Lebanon: Turning the corner?

2005 was not a great year for the economy. It now looks as though the economy almost stagnated in the aftermath of the assassination of former Prime Minister Rafiq al-Hariri. The best indicator of the impact of this event on the economy was the 1.3% decline in airport arrivals (despite a 25% leap in the first month of the year). But the impact of increased political uncertainty - which has yet to be resolved (see below) - has been felt across the whole economy. For instance, electricity production rose an anaemic 0.9%.

However, there are two pieces of good news. First, it could have been a lot worse. The structural nature of the economy makes it very vulnerable to any shocks in investor confidence, both domestically and internationally. The ability of the authorities weather the 5% dollarisation of deposits without abandoning the peg was crucial to avoiding a catastrophic sequence of events.

Looking forward, the risks to the Lebanese pound's peg to the USD look relatively limited as the country continues to record balance of payments surpluses, despite a still high current account deficit. This has resulted in a significant rise in foreign exchange reserves to USD 11.68bn at the end of March, equivalent to 15 months import cover (see page 11). Meanwhile, the West remains committed to stand by Lebanon after the exit of Syrian forces and this is unlikely to change for the foreseeable future.

Second, the indicators are starting to show signs of gradual improvement. Both tourist arrivals and electricity production have tentatively turned north. Therefore, we expect a modest acceleration in economic growth in 2006 to 2.5%, from a revised 0.5% estimate in 2005 (previously 1.0%). However, two inter-related things have to happen in order for such an outcome to occur: 1) concessional funding from the international financial community must be agreed; and 2) an acceleration of the reform agenda achieved.

The former requires the government to be able to convene a new donor conference where it apparently hopes an additional USD 5bn (over 20% of GDP) in loans will be extended. We expect this request to be well received by the international community with Prime Minister Siniora to visit the US and meet President Bush on April 18 and US officials already talking about the need to help Lebanon.

However, the timing is critical. Plans for a conference at the end of 2005 were put on hold, partially due to the political situation and partially due to the need for the Lebanese government to show its commitment to the reform process by passing the economic reform program discussed below. On the former, there are a lot of concerns about the current political situation, particularly surrounding the Presidency, and this could delay any such agreement being reached. Politicians have set a deadline on April 28 to decide on Lahoud's fate. As it stands, Lahoud's extended term is due to end in 2007, but many hope to remove him this year due to his pro-Syrian history.

On the latter, potential donors have been keen to stress that any funds will be conditional on the government's ability to reduce the fiscal deficit and increase the primary surplus, necessary to reduce debt levels. However, we expect lenders to be reasonably lenient as the nation gets used to independence. Therefore, as long as the administration is making real efforts to rectify the situation, then the lending agencies are unlikely to cease any program agreed.

That said, we still need to see an acceleration of the reform program. Prime Minister Fouad Siniora clearly has the credentials and the desire to push ahead with the reform program. Indeed, he has made some significant steps in terms of trying to limit the size of the fiscal deficit, although the decline in the deficit to the lowest post-war levels (still a whopping 8.2% of GDP) was largely caused by a decline in debt servicing costs despite an increase in the level of debt. And his attempts to streamline the policy decision-making process by allowing majority votes within the cabinet (rather than seeking consensus) and his efforts to emphasise the power of the Finance Ministry to restrain the spending of other ministries (which had previously paid little attention to budgets) are good starts.

Unfortunately, the harder issues remain and this is where cooperation with the President is required. Still the best example of the failure in this regard is the dramatic losses being suffered by state-owned Electricite du Liban (EdL). Lahoud and Hariri had a different perception as to the value of EdL to the government. Lahoud saw it as an asset that should remain in state hands. Hariri felt it was a liability that needed to be restructured and then sold off. Thus far, Hariri's analysis appears to have been closer to the point. The IMF has suggested that the government's support for EdL cost 4% of GDP in 2005.

With government debt standing at over 180% of GDP and rising, this is clearly money that the authorities do not have. Therefore, there needs to be an improvement in the relationship between the PM and the President. In terms of immediate priorities, while the EdL situation needs rectifying, this will take time. Therefore, the government needs to press ahead with the quicker fiscal wins such as trying to cut spending or, more importantly in the near term, raising taxes. The government has already formulated a plan aimed at first stabilising and then reducing the level of public debt. The plan includes the traditional remedies for such a weak position of cutting spending (in part by reducing the size of the public sector workforce), raising taxes (including the rate of VAT being increased from 10% to 15%) and pushing ahead with the privatisation of state assets.

Unfortunately, passing and implementing this reform package is unlikely to be straightforward. Discussions at the cabinet level were being put aside due to the need to resolve the political situation and dialogue has only recently started on the package. Meanwhile, there are many complaints about the rise in taxes with some calling on the government to sell its telecom operations instead to raise revenue to pay down the level of debt.

On the face of it, this looks like a good idea. The problem is that these clearly meet the definition of an asset with the telecoms sector as a whole generating around USD 1bn (4% of GDP) in revenue for the government per annum. Therefore, even if the President were to notionally agree to the sale, in itself a big assumption, the price of the sale would be hotly debated. Thus a sale this year looks highly unlikely. Given the time sensitivity of the situation, the government would be wise to make some quick wins in order to convince the international financial community that it is serious about pushing ahead with economic reforms aimed at reducing the level of the country's onerous debt burden.