and now move around the emerging markets average.

B. End-June performance under EPCA

Performance through end-June under the EPCA-supported program has remained broadly favorable, despite a few slippages.

International reserves exceeded the end-June indicative target by a wide margin. Strong deposit inflows and ongoing dedollarization have enabled the BdL to accumulate international reserves at a rapid pace, easily surpassing the program target.

The primary balance target was also met. Strong growth and the reintroduction of gasoline excises boosted tax revenues. Higher tax revenues compensated for lower telecom receipts and higher transfers to the Higher Relief Council and Electricité du Liban (EdL), resulting in a primary balance above the program floor.

Despite these favorable outcomes, government net borrowing from the BdL was substantially higher than the program ceiling, although the BdL’s monetary interventions more than offset the impact on reserve money. The net borrowing target was missed by 44 percent (LL 2.6 trillion) reflecting a drawdown of government deposits at the BdL and further T-bill purchases by the BdL. This overrun was in part a result of the commercial banks’ preference to purchase high-yielding 5-year Certificates of Deposit (CDs) offered on tap by the BdL rather than lower-yielding 3-year T-bills. Conducting monetary operations through CDs helped attract inflows, build reserves and support confidence during the global crisis, but crowded out the demand for lower-yielding T-bills and increasingly weighed on the BdL’s finances. In July, the BdL discontinued all issuance of CDs, and government net borrowing declined somewhat, also in light of a sizeable reduction in the BdL’s holdings of Lebanese government Eurobonds.

There has been limited progress on the program’s monitorable actions. The BdL has adopted formal policies for the selection, appointment, and rotation of the BdL’s external auditors (end-June monitorable action). However, the introduction of a Treasury Single Account (end-June monitorable action) was postponed because parliament did not pass the corresponding legislation. There has also been little progress on the revision of energy tariffs and the Global Income Tax law (end-December 2008 and end-March 2009 monitorable actions, respectively) because of the difficult political environment in the run-up to the election. Moreover, privatization of the mobile telephone companies (end-March monitorable action on the issuance of a request for applications), which had been postponed due to market conditions, would require a renewed political decision by the incoming government.

C. Economic and financial policies

Strong economic growth offers an opportunity to move decisively towards fiscal consolidation. Despite the recent successes in reducing the government debt-to-GDP ratio, the still very high debt remains a key vulnerability that needs to be addressed through higher primary surpluses. In the near-term, buoyant fiscal revenues provide a window of opportunity to move in this direction. In this environment, strict expenditure discipline would ensure that the strong revenues can be used to reduce the large fiscal deficit. On unchanged policies, a primary surplus (excluding grants) of 0.9 percent of GDP this year appears achievable (up from 0.6 percent in 2008), implying an overall fiscal deficit of 10.6 percent of GDP. With this, the debt-to-GDP ratio could decline to 151 percent by the end of the year.

With continued fiscal discipline, the government will likely be able to obtain the necessary financing from the market during the remainder of 2009. In light of continued strong commercial bank deposit inflows and the gradual unclogging of international capital markets, financing conditions are broadly favorable. Sufficient market financing will hence likely be available for the government during the remainder of 2009. The discontinuation of BdL CD issuance will also be beneficial in this respect. The government should continue to closely coordinate its foreign exchange financing policy with the BdL. Following the formation of a new government, swift authorization by parliament for additional issuance would substantially help in this respect.

Decisive action by the incoming government will be necessary to reach the substantial primary surpluses required to move the fiscal position towards sustainability over the medium term. The incoming government should strive to quickly restore the fiscal consolidation agenda set out under Paris III. Top priorities include a reduction in the need for budgetary transfers to EdL and an increase in the VAT rate. In addition, the authorities should work towards a substantial reform of the energy sector to spur growth, and reconsider the privatization of the two mobile phone providers in light of evolving market conditions.
Interest rates should gradually decline further in line with market conditions. Prior to the welcome discontinuation of CD issuance (mainly 5-year maturities), the BdL had reduced 5-year interest rates to 9 percent, a decline of 100 basis points over a 2½ month period. At an 8.4 percent yield, the newly issued 5-year T-bills trade even lower. Deposit inflows have so far not reacted to lower policy rates, perhaps in part due to lags, and it may be too early to evaluate the full impact. Further declines should therefore be implemented at a gradual pace, to allow adequate time for a fuller evaluation of the effects of earlier reductions. Making use of parts of the BdL’s large T-bill portfolio to absorb excess local currency liquidity would help prevent an overly quick decline in yields and allow the BdL to reverse the second quarter increase in net lending to government. Although these steps will likely help to reduce the cost of sterilization, over the medium term, a strategy to strengthen the BdL’s balance sheet would be welcome.

The increased confidence in the Lebanese pound has also helped to reduce dollarization. The share of U.S. dollar deposits in total bank deposits has declined to 66 percent in July 2009, down more than 10 percentage points since early 2008. However, dollarization of bank credit to the private sector has declined only marginally and still stands at 83 percent. Lower interest rates in Lebanese pound would increase the attractiveness of local currency loans and over time also reduce the need for subsidized local currency lending as a means to encourage loan dedollarization.

D. Other issues

The authorities’ interest in continued close engagement with the Fund following the expiration of EPCA is highly welcomed. Possible modalities can be explored once a new government is in place.

