Statement at Donor Meeting

Statement by the IMF Representative at the International Donors' Conference for Lebanon

January 25, 2007

1. This International Donors' Conference comes at a very critical juncture for Lebanon. The heavy economic and financial toll of the conflict with Israel and subsequent air and sea blockade was a blow to what was already a fragile macroeconomic situation. The Lebanese authorities have prepared an ambitious reform program that is intended to address comprehensively the country's fundamental financial imbalances and constraints to growth. Today, by providing its financial support to this program, the international community has a unique opportunity to enable Lebanon achieve a path of sustained economic growth and a return to social stability.

A. Background

2. The large debt overhang remains the key macroeconomic challenge faced by Lebanon, acting both as an impediment to growth and as a major risk to financial stability. The debt-to-GDP ratio was on a sharply rising path at the end of the 1990s, owing to large fiscal imbalances but was roughly stabilized at around 170 percent of GDP following the Paris II conference, owing to the consolidation of adjustment gains made in 2002-03, donor financing, interest rate relief from commercial banks, and the effect of improved confidence on market interest rates. However, the additional fiscal adjustment that had been targeted to begin reducing the debt ratio to more sustainable levels did not occur. More recently, the debt ratio was ratcheted up further by shocks to the economy stemming from the assassination of former Prime Minister Rafiq Hariri, the uncertainty created by the Syrian withdrawal, the subsequent wave of political violence, and the even more severe impact of the conflict with Israel.

3. The 2006 war led to a substantial setback on the economic front. As reported by the authorities, infrastructure damage from the conflict is estimated at around $2.8 billion. Real GDP, which was expected to grow by 5-6 percent in 2006, is estimated to have contracted by around 5 percent, which implies a loss of income of over $2 billion. Much productive capacity has been lost, and there has been a massive displacement of the population, including the exodus of many professionals. Accordingly, the costs in terms of foregone economic activity and income are likely to stretch well beyond 2006.

4. A large share of the cost of the war has been, and will continue to be, borne by the budget, in terms of reconstruction and recovery costs, foregone tax revenues, and the impact of higher market interest rates on debt service. The direct and indirect impact of the conflict on the budget in 2006 is estimated at roughly 5 percent of GDP. Although grants from donors equivalent to 2.5 percent of GDP have helped fill the gap, the overall deficit is estimated to have reached 14 percent of GDP in 2006. On current trends, the fiscal outlook for 2007 looks similarly difficult owing to the residual budgetary costs of the war and the slow recovery of the revenue base.

5. Despite the large confidence shock associated with the conflict, the Lebanese banking system proved once again its resilience, and by end-2006, all of the deposits lost during the conflict had been recovered. However, there is always a risk of a quick turnaround in market sentiment. Given Lebanon's dependence on deposit inflows to meets its large fiscal and external financing needs, a large scale and sustained withdrawal of deposits—had it occurred—could have precipitated a financial crisis. The ample liquidity cushion maintained by the central bank and commercial banks going into the war played an important role in preserving depositor confidence, as did the authorities' skillful handling of financial pressures, and the prompt financial support of Saudi Arabia and Kuwait in placing deposits of $1.5 billion at the central bank early on in the conflict. As a result, overall confidence in the financial system was maintained, and by September deposits began reflowing back into the system, with the government regaining access to market financing.

6. At the end of 2006, government debt stood at $40.4 billion, or 188 percent of GDP.¹ The debt is about equally divided between domestic currency and foreign currency (mostly dollar denominated) debt. The domestic banking sector (including the central bank) holds 75 percent of the debt. Given the structure of the debt, a strategy of strong and sustained fiscal adjustment backed by highly concessional external support, preferably in the form of grants, offers the most promising way out of the debt overhang.

