Imagine an investor who, at the end of 2004, receives information that a country with government debt of 165 percent of GDP (half of it in foreign currency), an external current account deficit of 18 percent of GDP, and a fixed exchange rate faces a major political shock—the assassination of a popular former prime minister, mass street demonstrations, elections, and a protracted political crisis. Likely reaction? An immediate pullout and, possibly, speculation against the currency. The investor would have been wrong, though. The country is, of course, Lebanon. Despite all these adverse events during the first half of 2005, the government and the central bank have managed to restore financial stability, and the country has been able to again attract capital at relatively narrow spreads over international interest rates. Can Lebanon now, finally, tackle its perilously high debt?
Before 1975, the Lebanese economy was one of the most dynamic in the Middle East, and Beirut had established itself as the regional financial hub. But 1975 saw the country plunge into civil war. The war took a heavy human toll and also produced substantial output losses, an extensively damaged infrastructure, and a tremendous loss of human capital as a result of emigration. At no time during the war, however, did Lebanon default on its financial obligations, and the country emerged from civil war in 1991 with a moderate level of debt (about 50 percent of GDP).
GDP subsequently rose in the 1990s, but growth was outpaced by rising debt as the government resorted to large-scale borrowing to rebuild the country (see chart, this page). Faced with dangerous debt dynamics and eager to avert a possible debt and balance of payments crisis, the government developed an ambitious reform agenda in 2002 that received substantial donor support at the Paris II conference. The authorities were able to achieve significant adjustment, although not enough to reverse the debt dynamics—in part because the country was suffering a parallel slowdown in growth. Implementation of the reform agenda also proved difficult, and the reform effort eventually stalled.
Facing down a crisis
It was against this backdrop that former prime minister Rafik Al-Hariri was assassinated in February 2005, throwing the country into a period of political and financial turbulence. Investors withdrew from Lebanon, and dollarization rose sharply—leading to substantial pressure on international reserves, which declined by about 20 percent over two months (see chart, page 201).
The authorities reacted by raising interest rates and providing additional incentives for commercial banks to extend maturities on government debt and maintain their foreign assets within Lebanon. These steps stabilized the situation until the political crisis waned. Deposit inflows resumed in the second half of 2005, dollarization receded, and international reserves recovered.
The political crisis temporarily interrupted an acceleration of economic growth. A surge in tourism and construction as well as exports raised GDP growth to 6 percent in 2004. But in the wake of the political crisis, public and private demand contracted in the first half of the year. And, although activity recovered toward the end of 2005, real GDP growth was subdued, at 1 percent for the year as a whole. Along with economic activity, foreign direct investment and portfolio inflows picked up again in the second half of 2005, more than offsetting a narrowing current account deficit.
In the absence of an approved budget, fiscal policy remained largely on autopilot during 2005, and public debt rose further. There was a de facto nominal freeze in most expenditure categories, although spending increased in some areas—notably transfers to social security funds and to the state electricity company, whose financial losses were estimated to be at least 3 percent of GDP in 2005. The economic slowdown weakened tax revenues, and a cap on domestic petroleum product prices exacerbated falling revenues, but these factors were mitigated by a decline in interest payments. As a result, the overall fiscal deficit narrowed slightly, but government debt still rose to 175 percent of GDP.
Rebuilding compounded debt
Government debt—already high—rose sharply during post-civil war reconstruction.
Data: Lebanese authorities and IMF staff calculations.
Resilience and risk
The events of 2005 underscored the resilience of the Lebanese economy in the face of shocks but also exposed significant vulnerabilities. The large and growing public debt overhang, the high degree of dollarization, large fiscal and current account deficits, and Lebanon’s reliance on short-term inflows to finance these deficits are the core vulnerabilities. The risks associated with these imbalances have been muted by a benign external environment, ample regional liquidity, and the relative stability of the depositor base. Lebanon’s resilience has also been bolstered by the liquidity cushion held by banks, its strong reputation for safe banking established over decades, and the authorities’ skillful handling of the financial pressures.
Without a doubt, Lebanon has defied the conventional economic wisdom on debt sustainability—and, some say, gravity—for quite a while. As long as the confidence of depositors is not disturbed, this equilibrium may prevail for some time.
But even if a crisis is not imminent, the heavy debt burden severely restricts the fiscal room that authorities have to actively pursue policies to, among other priorities, strengthen growth and raise the standard of living further. In 2005, interest expenses accounted for 34 percent of total government spending and 46 percent of government revenue. This, in itself, is a reason to strive for debt reduction. Not only would lower debt reduce fiscal vulnerabilities, it would also ultimately free up resources for other government priorities. Another reason for concern is that the large debt overhang stifles investment in productive capacity and, thus, growth. The risk of a major financial crisis severely shortens the investment horizon.
Skillful policy handling helped Lebanon weather the political crisis in 2005.
Data: Lebanese authorities and IMF staff calculations.
Reform in the balance
What to do? A well-prepared mezze of individual reform measures, including growth-enhancing policies, will work best to balance the short-term costs of adjustment with the long-term benefits of debt reduction. The authorities are committed to pursuing such a comprehensive reform program around a debt-reduction strategy, and they are aware that it will take time to significantly lower Lebanon’s debt-to-GDP ratio. Still, up-front fiscal adjustment is needed to reverse debt dynamics and put Lebanon on a downward debt trajectory. Privatization can also lower gross indebtedness.
In its recent report on the Lebanese economy, the IMF staff presented a scenario consistent with the authorities’ debt-reduction objectives. In this scenario, government debt would fall below 100 percent of GDP over the next 10 years. If Lebanon could again secure donor assistance, this pace would be accelerated. Of course, the scenario is also subject to uncertainties surrounding possible shocks to interest rates and growth, as well as to the political difficulties of delivering sustained adjustment.
Adoption of a comprehensive reform program is only one of many contentious issues on Lebanon’s complex political agenda. There are ongoing political tensions over relations with Syria, the legitimacy of the president, and the United Nations’ calls for the disarmament of Hezbollah (one of the government’s coalition partners). These issues have proved difficult to solve swiftly in a political system that requires a high degree of consensus among the various communities.
In fact, favorable economic developments since mid-2005 may have lessened the sense of urgency in the wider political arena to pursue a reform program that is likely to include some unpopular measures. But, in a volatile political and financial environment, Lebanon remains highly exposed to the risks of a shock that could trigger a widespread financial crisis. The government’s economic team is fully cognizant of these risks and has prepared a credible program to address them. Now it is up to the political leaders and the people of Lebanon to take up the challenge.
Edward Gardner and Axel Schimmelpfennig
Middle East and Central Asia Department
For more information, see Lebanon: 2006 Article IV Consultation, IMF Country Report No. 06/201. Copies are available for $15.00 each from IMF Publication Services. Please see page 208 for ordering details. The full text is also available on the IMF’s website (www.imf.org).