Mission Concluding Statement 

Lebanon: Concluding Statement of the 2015 Article IV Mission

May 14, 2015

May 14, 2015

This statement summarizes select findings and recommendations of the recent Article IV Consultation mission to Lebanon, which visited during April 29–May 12, 2015. A more complete analysis of policy issues will be included in the forthcoming staff report. Discussions were held with a broad range of government- and non-government representatives. We are grateful for the quality and openness of this dialogue and would like to thank the authorities for their ongoing cooperation and warm hospitality.

Key messages

• Policy inertia is taking a growing toll on the economy and, in the face of a continued refugee presence and new challenges, is threatening Lebanon’s resilience.

• Short term, the authorities should look beyond the temporary impact of lower oil prices and deliver a credible policy mix with sustained adjustment and a falling public debt ratio.

• Medium term, social stability requires job-rich, sustainable growth—this cannot happen without structural reform, starting immediately with the electricity sector.

The Cost of Policy Inertia

Lebanon has a well-deserved reputation for resilience, but now faces an exceptionally challenging environment. The Syria crisis, now in its fifth year, dominates Lebanon’s short-term outlook and longer-term prospects. Although the number of refugees has steadied, they comprise over one-quarter of the population, with negative impact on poverty and unemployment and strains on already-weak public finances. Lebanon should be commended for hosting the Syrian refugees, but will need ongoing and sizable international assistance as it, alone, cannot shoulder the related costs; to date, the government’s Lebanon Crisis Response Plan remains largely unfunded by donors.

Combined with regional tensions, domestic political paralysis is also undermining confidence. In the face of political deadlock, the Presidency has been vacant since May 2014, the Council of Ministers is often unable to make progress, and Parliament lacks sufficient consensus to convene to discuss key legislation.

As a result of the domestic and external uncertainty, growth remains disappointing. Following a sharp drop in 2011, growth has crawled upward to about 2–3 percent but remains well short of potential. We estimate growth in 2014 at about 2 percent, and project a similarly modest rate in 2015. In this context, our projection for 2015 would have been worse without the one-off impact of lower oil prices. Lebanon’s traditional growth drivers—tourism, real estate, and construction—have all received a significant blow, and a strong rebound is unlikely soon. We have therefore revised downward our medium-term projections. Inflation also declined sharply in 2014 on the back of lower oil prices and other one-off factors, but should return to a trend rate of about 3 percent by end-2015.

Exceptional factors allowed for a welcome primary surplus in 2014, but without decisive action fiscal deterioration will continue in 2015. The 2014 primary surplus of about 2½ percent of GDP largely resulted from exceptionally high telecom transfers and, to some extent, from withheld and delayed payments. We project the primary balance will deteriorate to almost 1¼ percent of GDP in 2015, with public debt remaining at 132 percent of GDP, very high by international standards.

Foreign-exchange and financial markets have remained resilient, despite Lebanon’s sizable external financial requirements. Following recent data revisions, we estimate the current account deficit in 2014 at about 25 percent of GDP. This is a clear vulnerability, particularly in light of the currency peg to the U.S. dollar. Nonetheless, the Banque du Liban (BdL) has maintained an ample level of gross FX reserves, which stood at around $38 billion at end-March. And in February, a $2.2 billion Eurobond issue by the Treasury—the largest so far—was significantly oversubscribed.

Lebanon’s economic model rests on confidence. The underlying faith of foreign investors and the large Lebanese diaspora is the basis for the country’s continued ability to attract sizable deposit inflows, which have in turn helped fund large budget and current account deficits. Historically, these inflows have been resilient, including in the face of global commodity- and financial-market volatility. However, the growth rate of deposits is slowing. A decisive change in policies is thus needed to strengthen confidence, which cannot be taken for granted in the current international environment.

Anchoring Confidence: A More Balanced Policy Mix

Policymakers need to find common ground to overcome the current policy paralysis. While Lebanon is not in a crisis, it needs to avoid one to preserve its economic model, macroeconomic stability, and social cohesion. The strategy proposed below seeks to anchor confidence by starting the process of fiscal adjustment immediately; and laying the ground for higher, sustainable and more inclusive growth. In addition to the authorities’ efforts, there is a need for considerable international aid to shoulder the costs associated with the Syrian refugees.

Sustained and balanced fiscal adjustment is essential. In the recent past, high growth and low global interest rates have helped lower Lebanon’s debt burden. But global and domestic conditions will be less favorable in the foreseeable future, and without adjustment public debt will continue to increase—and with it risks and vulnerabilities will further rise.

Ignoring the need for fiscal adjustment is risky, costly, and unfair. Risky, because reliance on deposit inflows to fund an ever-increasing public debt exacerbates the economy’s exposure to sudden swings in confidence, and deepens the codependence between banks and the sovereign. And costly, because interest rates will inevitably rise along with global rates. Similarly, lack of adjustment is also unfair: interest payments are set to increase to some 12 percent of GDP (about 40 percent of total spending) over the medium term, crowding out essential spending on public investment and social programs, and benefiting debt holders at the expense of the less well-off.

A proper adjustment strategy needs to strike a balance between increasing revenue and changing the spending mix.

• There is scope to increase taxation in a fair manner, including by broadening tax bases and strengthening compliance, ensuring that all economic sectors share the burden. Ongoing efforts by the ministry of finance to introduce more discipline to tax collections are encouraging, but are not sufficient. Measures should include the introduction of a capital gains tax on real estate transactions, and increased withholding tax on interest income and corporate income tax—all well-known and previously debated. The authorities need to seize the opportunity afforded by low oil prices to remove the VAT exemption on diesel immediately, and increase gasoline excises. Additionally, we recommend a modest increase in the VAT rate, by one percentage point; and increased transparency and regularity in the telecom transfers.
  

