Public Information Notice No. 06/58

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Lebanon

May 30, 2006

On May 3, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the 2006 Article IV consultation with Lebanon.¹

Background

Economic developments since 2003 have been shaped by major changes in the political landscape. Former Prime Minister Hariri's assassination in February 2005 plunged the country into a period of political and financial turbulence. Significant deposit withdrawals and a sharp rise in dollarization put pressure on international reserves, which declined by about $2 billion in the first quarter of 2005. However, by mid-year, the financial situation had stabilised, and with a resumption of deposit inflows, liquidity conditions have improved markedly. Upon taking office in July, Prime Minister Siniora announced that the government would pursue an ambitious economic reform and adjustment program. However, adoption of the program has been delayed by renewed political tensions.

GDP growth slowed down considerably in 2005, following a strong showing in 2004. A surge in tourism and construction activity, and strong exports contributed to increase GDP growth to 6 percent in 2004. In the wake of the political crisis, public and private demand contracted in 2005, though export growth remained strong. In the event, real GDP is estimated to have grown by 1 percent, and inflation declined to 0.3 percent in 2005.

Rising oil prices, the economic slowdown, and payments of arrears all weakened public finances, although a decline in the interest bill helped mitigate these factors, and the overall fiscal deficit declined slightly to 8 percent of GDP in 2005. Still, the government debt rose to 175 percent of GDP. Part of the cost of financial stabilization in recent years has been absorbed by the central bank.

The economic slowdown as well as buoyant exports helped narrow the current account deficit to an estimated 13 percent of GDP in 2005, notwithstanding higher oil prices and losses in tourism. The negative shock to the financial account of the balance of payments in the first half of the year was more than offset by the recovery of Foreign Direct Investment and portfolio inflows in the second half, and by end-2005 gross international reserves were back at their end-2004 level.

Moderate progress has been made on the structural reform agenda since 2004. Most public sector reforms have been of an administrative nature, with a number of legislative proposals pending in parliament, including those on revenue administration and debt management, laws to regulate capital markets and bank mergers, as well as competition and domestic market reform.

Executive Board Assessment

Executive Directors welcomed Lebanon's swift recovery from the financial shock triggered by Prime Minister Hariri's assassination in February 2005, and praised the authorities for their skillful handling of the economy during this period, which helped restore market confidence by mid-2005.

Directors pointed to recent developments that exposed not only the Lebanese economy's resilience to shocks, but also the significant vulnerabilities that need to be addressed. In particular, they emphasized the risks deriving from the large and growing public debt overhang, the high degree of dollarization, the large fiscal and current account deficits, and Lebanon's reliance on short-term inflows to finance these deficits. While the benign external environment, ample regional liquidity, and the stability of the depositor base have muted these risks so far, continued capital inflows are highly dependent on depositor confidence, which may not prevail indefinitely if reforms are delayed further.

Directors were encouraged by the broad convergence of views on the necessary policy and institutional reforms, and urged the authorities to seize the opportunity provided by the restoration of market confidence and the ongoing political transformation to press forward with these reforms.

Directors supported the authorities' strategy of debt reduction through sustained fiscal adjustment to reduce the debt overhang. As regards the pace of fiscal adjustment, many Directors felt that a gradual, sustained fiscal consolidation effort was appropriate. However, a number of Directors considered that the size of the imbalances called for a more rapid pace of fiscal consolidation to establish forward momentum and underscore the credibility of the reform program.

Directors supported the authorities' view that the required fiscal adjustment necessitated strong revenue and expenditure measures, backed by institutional reforms to strengthen budgetary control. On the revenue side, possible measures included an increase in the Value Added Tax rate, the introduction of a more efficient and progressive income tax system, and a return of the taxation of gasoline to its 2003 level. On the expenditure side, they saw scope for reducing non-productive and poorly targeted outlays. Directors urged the authorities to restore the financial viability of the state electricity company to reduce the associated large drain on the budget. They also called upon the authorities to correct looming imbalances in pensions and the social security system.

Directors agreed that a vigorous privatization effort, generous external concessional assistance, and a voluntary contribution of domestic creditors commensurate with their financial strength would have to complement fiscal adjustment to accelerate debt reduction. However, even with an ambitious program in place, it will take several years before Lebanon's debt-to-GDP ratio reaches a sustainable level.

Directors agreed that the exchange rate peg remains the appropriate monetary anchor for Lebanon, and saw no immediate competitiveness problems. The high degree of dollarization also tended to limit the effectiveness of the exchange rate as a policy tool. They considered that the current level of international reserves provides a reasonable buffer against liquidity shocks given the costs of holding reserves.

Directors called on the authorities to establish stricter constraints on central bank financing of the government and share more evenly the fiscal cost of financial stabilization, not least to restore the health of the central bank's balance sheet. Directors noted that the monetary impact of central bank losses has so far been limited by the buoyant demand for money, but emphasized that the conduct of monetary policy and the central bank's capacity to fend off financial pressures in the event of another financial shock would be much diminished by continuing losses. Directors also recommended that the central bank re-center its operations on monetary and liquidity management and unburden its balance sheet of real assets.

Directors underscored that the success of the adjustment strategy depends crucially on preserving depositor confidence. In this regard, they were encouraged by the high degree of capitalization and liquidity in the banking system, and welcomed the proactive stance of banking sector supervision. In this respect, they observed that the regulatory framework could be reinforced by providing legal protection to supervisors. They also considered it necessary to put in place a well-functioning deposit guarantee scheme to ensure that the expected consolidation of the banking system takes place in an orderly, market-based manner. Directors encouraged the authorities to adopt an independent and strong securities regulator with adequate legal protection to enhance the stability of the stock market.

Directors noted that there is considerable scope to strengthen the environment for private sector activity, including by enhancing the productivity of government spending, reducing red tape and corruption, reactivating the liberalization and privatization of the telecom sector, lowering the high costs of entry and exit, and strengthening contract enforcement. In this regard, Directors encouraged the authorities to reinvigorate the Paris II structural reform agenda in formulating their program.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.