Mission Concluding Statement 

Libya-Staff Visit Concluding Statement

May 4, 2012

I. Recent Developments and Outlook

1. Libya is at a historic juncture and the authorities face the twin challenges of stabilizing the economy and responding to the aspirations of the revolution. The short-term challenges are to manage the political transition, normalize the security situation, and exercise budget discipline while maintaining macroeconomic stability. Although Libya can afford elevated levels of current expenditures in a transitional period, the increase in wages and subsidies is eroding fiscal buffers and undermining prospects for fiscal sustainability. Over the medium term, Libya needs to address issues including capacity building and improving the quality of education, rebuilding infrastructure, financial market development, reducing hydrocarbon dependence, and putting in place an efficient social safety net. It will also need to set up a governance framework linked to transparency and accountability that would promote private sector-led development, job creation, and inclusive growth.

2. Despite daunting challenges, economic activity is recovering rapidly with the restoration of hydrocarbon production. While GDP is estimated to have contracted by 60 percent in 2011, as of April 2012 crude oil output had reached 90 percent of pre-conflict levels, boosting hydrocarbon exports and raising the budget and current account surpluses.

3. A high level of reserves preserved confidence in the currency, which mitigated the economic impact of the conflict. During the conflict, currency in circulation doubled while Libya’s foreign assets were frozen and the Central Bank of Libya (CBL) was unable to provide adequate foreign exchange to the market. Accordingly, the currency traded on the parallel market at about two-thirds of its official value, contributing to inflation, which peaked at 29.7 percent in September 2011 (year-on-year). Most of the UN sanctions that had frozen Libya’s foreign assets (a total of 200 percent of 2010 GDP) were lifted on December 16, 2011, which has allowed the CBL to provide foreign exchange liquidity to banks and help normalize banking operations. During December 2011–March 2012, the CBL reaffirmed the exchange rate peg by purchasing the equivalent of $3 billion—equivalent to approximately 25 percent of currency in circulation. Consequently, the parallel market for foreign exchange has been eliminated.

4. Due to the fall in hydrocarbon exports the budget was in a very large deficit and the current account surplus was reduced sharply. The budget deficit was 27.0 percent of GDP in 2011, compared to a budget surplus of 16.2 percent in 2010. Similarly, the current account surplus narrowed from 19.8 percent of GDP in 2010 to 1.3 percent in 2011.

5. Adequate buffers allowed commercial banks to withstand the impact of the conflict on asset quality. As of end-2011, commercial bank deposits at the CBL were equivalent to 65.2 percent of their liabilities, while the pre-conflict credit-to-GDP ratio was below 15 percent. Although the conflict will have caused asset quality to deteriorate, the systemic impact should be modest in light of the liquidity buffer provided by substantial reserves, along with limited claims on the private sector and the implicit government guarantee of the loans to state-owned enterprises.

6. Economic activity will rebound in 2012. Crude oil production should reach pre-conflict levels, while reconstruction expenditure and the release of pent up private demand should facilitate an improvement in non-hydrocarbon sectors. Increased hydrocarbon exports will lead to a fiscal surplus of 14.2 percent of GDP and increase the current account surplus to 21.9 percent. The normalization of imports will continue to contain consumer price inflation at 10.0 percent, despite the upward pressure on prices arising from supply bottlenecks in housing and transportation. Nevertheless, a significant reduction in unemployment, which is largely structural— estimated at 26 percent as of end-2010—will not occur as a result of a return to the pre-conflict status quo.

7. Risks to the outlook include continued political uncertainty, delays in normalizing the security situation, and lower international prices for oil and gas. Although hydrocarbon prices remain high, a deepening of the European crisis and a widespread global economic slowdown could lower petroleum prices and present additional challenges to Libya’s hydrocarbon-dependent economy.

II. Policy Discussions

8. The exchange rate peg is the anchor of macroeconomic policy. The CBL has announced its intention to maintain the peg over the medium-term. Ample foreign exchange reserves will preserve confidence in the currency, thereby restraining consumer price inflation. Monetary policy needs to be supportive of exchange rate policy, particularly as exchange controls are eased.

9. The mission welcomed the CBL’s plan to further ease restrictions on deposit withdrawals and foreign exchange transactions that were put in place during the conflict. Nevertheless, the removal of restrictions should be handled with much care by the CBL and the commercial banks to avoid any market pressures. Commercial bank reserves at the CBL (90 percent of deposits) and the CBL’s foreign assets (300 percent of commercial bank reserves) will allow the system to absorb large withdrawals of domestic currency and subsequent purchases of foreign exchange. The removal of restrictions would improve confidence in the banking system and help normalize liquidity conditions. Non-performing loans (NPLs) may have increased during the conflict due to physical damage and income loss and the CBL should stand ready to work with the government to replenish bank capital, if necessary.

10. The banking sector remains underdeveloped with large deposits at the CBL and low credit as a share of GDP. Commercial banks deposits at the CBL increased from Libyan dinar 43.9 billion at end-2010 to dinar 46.0 billion as of February 2012, while credit to the private sector contracted from dinar 8.8 billion to dinar 8.1 billion over the same period. Banks continue to face competition from specialized credit institutions (SCIs) with their lending rising in a state-directed attempt to address socio-economic pressures. The mission continues to echo past advice of finding a viable business model for the future role of SCIs that is consistent with international best practices. Guiding principles should include reducing their scope and size, loan recovery improvements, effective supervision by the CBL, as well as strengthening their auditing standards.