• The salary scale adjustment for the public sector remains controversial. If implemented, it should be funded by credible revenue measures, phased in gradually and without retroactive payments. It should also be accompanied by steps for a comprehensive public-sector reform, ensuring that public servants are adequately remunerated based on their productivity. The salary debate, however, has drawn attention away from the more pressing need for fiscal adjustment: fully funding salary increases will not be sufficient to reduce the deficit.
  

• Spending on capital projects and social programs should increase in line with the creation of greater fiscal space. Capital outlays have been cut to the bone, jeopardizing future growth, and there has not been adequate social spending. The refugee presence has further exacerbated pressures, especially on already-weak infrastructure. Rebalancing the spending mix will also mitigate the growth-dampening effect of fiscal adjustment. In this connection, placing EdL on a sound financial footing to reduce government transfers is an urgent priority.
  

• Compressing spending on an ad hoc basis is not a lasting strategy to reduce the deficit. The reported increase in delayed payments could result in future government obligations and further undermine economic activity.
  

As an important first step toward anchoring confidence, the authorities should pass a comprehensive budget for 2015. Lebanon has not had an approved budget for ten years, and passing a 2015 budget would be a powerful signal of political will and accountability.

Fiscal adjustment would also reduce the financial—and institutional—burden on the BdL and ultimately promote interest rate flexibility. The BdL has been maintaining financial stability by building large foreign exchange reserves buffers and funding the government as needed, while also supporting aggregate demand through subsidized credit schemes. It has also successfully managed short- and medium-term T-bill yields by using its CDs rates as a key signal, while sometimes acting as a buyer of last resort in the T-bill market. While this has helped contain market volatility and government borrowing costs, it has also tended to dampen market signals. As fiscal adjustment takes hold, the BdL should scale back its role as intermediary between banks and the sovereign, paving the way for more market-based benchmark T-bill yields. In addition, as conditions normalize, the BdL should discontinue its quasi-fiscal operations and strengthen its balance sheet over the medium term.

Aiming Higher: Stronger and More Inclusive Growth

Higher growth, better growth. Even when successful, the traditional drivers of activity in Lebanon have failed to provide the high-quality, job-rich growth needed to secure long-term social stability. Therefore, a more dynamic, inclusive, less volatile growth model is needed. While wide-ranging and sustained structural reforms are required, even small and selective steps can make a critical difference—not least by demonstrating the government’s capacity to move forward.

• Implementing electricity sector reform. Lebanon’s inefficient electricity supply is a major impediment to growth: EDL losses weigh heavily on public finances, and poor service delivery has prompted the extensive use of costly private generators. The refugee crisis has put further strains on the sector. Longstanding plans to strengthen public generation capacity, switch to less expensive natural gas, improve transmission and distribution, and progressively increase tariffs (while protecting lower-income consumers) should be implemented without delay. The result would be reduced business and consumption costs, more equitable access, and ultimately, sizable budget savings, along with an improved external position. The ultimate goal should be zero EdL transfers, freeing up fiscal resources for more productive uses.
  

• Tabling long-pending legislation. There is an urgent need to jump-start the legislative agenda and deliver results—including on the new Petroleum Tax Law, the Exploration and Production Agreement for the oil and gas sector, and the Public Private Partnership framework law to attract private investment.

Sustained, broad-based growth requires a sound and stable financial system. By regional standards, Lebanon’s banks—by far the dominant pillar of the financial system—have helped promote financial inclusion. However, although the banking system is liquid, capital buffers are modest considering banks’ sizable exposure to (zero-weighted) local-currency sovereign debt and the economy’s uncertain outlook. Moreover, net interest margins have been contracting and growth in profitability is down. Continued efforts to strengthen banking regulation and supervision are essential, particularly regarding loan classification and provisioning rules. In this regard, the authorities’ recent request for a Financial Sector Assessment Program is both timely and welcome.

Labor reforms are also needed for high-productivity growth. The immediate need is to create formal-sector employment opportunities for lower-skilled workers (for example, through special programs and targeted public work schemes), particularly in light of added pressure from the Syrian refugees. But over time, Lebanon needs to develop higher-quality sectors to absorb its flow of highly-skilled job seekers—most of whom now look outside Lebanon to secure a promising future.

Better public services will not only improve competitiveness but also increase equity. In addition to Lebanon’s large current account deficit, other indicators suggest that the economy is losing external competitiveness. Part of the explanation is the fact that public-service delivery and social safety nets are far from satisfactory: hindering the economy’s ability to respond to new opportunities and to provide an environment in which dynamic and innovative firms can thrive. Indeed, Lebanon has an enviable supply of high-quality human capital, but halting the economy’s ongoing brain drain will require better core services and a social protection system that is both reliable and fair. A case in point is the pension system, which is not only fiscally unsustainable but also suffers from striking equity shortcomings—ultimately, a unified and fairer pension system for public and private sector employees should be introduced.

Finally, timely and reliable data are crucial for greater accountability. Although data collection and dissemination have improved in some areas, national and external accounts, fiscal, and social and labor-market statistics remain weak, undermining economic decision making, transparency, and policy effectiveness. We are concerned about accumulating delays in the provision of data to the public, and note increasing lack of cooperation and coordination among various agencies. Steps to restore and strengthen collaboration—along with adequate funding and high-level support for the Central Administration of Statistics—will help improve statistics.