Public Information Notice No. 01/109

Public Information Notice: IMF Concludes Article IV Consultation with Lebanon

October 29, 2001

On October 17, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Lebanon.¹

Background

Economic conditions have worsened in Lebanon in the past few years. Growth has stagnated, leading to a fall in per capita real GDP. The fall in growth is related to the slowdown in residential housing construction and in the government's reconstruction program, but it is also attributable to the very large and persistent macroeconomic imbalances, the loss of competitiveness, and structural and administrative impediments. Stubbornly high fiscal deficits in the context of decelerating growth and high interest rates have led to a rapid accumulation of public debt. Competitiveness has been adversely affected by a substantial appreciation of Lebanon's real effective exchange rate—mainly a consequence of de facto peg of the Lebanese pound to the U.S. dollar since late 1998 and the latter's strength vis-à-vis world currencies—and rapid growth in unit labor costs.

The fiscal deficit, after some reduction in 1998 and 1999, widened substantially in 2000 to about 25 percent of GDP. The deficit is expected to decline to about 18½ percent of GDP in 2001. Gross public debt has risen by almost 20 percentage points a year since the end of 1998 and reached 160 percent of GDP at the end of June 2001. Interest obligations on this debt exceeds 90 percent of government revenue. The bulk of the debt is held by Lebanese banks and is denominated in Lebanese pounds, although the share of foreign currency loans is growing. Banks have been able to finance the deficits because of robust growth in the deposit base. However, since early 2000, growth in money demand and the demand for claims on the government have softened and even rolling over some traditional public debt instruments has become more difficult. The government's financing needs have increasingly been met by the central bank.

The expansion in central bank financing of the government, in the context of a fixed exchange rate regime and unchanged interest rates, has resulted in a substantial loss of international reserves of Banque du Liban. Even though Eurobond proceeds and additional deposits have added to international reserves, gross international reserves (excluding gold) were US$5.1 billion at the end of June 2001, down by US$2.6 billion since December 1999. The decline in net international reserves has been steeper, reflecting the trend shift from local currency to dollar deposits, and stood at US$1.2 billion at the end of June 2001, compared with US$5.1 billion at end-1999.

An updated Financial Sector Stability Assessment (FSSA) found the banking system to be profitable, liquid, well capitalized, and well-hedged against several important sources of risks, even though the zero risk weight attached to government securities denominated in Lebanese pound overstate the strength of the system. Interest rate risk represents the main risk for banks, relating to the large and growing maturity mis-match between bank assets and liabilities.

The government that took office in October 2000 is preparing for a major fiscal effort starting in 2002 to halt the growth in public debt. The objective is to turn the primary deficit of 1½ percent of GDP in 2001 into a surplus of 1 percent of GDP in 2002 and 4 percent in 2003, and reduce the overall deficit to 15 percent of GDP by 2003. The main measures are the introduction of a VAT and expenditure cuts. To restore competitiveness and spur economic growth, the authorities rely on structural reforms, and key priorities are privatization, tariff reductions, and improvements in the business environment more generally.

Executive Board Assessment

Lebanon faces formidable economic challenges in a context of severe fiscal imbalances and a particularly difficult external environment. Over the past few years, the government deficit and real interest rates have been extremely high, the public debt ratio has risen sharply to unsustainable levels, and real GDP growth has slowed. Directors considered that nothing short of a major and sustained adjustment effort in the public finances in the short and over the medium term would help restore confidence, lower real interest rates, and begin to address the debt dynamics.

Implementation of structural reforms also would be critical. In this regard, Directors welcomed the authorities' efforts in the past twelve months to develop a series of wide-ranging reforms aimed at reducing the cost of doing business, and thus encouraging private investment and reinvigorating the economy. They stressed the key role that privatization may play in this regard, and highlighted the urgency of putting promptly in place an appropriate regulatory framework for each of the activities to be privatized. The importance of good governance and transparency in the implementation process was also emphasized.

In looking at the period immediately ahead, Directors expressed concern about the vulnerability of the economy, particularly in light of the economic slowdown, the size of the fiscal deficit, the real appreciation of the local currency, the serious deterioration in the external reserve position, the negative perception of rating agencies, and the difficulties in placing domestic currency debt with banks. They stressed that it was essential to build confidence to avert a serious problem and create conditions for implementation of the authorities' medium-term strategy. To this end, key elements would be steeped-up efforts now to reduce fiscal imbalances, and parliamentary approval and full implementation of the fiscal adjustment envisaged for 2002. In this regard, Directors were encouraged by the authorities' recent measures to strengthen fiscal performance during the remainder of this year, and they welcomed the measures included in the 2002 budget, in particular the decision of the cabinet to introduce the VAT. They urged the authorities to press for timely passage of the VAT law, and to proceed to implement the tax swiftly. Directors welcomed the planned cuts in non-interest expenditure as well as the containment of public sector wages and capital spending. Timely steps to strengthen the management of the electricity company, so as to phase out its reliance on budget transfers, were also viewed as critical.

Directors welcomed the authorities' commitment to reviving economic growth and consolidating the public finances over the medium term. They considered, however, that even if fully implemented and consolidated in subsequent years, the envisaged fiscal adjustment would stabilize the debt ratio at a still extremely high level. Moreover, they saw a risk in that a more manageable ratio was expected to be achieved mainly through the realization of uncertain privatization proceeds. Directors, therefore, urged the authorities to develop as rapidly as possible a convincing strategy to bring down the debt ratio. In this connection, some Directors also recommended keeping open the option of an exchange rate adjustment, in conjunction with appropriate fiscal and monetary policies and ambitious structural reforms. While acknowledging the need for strong macroeconomic and structural policies, other Directors, pointing to Lebanon's circumstances, and the risks involved, saw however, little merit in pursuing the option of exchange rate action.

Directors commended the authorities for having effectively addressed previously identified issues in banking supervision. They were encouraged with the FSSA report that indicated that the banks are relatively well capitalized, liquid, and profitable, and that the continuing growth of private financial savings rewards the emphasis of the authorities on the soundness and credibility of the banking system. Moreover, strong steps had been taken to reform the provisions of bank secrecy and meet Financial Action Task Force recommendations for money laundering. While confidence in the banking system is strong, Directors concurred with the conclusion of the FSSA update that the banking system remains vulnerable to interest rate risk and its large exposure to government debt, until macroeconomic imbalances and the debt overhang are fundamentally addressed.

In other areas of structural reforms, progress on regional trade agreements and on negotiating an association agreement with the European Union was welcomed as were the initial steps taken toward reforming the National Social Security Fund.

Directors regretted that the paucity of hard economic data seriously hindered Fund surveillance and policy design, and could affect market confidence. Accordingly, they welcomed the ongoing administrative rehabilitation of the Central Administration of Statistics, and noted the need for quick progress, particularly in the areas of national accounts and balance of payments data. In addition, Directors urged the authorities to make productive use of IMF technical assistance in order to enhance data quality in general.

Directors expressed the view that financial support from the international community for Lebanon's adjustment efforts would have to be predicated on the implementation of a strong fiscal and structural adjustment strategy, including measures to enhance competitiveness, and on the development of a policy framework for the medium term that would effectively reduce the debt ratio. In this context, Directors recommended that the authorities intensify their close cooperation with the Fund.