Lebanon: Rebuilding all over again

A fragile truce

At the time of writing, the UN-brokered ceasefire, which ended the 33-day conflict between Israel and Hezbollah on 14 August, continued to hold. However, the ceasefire remains fragile. Israel has indicated it is entitled to use force to prevent Hezbollah from rearming and to clear guerrilla positions under the UN resolution. Meanwhile, Hezbollah has said it reserved the right to fight Israeli soldiers still on Lebanese soil.

Indeed, there have been clashes between Israeli troops and Hezbollah fighters, which could easily spiral back into a larger conflict. The ceasefire is weakened by the delay in sending international and Lebanese troops to the border area. On a longer-term issue, implicit in Resolution 1701 is that Hezbollah should no longer operate as a military force.

This will be difficult for the Lebanese government to enforce, especially as Hezbollah has indicated now is not the time for disarmament. The risk of the conflict escalating remains significant, which would be detrimental for the recovery process. However, in our central scenario, although skirmishes will continue in the border area, the conflict is not forecast to spread to the levels earlier in the short-term.

Economy to contract in 2006

Along with the devastating cost to human lives, Lebanon's economic position has deteriorated markedly as a result of the war. This follows indications that the economy rebounded strongly in H1 2006. The buoyant economic performance was being driven by a rebound in tourism and strong performance of exports.

The Council for Development and Reconstruction has placed the cost of infrastructural damage at USD 3.6bn. However, this excludes the wider losses to the economy. As a result of the conflict, the economy will contract sharply in H2 2006 and we are now forecasting real GDP growth will contract by 6.2% in 2006.

There are a number of factors behind the contraction in the economy, namely the loss of tourism revenue and export capacity. The ability of companies to function and export has been greatly curtailed by the damage to infrastructure as well as blockades from Israel. These factors, along with the loss in private income and sentiment, will result in private consumption to contract sharply in H2 2006.

Wider deterioration in the economy

Other macro-economic indicators will also deteriorate in 2006 owing to the conflict. The fiscal deficit will widen as tax revenues fall with the contraction in business activity. Meanwhile, government spending will expand sharply as a result of emergency and reconstruction spending.

The trade deficit will also deteriorate given the destruction to the production and export capacity. Despite the end of the conflict, the Israeli air and sea blockade continued at the time of writing. The import bill will surge to cover fuel imports and basic goods. Imports will also be driven higher by the rebuilding process.

Furthermore, the services account will deteriorate as tourism revenue plummets. However, the overall current account deficit will likely narrow with increase inflows of aid, grants and remittances. Meanwhile, inflation will accelerate in H2 2006 as the sea and air blockade and shortage of goods will result in rising prices. The cost of vegetables and other household products, as well as black market fuel, in some cases doubled during the war.

V-shaped recovery

However, we are forecasting a v-shaped recovery, although this is dependant on the ceasefire holding. Higher investment spending linked to the reconstruction process is expected to drive real GDP growth of 12.0% in 2007. The majority of the rebuilding will initially be financed by either donor support or government and private Lebanese initiative.

For example, Lebanese individuals and private companies have donated funding for the reconstruction of 12 of the 80 bridges destroyed. With regards to donor support, the Saudi and Kuwaiti governments have donated USD 500m and USD 300m respectively in grants for the rebuilding and the international community pledged USD 940m in aid in a donor conference held at end-August. It will take a longer period of peace for foreign investment to return to Lebanon.

With regards to the government, emphasis has shifted from the reform program, which focused on reducing fiscal imbalances, to the reconstruction of the country. The parliamentary Commission for Public Works, Energy and Water has devised a 6-step plan to tackle the reconstruction. Beirut had made it clear to potential donors it wants to lead its own reconstruction effort.

In another positive development, the authorities have continued in managing the stability of the currency. Breaking of the currency-trading band against the US dollar would have increased the cost of servicing and repaying external debt, which accounted for 51.3% of total government debt in May 2006.

Supporting the Lebanese pound

The greatest demand for the US dollar was at the initial stages of the conflict and the central bank had to intervene by drawing down its FX reserves. However, the central bank indicated the intervention required was less than following the assassination of ex-Prime Minister Rafiq Hariri. The domestic currency was partly supported by the record high FX reserves held at the central bank; reserves stood at USD 12.9bn at mid-July.

Confidence in the Lebanese pound increased following Saudi Arabian and Kuwaiti's announcements that they will transfer USD 1bn and USD 500m to Lebanon's central bank respectively. By the fourth week of the conflict, the central bank barely had to intervene in the currency market. Importantly, FX reserves only fell to USD 12.6bn by 15 August, following the USD 1bn Saudi deposit; this figure excluded the USD 500m pledged from Kuwait.

Debt support required

As in previous crises, the yields on government Eurobonds increased owing to the higher risk premium. However, the government is unlikely to default on its sovereign debt in the short term due to the combination of the composition of investors and the Gulf support highlighted. The bulk of the government debt (including foreign) is held by Lebanese banks, which alleviates massive exists at times of crisis.

Credit ratings agency Standard & Poor's said the Gulf pledges are helpful for the country's near-term rating prospects and would help bolster depositor confidence in the Lebanese banking system, although the agency placed Lebanon's 'B-' long-term sovereign rating on credit watch with negative implications. Meanwhile, Fitch cut Lebanon's credit rating outlook to stable from positive.

Donor support also remains vital for managing the already high debt positions. Prior to the conflict, government debt amounted to USD 38.7bn, equivalent to over 175% of GDP. Debt levels will increase going forward with the rebuilding process and international grants will be central in limiting the increase in debt. Importantly, the crisis has hastened the convening of the delayed meeting to 31 August in Sweden.

This will be followed by a meeting in Beirut to address longer-term economic needs. However, for Lebanon's debt position to reach a sustainable long-term level, a significant level of debt forgiveness is required, rather than just restructuring and grants.