O C C A S I O N A L   P A P E R
	176

Edited by Sena Eken and Thomas Helbling

Contents
Preface
I	Reconstruction and Stabilization--An Overview Sena Eken
II	Public Investment Planning and Progress John Wetter The Horizon 2000 Program Private Sector Provision of Infrastructure Conclusions
III	Postwar Reconstruction, Public Finances, and Fiscal Sustainability Thomas Helbling Lebanon's Public Finances--An Overview Fiscal Adjustment and the 1998 Budget Theoretical Aspects of Fiscal Sustainability Fiscal Adjustment and Aspects of Fiscal Sustainability Conclusions Appendix. Intertemporal Government Budget Constraint and    Solvency References
IV	Dynamics of Interest Rate Movements: An Empirical Study Taline Urnéchlian with Sena Eken and Thomas Helbling Analytical Framework Macroeconomic and Financial Developments, 1985–97 An Empirical Examination of the Interest Rate Differential    Between the Lebanese Pound and the U.S. Dollar Conclusions Appendix. Explaining Excess Returns in Lebanon, 1993–97 References
V	Issues in Public Debt Management Thomas Helbling Lebanon's Public Debt and Its Management, 1991–97 Theoretical Aspects of Public Debt Management Public Debt Management: Options and Strategies Conclusions References
VI	Financial Sector Developments Klaus Enders Structure of the Financial System Financial Deepening, 1991–97 The Challenge for Future Reform References
VII	Association Agreement Between Lebanon and the European Union Annalisa Fedelino Background to the Association Agreement with Lebanon Main Implications of the Association Agreement:    A Review of the Literature Liberalization of Trade in Services Conclusion Appendix. A Specific-Factor Model for Liberalization    of Services References
Statistical Appendix
Boxes
VII	7.1.	Lebanon's Current Trade Regime with the European Union
	7.2.	Draft EU Association Agreement with Lebanon
	7.3.	Protection of Services in Lebanon
Tables
II	2.1.	Horizon 2000 Program: Sectoral Distribution of Actual and Projected Public Expenditures, Contracts Awarded, and Contracts in Preparation
	2.2.	Horizon 2000 Program: Original Financing Scenario
	2.3.	Horizon 2000 Program: "Documented" Foreign Funding as of December 31, 1997
	2.4.	Government Projects Available to Private Investors
III	3.1.	Government Operations
	3.2.	Revenue in Percent of GDP and Buoyancies of Major Categories of Taxes and Other Revenue
	3.3.	Public Debt and Public Debt Dynamics
	3.4.	Budget Targets and Actuals
	3.5.	Primary Gap Measures
	3.6.	Fifteen-Year Primary Gaps with Autoregresive(1)-Adjustment
IV	4.1.	Analysis of Excess Returns
	4.2.	Monetary Policy, the Lebanese Pound—U.S. Dollar Interest Differential, and Yield Spread: Granger Causality Tests
	4.3.	Explaining Excess Returns, 1993M1–1997M12
V	5.1.	Public Debt Structure
VI	6.1.	Structure of the Banking System
	6.2.	Indicators of the Banking System's Financial Strength
	6.3.	Commercial Banks' Claims on Private Sector, Classified by Economic Activity
VII	7.1.	Composition of Imports by Source, 1996
	7.2.	Weighted Average Tariff Rates and Import Shares, 1995
	7.3.	Protection Against Lebanese Exports, 1995
	7.4.	Some Effects of Trade Liberalization
	7.5.	Reduction Factor for Tariff Rates During the Transition Period of the Association Agreement
	7.6.	Average Effective Rates of Protection
Figures
I	1.1.	Selected Economic Indicators
	1.2.	Selected Economic Indicators
III	3.1.	Fiscal Shocks and Delayed Adjustment
	3.2.	Public Finances
	3.3.	Public Debt
	3.4.	Adjustment Path of Primary Balance
	3.5.	Cross-Country Comparison of Capital Expenditure
IV	4.1.	Lebanese Pound–U.S. Dollar Exchange Rate and Interest Differential
	4.2.	Uncovered Interest Parity and Excess Returns
	4.3.	Interest Rate Dynamics and Monetary Policy
V	5.1.	Public Debt
	5.2.	Public Debt Management and Monetary Policy
VI	6.1.	Real Interest Rates
	6.2.	Financial Deepening and Dollarization
	6.3.	A Cross-Country Comparison of Liquidity Ratios
	6.4.	A Cross-Country Comparison of Credit Ratios
	6.5.	A Cross-Country Comparison of Money Multipliers
	6.6.	A Cross-Country Comparison of Private Sector Credit Financing
	6.7.	A Cross-Country Comparison of the Share of Commercial Banks in the Banking System
	6.8.	Interest Rate Spreads in Banking
	6.9.	Stock and Bond Markets
VII	7.1.	Supply and Demand for Service Products, Their Prices, and Remuneration to the Service Factor
	7.2.	Prices of Service Products and Remuneration to Service Factors
Statistical Appendix Tables
	A1.	Selected Social, Economic, and Financial Indicators
	A2.	Selected Indicators of Sectoral Economic Activity
	A3.	Aggregate Demand
	A4.	Consumer Price Index
	A5.	Real Wages and Unit Labor Costs
	A6.	Government Operations
	A7.	Public Debt
	A8.	Treasury Bills in Circulation
	A9.	Central Bank Balance Sheet
	A10.	Commercial Banks' Balance Sheet
	A11.	Monetary Survey
	A12.	Factors Affecting Changes in Total Liquidity (M3)
	A13.	Discounts and Yields on Three-Month Treasury Bills
	A14.	Commercial Bank Interest Rates on Lebanese Pound Transactions
	A15.	Balance of Payments
	A16.	Composition of Industrial Exports
	A17.	Destination of Exports
	A18.	Sources of Imports
	A19.	Exchange Rate of the Lebanese Pound
	A20.	Nominal and Real Effective Exchange Rates of the Lebanese Pound