B. The Government's Reform and Adjustment Strategy

7. The authorities' economic growth and debt reduction objectives are supported by a five-pronged strategy of fiscal adjustment, privatization, growth-enhancing structural reforms, prudent monetary and exchange rate policy, and a social reform agenda. The envisioned fiscal adjustment over five years is indeed ambitious but commensurate with the underlying fiscal imbalance. It is based on identified measures which adequately address the difficult economic and political tradeoffs. On the revenue side, the fiscal effort is diversified so that the cost of adjustment is shared equitably within society. On the expenditure side, and in line with the international experience on successful fiscal adjustment, the expenditure reduction is based on structural reforms aimed at eliminating the least productive spending, notably energy subsidies, while protecting and increasing the efficiency of investment and social spending. At the same time, and with IMF technical assistance, the authorities have also focused on reinforcing budgetary management to reduce implementation risks. They are also cooperating closely with the World Bank on the review of public expenditures and critical structural issues, including the complex question of electricity reform. As always, there are downside risks inherent to this strategy stemming from possible macroeconomic and fiscal shocks, as well as the difficulty of mobilizing domestic political support for policy measures envisaged both for this year and, more importantly, over the next few years. While it could be argued that adjustment be more front loaded, the political constraints of doing so have to be taken into account, along with the authorities' concern about jeopardizing the economic recovery from the war.

8. Privatization is a key element of the overall strategy. It is presented by the authorities primarily as a way of enhancing the economy's growth potential by introducing more competition and efficiency in the provision of key services, such as telecommunication and electricity. On the financial front it will, of course, contribute to more rapid debt reduction and thus reduced debt servicing costs, though the impact on the overall deficit should be offset by a parallel reduction of profit income from the privatized companies.

9. To assess the macroeconomic implications of the authorities' program, the impact of the policy measures has been evaluated in a medium-term scenario by IMF staff. The scenario confirms the authorities' own estimate that fiscal adjustment, electricity sector reform, and the planned partial privatization could bring down the debt ratio to under 150 percent in 2011, from 188 percent in 2006. Most of the reduction in the debt ratio would come from privatization, and, in the absence of any donor support beyond that committed at the Stockholm conference, the debt ratio would remain dangerously high. Moreover, the debt sustainability analysis suggests that typical macroeconomic shocks (e.g., to growth or interest rates) or fiscal shocks (e.g., revenue shortfalls, unexpected spending needs) could cause the debt ratio to revert to an explosive path. Therefore, despite its large fiscal effort, the authorities' reform program, by itself, would not be enough to steer the country on a safe path toward debt sustainability. This concern is explicitly acknowledged in the Lebanese program document.

10. However, in combination with considerable donor support in grants or on highly concessional terms, the authorities' strategy does offer a promising path out of the debt overhang problem. And the level of support should be such that the debt ratio remains on a clear downward path under most macroeconomic and fiscal shocks. This is particularly important in view of the fact that the primary surplus targeted by the authorities cannot be sustained indefinitely, as recognized in their reform program.

11. The success of the adjustment strategy depends also on preserving depositor confidence. In this regard, the authorities' decision not to restructure the debt and to anchor financial stability on the exchange rate peg is appropriate. Monetary and exchange rate policies will need to be supported by a comfortable international reserve buffer, which has proven essential in maintaining stability in the face of shocks to confidence, such as in 2005 and 2006. In addition, it is hoped that implementation of the proposed program and the financial backing of the international community will permit an easing of interest rates, all the while maintaining a comfortable level of reserves.

12. The program is not without risks. Lebanon's position in a volatile region exposes it to large potential external and geopolitical shocks that could compound traditional macroeconomic risk factors stemming from a possible fall off in global activity and interest rate shocks. On the policy front, failure to achieve domestic political consensus could interfere with the sustained implementation of reforms. Also, in light of the targeted large fiscal effort, there is a risk of backtracking in the face of adjustment fatigue over such a relatively long period of adjustment. To minimize these risks and maintain the momentum of reform, the authorities' intention is to seek a long-term engagement with the donor community, including through the phased disbursements of financial support.

13. In conclusion, the program presented by the authorities constitutes by far the best and most effective way for the country to resolve its fundamental economic problems. It is comprehensive in its coverage, well targeted in its approach, and grounded in appropriate policy measures. The authorities have requested IMF support for their reform program through Emergency Post-Conflict Assistance (EPCA). IMF staff is working with the Lebanese authorities on an EPCA, and their request will be presented shortly for Executive Board approval.