Confidence is Key

The UN report on former Lebanese PM Hariri's assassination on Friday pointed the finger at senior government/security officials in Syria and Lebanon. However, the decision to give until December 15th for further investigation may buy time for a UN-Syria diplomatic agreement to be reached. The impact of this report on financial markets is likely to be relatively muted as the conclusions drawn were widely expected. However, given Lebanon's precarious financial position, confidence is key.

International versus domestic

The UN's report has serious consequences for both Syria and Lebanon. For Syria, international pressure is increasing, while in Lebanon, domestic political pressures are building.

Syrian President Bashar Al Assad is clearly under intense scrutiny with his brother and brother-in-law amongst those under suspicion of involvement and the UN report concluding senior Syrian officials deliberately tried to mislead investigators. The US has already indicated there is sufficient information to warrant action of some description. The tone of the language has led some to fear they are considering military action.

However, we doubt the UN would agree to such a response and, with the events in Iraq fresh in the memory of both the US administration and its electorate, it is doubtful the US will be prepared to go it alone. Therefore, sanctions are the more likely outcome.

A decision on this could come as early as the scheduled UN Security Council meeting on Tuesday, but this possibility is complicated by the release of another UN report, expected to allege the Syrian funding of guerrilla activities in Lebanon. The timing of this report may give the US an incentive to delay the UN reaching a decision on what action to take.

Meanwhile, Syrian authorities remain resolute there is no evidence of any official involvement in the assassination and that the UN report is politically motivated. It also called criticism that it delayed cooperation initially and later was cooperative only in 'form, not substance' as baseless.

The authorities also promised to cooperate in the future, allowing the UN investigation team to question Syrian officials outside of Syria - something not allowed previously. There is clearly much international consternation at the alleged government involvement in the assassination, but domestically it is unclear at this juncture what the long-term political impact will be.

In Lebanon, the pressures appear more intense. President Emile Lahoud's close association with the Syrian leadership, and with those who have been named as suspects in the investigation, is resulting in many questions being asked.

Following the report's release, a rally of around 2000 Hariri supporters demanded the President step down. At the moment, these demonstrations appear unlikely to force Lahoud's resignation. However, a change in the domestic political environment is an increasing possibility following the UN report.

Confidence is key

The key here is what the impact of this is on confidence. Lebanon has many economic challenges, including a huge current account deficit (around 20% of GDP), external debt of around 140% of GDP and a budget deficit at close to 10% of GDP. This is reflected in weak long-term foreign currency ratings of B3 (Moody's) and B- (S&P), both with a stable outlook. Thus anything that increases uncertainty could undermine the country's ability to service its high debt levels (around 180% of GDP).

So far this year, the news on this front has been encouraging. The country's Eurobonds have tightened over the past 8 months. For instance, the spread of a 2yr issue over the comparable US Treasury has narrowed from almost 420bps to around 220bps currently. While this widened marginally on Friday, it remains significantly narrower than the 270bps spread seen before the assassination and narrower than week ago levels.

Furthermore, earlier this month, the government launched a 10yr issue and increased its size from a suggested USD 500m to USD 750m, illustrating the still strong demand for its paper. On the stock market, the BLOM index fell 1.8% on Friday, but has risen so far today and is above week ago levels.

Cognisant of the vulnerabilities, however, the authorities have been lengthening the maturity profile of its foreign debt, and thus reducing its vulnerability to swings in appetite for its paper.

This reduced vulnerability is reinforced by the fact that there is a significant local bid for the country's foreign currency paper. For this reason, its USD 3.1bn in maturing debt in 2006 (despite being over 15% of estimated GDP) is not seen as problematic.

However, should the domestic political and reform environment deteriorate, a loss of confidence could ensue and lead to a debt spiral that everybody fears. The presence of continued foreign worker income inflows, reduces the probability of this outcome, but it is still a risk.

Ultimately, the relationship between the Prime Minister and the President is key. Previously, disagreements on the direction of economic reforms between President Lahoud and former PM Hariri stalled the reform process. Recent developments risk forging an even bigger gap between Lahoud and new PM Fouad Siniora, which would be disappointing for reform and the country's medium-term prospects.