11. The CBL has encouraged banks to modernize commercial operations with a view to moving away from cash-based transactions. Financial intermediation will be an important component of the post-revolution private-sector lead growth strategy. Although the Libyan financial system is shallow, with limited linkages with the real economy, diversifying the economy away from hydrocarbon dependence will require the active role of banks in financial intermediation. The mission commends the CBL on its steps to restore commercial banking operations and to promote the provision of credit cards, prepaid cards, and similar payment instruments.

12. The mission encourages the CBL to develop a medium-term strategy to strengthen commercial banking sector infrastructure, the regulatory framework, and human capacity. The mission commends the CBL on its efforts to encourage banks to upgrade their human resources and IT systems, to enhance banking sector competition by encouraging strategic foreign partnerships, and to remove impediments to credit, particularly for small and medium-sized enterprises (SMEs), which are crucial engines of economic growth, employment creation and social cohesion. The development of domestic financial markets, including Islamic banking, would likely attract new investors and depositors to the market, and allow SMEs and new entrepreneurs to gain greater access to finance; raising potential non-hydrocarbon growth, and making growth more inclusive. Accommodating the new demands on banks and financial sector would involve continued efforts to modernize the CBL as well as the regulatory framework in order to safeguard financial stability.

13. The fiscal policy stance needs to become supportive of macroeconomic stability. In 2011, current expenditures increased significantly, primarily due to policies of the former regime to increase public sector wages and employment, as well as to raise subsidies. In 2012, capital spending will remain constrained by limited execution capacity, while current spending on wages and subsidies is projected to increase to 30 percent of GDP. Although Libya can afford elevated current spending in the short term, the level of recurrent spending is inconsistent with appropriate budgetary prioritization and will lead to a damaging appreciation of the real exchange rate. Furthermore, in the absence of a fiscal policy anchor linked to macroeconomic stability (and intergenerational equity), it is difficult for the government to justify resistance to current spending pressures.

14. Unchanged fiscal policies would erode Libya’s wealth. An analysis of spending trends under the assumption of unchanged policies indicates that the budget balance will be in deficit from 2015. Similarly, the oil price at which the budget is balanced has increased from $58 per barrel in 2010 to $91 per barrel in 2012 and is poised to exceed $100 per barrel from 2013. A more thorough analysis of sustainability based on the present value of financial assets and future oil extraction indicates that, from 2012, public spending will exceed the sustainable, long-term level by over 10 percent of GDP.

15. Public sector employment should be determined by public service delivery needs, and wages should be market-based. The government needs to resist the temptation to create civil service jobs solely for the purpose of providing income to the unemployed. Public-sector wages should not be at a level that reduces incentives for individuals to seek employment in the private sector as this would undermine efforts to advance economic diversification. In this connection, the recent surge in the public sector payroll to 1.5 million (80 percent of the labor force) will need to be unwound.

16. Replacing universal price subsidies with targeted forms of social protection would reduce inefficiencies and better protect low-income households. Expenditure on subsidies and transfers is projected to increase to 13.3 percent of GDP in 2012 and remain elevated over the foreseeable future. The high level of subsidies motivates smuggling and corruption while affecting consumption and production patterns as well as the allocation of resources, with negative implications for the government budget, expenditure composition, and private-sector development. Since universal price subsidies—particularly on fuel—disproportionately benefit higher-income households, replacing them with targeted forms of social protection would reduce economic inefficiencies and better protect vulnerable groups.

III. Vision for the Future

17. The mission encouraged the authorities to conceptualize a medium-term development framework, set the commensurate strategies in motion, and articulate this new vision to the various stakeholders to maximize ownership. Libya has an opportunity to break with the past and promote inclusive growth by developing a vibrant, private-sector driven economy. Such a holistic strategy should also seek to address governance gaps, shortcomings in the legal and physical infrastructure, as well as improve workforce skills. Policies should be linked to a diversification strategy that includes fostering competition, establishment of a comprehensive social safety net, and financial system development that provides broader access to finance.

18. Strengthening public financial management remains a priority in order to enhance the efficiency of spending as well as accountability and transparency. Budget formulation remains fragmented, mostly steered by a bottom-up approach that is disconnected from an explicit policy rule or a medium-term development strategy. Libya would benefit from introducing reforms focused on ensuring a unified budget process integrating the recurrent and capital budgets, strengthening the policy context of budgeting, and adopting a comprehensive and transparent budget presentation. To increase transparency and accountability and better inform economic policymaking, reforms should focus on developing and implementing an internationally accepted budget classification and its associated chart of accounts, which would improve the comprehensiveness, reliability, and timeliness of budgetary information.

19. Enhancing human capital and labor mobility will support growth. Increased private sector employment needs to be underpinned by efforts to strengthen the education system and improve skills. In this connection, reforms should be coordinated with the private sector so that the labor force acquires skills that are in demand by the market. An efficient and comprehensive social safety net would ease transitory pressures and encourage risk-taking, thereby encouraging competition within the workforce and allowing a rationalization of the civil service.

IV. Other Issues

20. Libya will continue to receive technical assistance from the Fund. The CBL will resume its extensive TA program to continue modernization. The Fund is assisting the authorities to develop a strategy for subsidy reform and a donor-financed resident advisor at the Ministry of Finance should be in place later this year. The Fund’s Institute for Capacity Development, Middle East Technical Assistance Center, and the Kuwait Center for Economics and Finance will also help address urgent training needs.

21. Decision making and the public’s oversight of the government should be supported by reliable data. Compilation of national statistics should take place under the umbrella of an independent agency with a view to improving the coverage, quality, and timeliness of statistics. In this regard, the mission welcomes the formation of a new institution established to unify the compilation of national statistics