Sena Eken

Following the end of Lebanon's civil war, which started in 1975 and spanned 15 years, the authorities began the difficult task of simultaneous economic stabilization and confidence building on the one hand, and postwar reconstruction and development on the other. To this end, the government took the lead in reconstruction by formulating first the National Emergency Reconstruction Program and subsequently the Horizon 2000 Program. Each aimed to rapidly rehabilitate and enhance the country's severely damaged infrastructure in preparation for private sector-led growth over the medium term. At the same time, to stabilize expectations and achieve rapid disinflation, an exchange-rate-based nominal anchor policy was adopted starting at the end of 1992.

The strategy, despite a difficult environment characterized by episodes of domestic political uncertainty, a fluid regional context, and limited external assistance for the reconstruction program, has been successful in several respects.

Growth. The end of the war allowed households, firms, and the government to return to normal conditions of production and consumption, which, in conjunction with the rebuilding of residential and business structures, the productive capacity of enterprises, the stock of consumer durables, and the government-led reconstruction program to build infrastructure, had the expected strongly positive effect on growth. During 1991–97, the average annual growth rate of GDP amounted to 9.7 percent, significantly improving per capita income (Figure 1.1). In 1996, the rate of economic growth slowed to 4 percent, adversely affected by the bombings in April and the decline in construction activities resulting from the excess supply in some segments of the real estate market; in 1997, the growth rate is estimated to have remained at that level as the contractionary impact of further declines in construction activity offset the increased service sector activity (e.g., tourism).

Figure 1.1. Selected Economic Indicators   Sources: Data provided by the Lebanese authorities; and IMF staff estimates.

Inflation. Under the exchange-rate-based stabilization policy, the Lebanese pound (LL) appreciated from $0.544 per LL 1,000 at the end of 1992 to $0.660 per LL 1,000 at the end of June 1998 (Figure 1.2). The policy, supported by a prudent monetary policy, helped stabilize expectations and reduce inflation. The annual average inflation rate, which had increased from 52 percent in 1991 to 100 percent in 1992, declined rapidly once the nominal anchor policy was implemented and amounted to about 8 percent in 1997. With fiscal imbalances reduced and bottlenecks in the economy unclogged as reconstruction took hold, the average annual inflation rate slowed down further to about 5 percent during the first half of 1998.

Figure 1.2. Selected Economic Indicators   Sources: Data provided by the Lebanese authorities; and IMF Treasurer's Department; and IMF, International Financial Statistics. 1End of period. 2Differential between returns on three-month Lebanese and U.S. treasury bills in percentage points.

