Lebanon's credit ratings upgraded

The outlook is stable.

The long-term foreign currency ratings of six Lebanese banks that were constrained by the sovereign's rating - Bank Audi-Audi Saradar Group, BBAC, BLOM Bank, Byblos Bank, Credit Libanais, and Fransabank - have also been raised to 'B' with a stable outlook.

The upgrade in the sovereign's ratings primarily reflects Lebanon's improved international liquidity position but also takes into account the reduction in near-term financing risks resulting from increased investor confidence and banking sector liquidity. Underlying the improvement in the sovereign's credit profile is the return of relative political normality over the past year or so, evidenced most recently by peaceful and undisputed parliamentary elections in June.

The decrease in political risk perceptions coupled with favourable interest rate differentials has contributed to a pick up in financial inflows and greater demand for local currency denominated deposits, enabling the central bank to almost double its foreign exchange reserves between end-2007 and April 2009 to $19bn (equivalent to 60% of GDP). Official reserves are currently about four times as high as annual government foreign currency debt service and, combined with the liquid foreign assets of the commercial banks, cover more than 70% of short-term external debt.

Although the government's projected gross financing requirement for 2009 is high at about 45% of GDP, the majority of foreign currency amortisation has already been covered through a eurobond exchange in March and strong deposit inflows should enable the government to tap the market again later in the year.

The government benefits from a largely passive and 'friendly' investor base dominated by local banks with large dollarised deposit bases relative to the size of the economy. The banking system been little affected by the global financial crisis, confidence in the system is high and bank deposits have been remarkably 'sticky' in the face of economic and political shocks over the past decade. The authorities also have good relations with international donors, notably Gulf countries, who have proven willing and able to provide timely financial assistance at times of financial stress.

The sovereign's ratings remain constrained by its weak public finances and political risk factors. Lebanon is highly vulnerable to shocks, and downside risks, if they were to materialise, could have a precipitous impact on the ratings of the sovereign and the banks. The government is the most indebted of all sovereigns rated by CI, with gross debt equivalent to 162% of GDP or 672% of budget revenue at end-2008, and the debt stock is unfavourably structured, resulting in heavy exposure to refinancing, interest rate and exchange rate risk.

The budget deficit is unsustainably high at around 10% of GDP and fiscal flexibility is constrained by weakness in revenue mobilisation and substantial expenditure rigidities, with interest expense alone accounting for more than one-third of public spending.

Progress on the reforms needed to reduce the large debt overhang and raise potential economic growth has been slow. There have been some efforts to strengthen public finance management and contain the budget deficit, which have contributed to a decline in government debt ratios over the past two years, and much preparatory work is being done as part of the medium-term reform programme presented by the authorities to international donors at the Paris III conference in January 2007.

However, there does not yet appear to be a broad-based political consensus on the substance of reforms and there is a high risk that many of the proposed measures will not be implemented in the coming years.