Lebanon: Debt locked

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Political deadlock could rob Lebanon of a golden opportunity to reform its sluggish economy

editor's pickMonday 12, November 2018

As Lebanon celebrated its 75th Independence Day in November, more than a few of its residents may not have felt like joining the party. It was hoped that May’s election, the country’s first in nine years, would smooth the path for political progress and unlock urgently-needed economic reforms; however, the result did little to fundamentally shift the political status quo or ease the country’s fiscal challenges.

Prime Minister Saad Hariri lost 40 per cent of his seats but remains in power, and six months on he has yet to form a government. His failure to form a new coalition could cost the country $11 billion in foreign funds, which donors pledged on the condition that promised reforms would finally see the light of day. While the country faces political deadlock, the World Bank estimates that some 200,000 additional Lebanese have been pushed into poverty as a result of the Syrian crisis, unemployment is in excess of 35 per cent and economic growth remains well below potential with little hope of picking up in the near future.

Lebanon’s economy is plagued by corruption and characterised by high public debt, current account deficit and urgent funding needs. The two stalwarts of its economy, real estate and construction, have been flattened by regional turmoil and are unlikely to recover any time soon. A confluence of factors, local and global, continue to weigh down on Lebanon’s already fragile finances. The conflict in Syria rages on, while the persistently sluggish economy is taking a toll on private and public balance sheets, further quashing economic growth.

Golden moment

Its current political paralysis couldn’t have struck at a worse time. 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. However, in return for their generosity, donors wanted Lebanon to stick to promised reforms including an overhaul of its legal frameworks, fiscal discipline and regulatory environment.

Lebanon’s new benefactors wanted to see the country commit to a fiscal consolidation plan that will tame its debt and soothe corruption. Unless Hariri forms a government, this isn’t going to happen. If this line of credit is snapped back, it would be an enormous blow to sentiment and economic activity is likely to remain stagnant, leave businesses struggling with deteriorating basic infrastructure and the government with large external and fiscal deficits. A country in urgent need of financial assistance and fiscal reform cannot afford to waste such a golden opportunity.

Fiscally unit

However, although the loans would provide financial relief, Lebanon is already the most indebted country in the Middle East. The IMF estimates that public debt is above 150 per cent of GDP, which could rise to 180 per cent in the next five years. 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.

S&P 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. According to the World Bank, this is proving increasingly challenging in light of slower deposit growth, especially as US interest rates rise. Meanwhile, there is a near-complete void of government initiative to address macroeconomic imbalances and other structural bottlenecks such as power generation in Lebanon.

Progressively potent interventions by Banque du Liban to actively manage economic and financial challenges facing the country, even when successful, offer only temporary reprieve, and are not without additional macro-financial risks, the World Bank wrote. 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.

A flawed model

S&P forecasts 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, the World Bank and the IMF seem to think this is over optimistic, and don’t expect growth over 1.5 per cent. Furthermore, the World Bank recently wrote that Lebanon’s previous dizzying growth rate masked a flawed economic model. “Lebanon’s real GDP growth has decelerated sharply since 2010, but its main drivers have remained services characterised by low productivity and low employability potential for high-skill labour,” the World Bank said.

Breaking it down, Lebanon’s service sector constituted 72.4 per cent of real GDP over the 2004-2016 period, while industry and agriculture made up a much less 14 per cent and 4.3 per cent of GDP, respectively. Real estate is the largest service sector, averaging 13.7 per cent of GDP over the same period, and increasing to 17.3 per cent if combined with construction. Wholesale and retail trade is also a principal output for the economy, making up 13.4 per cent of GDP. This is followed by public administration at 9.4 per cent of GDP and financial services at 7.3 per cent of GDP. O

ut of the above, all but financial services are low value-added sectors and do not generate high skill employment opportunities, the World Bank noted. On the demand side, the economy is strongly biased towards a large structural external deficit position. Lebanon’s economy is heavily consumption based, with private consumption averaging 88.4 percent of GDP over the 2004-2016 period. The main supply-side sectors identified by the World Bank do not produce the consumption goods in demand, which are instead largely imported. “This renders the external sector a large net negative on output, averaging -24.4 percent of GDP over the 2004- 2016 period,” the World Bank said.