Foreign exchange reserves. The exchange-rate-based nominal anchor policy was implemented by means of a supportive interest rate policy. High interest rates helped attract large capital inflows, which together with foreign investment into the real estate sector and financing for the reconstruction program, more than financed the external current account deficits and led to a sharp increase in foreign exchange reserves. Gross official reserves rose from $1.2 billion at the end of 1991 to over $6.1 billion (equivalent to about 10 months of imports) at the end of June 1998, while net foreign exchange reserves rose from $1.2 billion to over $3.2 billion (6.9 months of imports) during the same period.

Dollarization. The decline in inflation, the stable exchange rate, and the buildup of reserves accompanied by the authorities' increased credibility in financial markets raised the demand for Lebanese pounds. As a result, dollarization, measured by the share of foreign currency deposits in total liquidity, declined from a maximum of 68 percent in mid-1993 to 53 percent by the end of 1996. Although dollarization increased slightly in the second half of 1997, as pressures on reserves emerged with the crises in Asia and uncertainty increased with regard to domestic public finances, the favorable trend was reestablished in May–June 1998 and the dollarization started to decline again.

Structural improvements. Favorable macroeconomic and financial developments were accompanied by structural improvements. A significant part of the infrastructure has been restored; the private sector has been getting more involved in reconstruction including through build-operate-transfer schemes; the financial sector has been deepened and widened, its supervision and capital base have been strengthened; and the budget process and administration have been streamlined and modernized, and revenue administration has been strengthened. Furthermore, the government and the private sector were able to tap international capital markets. Structural improvement in the economy increased productivity and helped compensate for the effects of the real effective exchange rate appreciation on competitiveness, which is more limited in Lebanon than in other countries given the highly dollarized nature of the economy.

Nevertheless, the conflicting claims of reconstruction and stabilization requirements have proven to be more challenging than envisaged.

Public finance and debt. Rebuilding the infrastructure and providing regular public services have been the government's crucial contribution to the reconstruction effort. However, the acceleration in the growth of government capital expenditure, together with large and expanding current expenditure and the slow recovery of the revenue-generation capacity, has led to sizable fiscal imbalances. While the deficit fell from 16 percent of GDP in 1991 to 8 percent in 1993, it rose and remained high thereafter; in 1997, it amounted to about 26 percent. The deficits have been financed mostly through the issuance of government papers (with maturities of up to two years) denominated in Lebanese pounds and held primarily by the domestic banking system. Consequently, the public debt increased rapidly. During 1993–97, gross public debt, as a percent of GDP, increased from 49 percent to 103 percent, and net public debt rose from 38 percent to 97 percent. Determined efforts to turn around the fiscal situation and stabilize the debt dynamics were made in 1998. To these ends, the 1998 budget involved both expenditure and revenue measures to initiate the front-loaded adjustment needed to ensure medium-term sustainability and underpin a soft landing. Furthermore, the mobilization of external financing has eased interest costs on the budget and allowed for lengthening the maturity structure of public debt. The budgetary outcome during the first half of 1998 confirms the government's determined efforts to achieve fiscal adjustment and bring down the overall deficit to the budgeted level of 15 percent of GDP; during January–June 1998, the cumulative deficit as a percent of expenditures was well within the 1998 budget target and significantly below the outcomes observed in 1996 and 1997. The continuation of these developments will ease strains on the overall macroeconomic policy mix and reduce the vulnerability of the budget to changes in financial market sentiments.

Interest rates. The large financing needs of the government with the nominal exchange rate anchor policy involved high and flexible interest rates. Over time, the authorities gained credibility in financial markets, which was reflected in the gradual decline in nominal and real interest rates and in the differential with respect to comparable U.S. dollar-denominated assets in 1996–97. Notwithstanding recent declines in nominal interest rates, the cost of servicing the growing stock of debt has been high and increasing: interest payments absorbed 90 percent of total budgetary revenues in 1997. Moreover, high interest rates have adversely affected private sector activity.

