Lebanon: now for the hard part

After three weeks of positioning by the major political parties, President Lahoud has approved the formation of a government under Prime Minister Siniora late on Tuesday.

The new cabinet will be the first since Syria's military withdrawal from Lebanon in the wake of the assassination of former PM Rafik Hariri in February and largely reflects the results of last month's elections.

International attention has centred on the first appointment of a cabinet minister from Hizbullah and the exclusion of Michel Aoun, leader of the main Christian block, the Free Patriotic Movement (FPM). Hizbullah's representative, Mohammed Fneish, has been appointed to the relatively minor role of water and energy minister, which will undoubtedly complicate relations with the US.

However, much more important for Lebanon's medium term economic prospects will be whether the new government can improve the domestic security situation and reinvigorate the reform process.

The first focus will likely be relations with Syria, following its recent military withdrawal, which the new PM has stressed are still important to the country, and the security situation, which has deteriorated markedly since the assassination of former PM Hariri.

Improving security will be critical in order to support Lebanon's tourism industry. The sector, the main driver of last year's economic upturn, has seen arrival numbers fall y/y since February. Arrivals in June fell 9.2% y/y, and first-half numbers were down 30% y/y. Instilling confidence in Lebanon's security will be crucial to seeing numbers improve.

$33bn public debt

The biggest medium term issue remains tackling Lebanon's USD 33bn public debt, equivalent to 180% of GDP, and avoiding a painful fiscal adjustment. Here, PM Siniora's appointment has led to increasing optimism that economic reform will now accelerate.

Siniora was the Finance Minster during most of the post war period and has a reputation of being business friendly. Although his tenure saw an exponential increase in government debt, Siniora was the architect of introducing the value-added tax in 2002, the most important economic reform in recent years.

From a reform standpoint how the relationship between Lahoud and Siniora evolves will be key. The often-fractious relationship between Lahoud and former PM Hariri was often cited as one of the main impediments to reform over the last decade. Following last year's constitution changes - that provoked UN Security Resolution 1559 - Lahoud is scheduled to remain in power until 2007.

Still time for reform

The good news is that Lebanon has time to put its economic house in order. However, much needs to be done to reduce the fiscal deficit. This is clearly an uphill struggle with almost two-thirds of government spending being used to service debt.

Clearly this cannot go on forever. Despite strong growth in tax revenues last year, the government fell short of reaching its target of a 6% primary budget surplus (which excludes debt service).

Under the IMF's Debt Sustainability Framework the Lebanese government needs to achieve an average primary surplus of 6.5% over the next five years to bring the debt to GDP ratio down to 146% of GDP. This is achievable but will require further fiscal consolidation, strong economic growth and critically significant privatisation.

There is no doubt that Syria's military withdrawal and June's parliamentary elections have created a new political environment in Lebanon. One in which hopefully meaningful economic reform can at last take place.

Nonetheless in previous 'fresh starts', such as following the Paris II debt agreement, there has been a tendency to disappoint. There are a lot of hopes that this time will be different. The cabinet's first policy statement and ensuing discussions will be the first indicator of the whether these hopes will be realised.