“Meanwhile, total investments at 23 per cent of GDP has mostly been focused on a non-productive, rent-seeking, real estate sector.” It is perhaps little wonder that Lebanon ranks as one of the least competitive economies, both globally and regionally. The Global Competitiveness Index by the World Economic Forum ranks Lebanon 105th of 137 countries, ahead of only Yemen in the region. Moreover, Lebanon’s backslide in competitiveness has been the most marked in the region over the past decade, the World Bank noted.

Debt trap

 Lebanon’s banks are shouldering the bulk of Lebanon’s debt. Thankfully, it appears to be in safe hands for the moment. Moody’s outlook for Lebanon's banking system is stable, reflecting the expectation of a modest pick-up in economic activity and continued inflows of foreign deposits, helping banks to finance the government and the economy. "Operating conditions in Lebanon have stabilised but will remain challenging," said Alexios Philippides, a Moody's Assistant Vice President, Analyst. "We forecast a modest rise in real GDP growth to a still weak 2.5 per cent in 2018 and three per cent in 2019 from 1.9 per cent in 2017.

This will be driven by greater economic policy coordination and our expectation that the government will resume long-delayed public investment projects." However, the rating agency warns that renewed political or geopolitical unrest could derail the reform agenda and damage confidence. With interest rates rising, Moody's expects modest domestic credit growth between two and three per cent over the next 12-18 months. Banks' heavy sovereign exposure are another threat. Large fiscal deficits of around eight per cent this year and next will be financed primarily by the banks.

Sovereign exposure made up about half of banks' total assets at end-2017, linking their creditworthiness with the heavily indebted Lebanese Government and exposing them to interest rate and liquidity risks. Continued pressure on the banks' loan quality is expected, driven by seven years of sub-par economic growth, rising interest rates and the impact of low confidence on the real estate sector and consumption Moody's base expectation is that Lebanese banks will continue to attract the needed inflows of customer deposits, much of this from the Lebanese diaspora.

Deposits should grow by between five and six per cent. A significant slowdown in deposit inflows would challenge both the banks' ability to finance the government and the economy; this is the main risk to Moody's stable outlook. The Lebanese financial system maintains considerable liquidity buffers, driven by the Banque du Liban's large gross foreign reserves, to weather a period of slower financial inflows or short-term outflows and conversions into foreign currency, partially mitigating the risk of deposit flight.

Moody's says that it continues to consider the banks' capital buffers to be modest, with sector-wide equity to assets at around nine per cent, in view of their heavy exposure to the sovereign and the challenging operating environment. Rated banks already meet the higher Basel III capital requirements that must be phased in by the end of 2018. Moody's expects banks to post a net income to tangible assets of around 1.0 per cent. This is below the 1.2 per cent average recorded for Lebanese banks during 2017. Subdued business generation, higher provisions costs from low levels in 2017 and higher taxes will trim banks' profitability.

Trouble next door

It could be said that Lebanon is a victim of its own generosity. It has taken in over a million Syrian refugees, an act the IMF says is worthy of the world’s support. 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. S&P predicts that real GDP per capita will remain around -1.2 per cent over 2012-2021, partly because of the heavy burden the influx of refugees has imposed on Lebanon’s already stretched resources.

Indeed, the swell in population has 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 long-term absence of a budget. Lebanon’s exports have also been severely afflicted by the regional turmoil, although a decline in their share of GDP has been in effect since 2008, when they reached a high of 78.1 per cent of GDP, according to the World Bank.

By 2017, exports regressed to a low of 36 per cent of GDP. Exports of merchandise goods were especially hard hit by the closure of the last remaining Syrian route in May 2015, through which exporters were able to access the GCC and Iraqi markets. At least the Syria-Jordan Nassib border crossing has recently reopened, which is a main gateway for Lebanese exports into the GCC and Iraqi markets.

Lebanon is bound to feel the benefits of this in 2019. The IMF says that early resolution of the conflict in Syria would do wonders for Lebanon’s growth prospects. However, that is not the only challenge the country is facing. While Hariri drags his heels, the US and Saudi Arabia are moving to counter Iran. In the eye of the storm, it is a wonder that Lebanon managed to have an election at all. Perhaps as Lebanon commemorates 75 years of independence among rising debt, political deadlock and an increasingly disillusioned public, it’s best to celebrate the small victories. 

TAGS : World Bank, Lebanese banks, Hariri, Moody's

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