External imbalances. The return to less trying conditions after the war took place in the context of marked divergence between current and anticipated future income streams, accompanied by domestic demand in excess of current capacity. The natural result of this divergence has been borrowing against future income as well as dissaving. Borrowing occurred not only by the government as discussed above, but also by firms. Meanwhile, dissavings and transfers (external assets) have been prevalent at the households level. Reflecting these saving-investment imbalances, large trade and external current account deficits accompanied reconstruction and the postwar normalization of economic activity. While the size of the current account deficit is subject to severe measurement problems, the occurrence of large financial inflows in the form of transfers, foreign direct investment, and portfolio flows, including from the large community of Lebanese expatriates, cannot be doubted. These large inflows, induced in part by high interest rates and exchange rate stability, made the economy more vulnerable to shifts in market sentiments. The vulnerability was well managed. The large amounts of foreign exchange reserves, which covered a significant share of public short-term domestic currency liabilities, supported the authorities' efforts to keep market sentiments in check. Moreover, data on identifiable gross external assets and liabilities of resident units (public sector including central bank, commercial banks, and nonbank private sector) indicate that assets exceeded liabilities by about a factor 2 at the end of 1997;¹ this suggests that the Lebanese economy is still in a net creditor position vis-à-vis the rest of the world despite the large cumulative current account deficit of the last few years. The net creditor position certainly contributed to the remarkable success of foreign currency bond issues by both government and private entities in international capital markets.

Challenges ahead. The main challenge for the years to come is to ensure the sustainability of the success in the reconstruction and the stabilization of the economy and to enhance the framework for a path of rapid and balanced growth. In this context, fiscal consolidation remains the most urgent policy issue in view of the debt dynamics and the need to crowd in private sector activity. This would involve not only a front-loaded reduction in the deficit and surpluses in the primary balance in the coming years, but also improvements in the structure of the budget, especially through reducing the dependency on customs revenues. The latter is particularly important in light of the envisaged Association Agreement with the European Union and the intention to reestablish Lebanon as a regional hub for trade in goods and services in the Middle East. The front-loaded fiscal adjustment and the improvements in the structure of the budget would be facilitated by the early introduction of a general sales tax, cost-recovery measures related to public infrastructure services, and continued efforts in strengthening tax administration. In addition to a stable macroeconomic environment and low production costs, institutions and regulatory reforms are needed to create an enabling environment for private-sector-led high growth over the medium term. High private-sector-led growth should increase employment opportunities and alleviate poverty. Nevertheless, there is also a need to address disparities in income distribution and regional socioeconomic differentials to enhance the sociopolitical acceptability of the medium-term adjustment and reform process.

The challenges facing the Lebanese economy in an environment of globalized financial markets are well recognized by the authorities. Determined implementation of fiscal adjustment and reforms holds the promise of virtuous cycles of economic stability and high growth in Lebanon, providing for increased opportunities for employment and higher standards of living.

Against this background, the sections that follow aim to contribute to the analysis of recent developments in the Lebanese economy and its policy challenges in the medium term. The analysis is based on information and data up to June 1998.

Section II reviews the evolution of Lebanon's public investment program over the reconstruction period, including its size, phasing, composition, and financing. In addition, it discusses cost recovery and the role of the private sector in the reconstruction, both of which have implications for policies aimed at fostering the economy's full long-term growth potential.

Section III discusses the evolutions and the structure of Lebanon's public finances, a key determinant of the country's financial outlook. In this context, it analyzes the issue of fiscal sustainability in Lebanon, focusing on (1) the adjustment in the primary deficit that is needed for the debt dynamics to become consistent with solvency and medium-term macroeconomic stability, and (2) the adjustment in the structure of the expenditure and revenue that should be targeted to maximize their positive growth effects and reduce their vulnerability to exogenous shocks and structural changes in the economy.

Section IV reviews the evolution of Lebanese pound interest rates, key variables for both monetary policy and public finances, and analyzes their determinants. The analysis focuses on factors that explain the interest rate differential between comparable assets denominated in Lebanese pounds and in U.S. dollars, which have remained large and positive despite the gradual and steady appreciation of the Lebanese pound against the U.S. currency.

Section V presents an overview of Lebanon's public debt structure and analyzes the policy problems associated with it, in particular the interaction between public debt management and monetary policy. It then discusses theoretical aspects of public debt management and applies it to the Lebanese case.

Section VI describes the institutional structure of the Lebanese financial system and discusses the impact of recent reforms on financial deepening, the soundness of the banking system and the development of financial markets. Given the progress to date, it considers the elements needed to enhance the role of the financial system in mobilizing domestic and foreign savings and ensuring their efficient allocation, as well as to achieve the authorities' objective of reestablishing Beirut as a regional financial center.

Section VII discusses Lebanon's current relationship with the European Union and potential modifications under the envisaged Association Agreement. After reviewing the implications of an Association Agreement with the EU, it focuses on the liberalization of trade in services--an area from which Lebanon can reap significant benefits.