The authorities have expressed interest in an updated financial sector assessment under the Fund’s Financial Sector Assessment Program (FSAP). Staff could aim to arrange for a mission before end-April 2010, soon after the installment of a new Board of the Banking Control Commission (BCC), or else in late 2010 or beyond depending on the availability of Fund and World Bank staff resources.

Staff recommends Lebanon to consent to the amendments of the Fund Articles of Agreement for the creation of an investment authority and for the “quota and voice” reform. Both proposed amendments were approved by the Fund’s Board of Governors in early 2008 and await acceptance by at least 60 percent of Fund member countries before becoming effective. The amendments constitute modifications of an international agreement, and hence measures might be required under Lebanese law to enable Lebanon to consent.

Despite recent progress, the statistical system remains an important area for improvement. Real sector statistics should be compiled on a timely basis by the Central Administration for Statistics (CAS). The development of comprehensive statistics in the areas of real estate and labor markets would constitute a key improvement. Increased resources for the compilation of the balance of payments statistics would also be welcomed.

…

EBS/09/44

• 42 pages
• Confidential
• March 31, 2009

EXECUTIVE SUMMARY

Impact of the crisis

Despite its large vulnerabilities, Lebanon has so far weathered the global financial crisis and succeeded in maintaining financial stability, raising international reserves, and reducing public debt in 2008. The economy achieved record growth, and Eurobond spreads are now lower than the emerging market average. Fund engagement in Lebanon through the EPCA (which was broadly on track at end-December) has contributed to this performance. Lower global liquidity and the world economic downturn, particularly in the Gulf, will likely affect Lebanon in 2009, with lower growth and deposit inflows.

Policy discussions

Lebanon’s economy and financial system face three key risks: a larger-than-expected impact
of the global recession and slowdown in the Gulf; more difficult-than-anticipated
government financing; and political and security shocks, particularly in coincidence with the
June elections. To address these risks, the authorities intend to:

• Further accumulate reserves to preserve confidence through a sufficiently high
interest rate differential between domestic currency and foreign currency rates;

• Maintain the debt-to-GDP ratio constant to protect fiscal achievements and
allowing the 2009 financing needs to be met from the market, while addressing the
potential social needs arising from the effects of the global recession;

• Step up their vigilance over the banking sector, as banks could be hit by a
stronger-than-expected fall in deposit growth or a worsening in loan quality.

The Paris III agenda will remain the anchor for medium-term plans focusing on continued
fiscal consolidation mainly through revenue measures, such as an increase in VAT rate, and
the reduction in the large losses at Electricité du Liban (EdL). In addition, the telecom
privatization would boost private sector activity and further reduce the debt.
Staff appraisal

• Staff agrees with the authorities’ view of the risks in 2009, particularly in light of
their possible combined effect, which warrant the preparation of contingency plans;

• Monetary and exchange rate policy is broadly appropriate, but, given the downside
risks, staff recommended a tighter fiscal stance in 2009 to keep unchanged financing
requirements and ensure continued debt reduction;

• Restarting the medium-term Paris III agenda should be priority after the elections.

…

Post-Conflict Assistance

• Strictly Confidential
• 12 pages
• November 3, 2008

Mr. Dominique Strauss-Kahn
Managing Director
International Monetary Fund
700 19th Street, N.W.
Washington, D.C. 20431

Dear Mr. Strauss-Kahn:

The agreement reached at Doha in May 2008 paved the way for the election of a new president and the formation of a new national unity government, which was sworn in on July 11, 2008. The government’s principal task is now to prepare for the legislative elections of May 2009. In parallel, the country’s main political forces have resumed their national dialogue under the auspices of President Suleiman, with a view to finding a solution to the contentious political issues that have fueled internal strife and dissent.

The 2007 program supported by Emergency Post-Conflict Assistance (EPCA) was concluded successfully and was instrumental in strengthening internal financial discipline and mobilizing external financial support, although less than envisaged under Paris III. Since the 2006 conflict, Lebanon has made progress toward fiscal consolidation and has shored up its external position despite difficult circumstances. The primary fiscal balance (excluding grants) shifted into surplus in 2007, lowering the government debt-to-GDP ratio beyond what we envisaged under EPCA. Fiscal developments in the first seven months of 2008 have been favorable. In response to the heightened political uncertainty and the international financial turmoil, the policies of the Banque du Liban (BdL) ensured a steady increase in international reserves, which grew by $5.2 billion to $16.7 billion during the first eight months of 2008. The effective shielding of the domestic financial sector from exposure to international financial risks, also helped by prudent regulation, contributed to strengthening confidence in the exchange rate peg and the financial system, as reflected by the marked acceleration of deposit growth and dedollarization of deposits. As a consequence, the government was able to finance its domestic and foreign exchange currency needs largely from the market.

While macroeconomic developments have been favorable, Lebanon has not yet fully recovered from the 2006 conflict and the following stalemate. The absence of a functioning parliament and vacancies in key ministries created a substantial legislative backlog and the reconstruction and reform efforts did not progress as envisaged, also because of security issues. Finally, Lebanon will need considerable external support in 2008–09 to reinforce our balance of payments position––which has been adversely affected by the conflict and by the rise in food and energy prices––and to finance the reconstruction effort.