The year 2004 revealed a great dichotomy between the “feel” of the economy – i.e., the anecdotal chatter and the empirical improvements. The primary reason for the downbeat mood was, and continues to be, the lack of political vision, and the continuing wrangling between the poles of political power. While very little true reform was achieved in the year due to this political paralysis, there were factors, not directly controlled by the local body politic that provided stability and some hope for future improvement. Taken in isolation, the net effect of the political landscape, if it continues in its trajectory of deception and unreliability, could quickly backfire and destabilize the positive elements in place. The sustained health of the real estate sector and the inflows of capital, while encouraging, are rendered fragile by the lack of true political drive to capitalize on these factors and push confidence in the economy even further. The departure of former prime minister, Rafik Hariri, for instance, has led some Gulf investors to pause for thought. Overall though, the statistical performance of the economy showed resilience, despite a political environment that continued to plumb new depths.
All available indicators point to a significant acceleration in growth, which is projected to reach 5% for the year. Strong export and tourism receipts, and a recovery in construction activity, are the driving factors behind this recovery.
The increase in growth also reflects a catch-up effect from the adverse impact of the war in Iraq in 2003. A modest acceleration of inflation to about 3% is expected in 2004, owing to increases in import prices, mostly related to the depreciation of the Lebanese pound against the euro, and of course, higher fuel prices. The external current account deficit is expected to decline by about one percentage point to around 12% of GDP in 2004, while the surge in external demand for Lebanese goods and services, mainly from the region, is expected to outweigh the impact of higher oil prices. Exports to Iraq have grown dramatically, albeit from a very low base. At the root of the improvement in the current account is a substantial improvement in the government financial balance, offset only in part by a decline in the saving-investment balance of the private sector. This development reflects the adverse terms-of-trade shock related to oil prices and the decline of private savings due to lower interest rates. This clearly shows that although the drop in rates is a positive, its net effect on the pool of savings is negative.
Sustained private capital inflows are financing the current account deficit. Although the surge of inflows recorded after Paris II is slowing down, the general reflow of Arab capital to the region continues to benefit Lebanon. If, however, the broken promises of Paris II remain, the government, especially this one, will have a tough time lining up more international sponsorship later on. Still, a potential reversal in investor confidence constitutes a major risk for the economy and highlights its overall fragility.
In addition to deposit inflows into the banking system, Lebanon continues to attract large foreign direct investment ($2 billion net in 2003), mostly into the real estate sector. Here it is important to bear in mind that although the real estate sector has been a contributor to growth, it remains to be seen whether this sector is benefiting from speculative flows from the Gulf, or whether it is a leading indicator of sustained improvement that will spillover into other areas. It is unlikely that Lebanon can rely on real estate to the degree that some pundits suggest. Without improvements in local disposable income and/or housing affordability, the real estate sector remains an anomaly, underpinned by anxious Gulf money.
On the monetary side, fueled by capital inflows, monetary growth remains strong at 12% over the 12 months ending June 2004 and the fact that domestic interest rates have not risen in tandem with international rates. As financial inflows into Lebanon moderate, monetary growth is expected to slow down in the period ahead. The level of international reserves has helped reinforce confidence, but the pace of depositor inflows will also be affected by developments in international and domestic interest rates as well as regional political developments. This remains a potential pothole, as the drop in the US dollar worldwide and the benign level of interest rates has kept pressure off the Lebanese central bank. If and when these trends reverse, it is unclear what the impact would be, though a safe guess is that it could exacerbate potential crises.
Banking sector capitalization and profitability remain high. Capitalization in major banks has increased, return on equity was 11% in 2003 and early 2004, and banks remain highly liquid. With the pick up of economic activity and the decline in lending rates, the trend increase in the share of problem loans was reversed in the first half of 2004, and problem loans now stand at 12.2% of the loan portfolio (net of provisions). Banks are also making use of the new loan-restructuring framework. However, private sector credit growth remains anemic, reflecting widespread over-leveraging in the non-financial private sector. Bank profitability may come under pressure in the period ahead as high-yielding government paper comes to maturity and international interest rates increase.
Budgetary performance in the first half of 2004 has been much stronger than expected, due largely to solid revenue growth. The primary budget surplus for the first six months of 2004 improved by about 1% of GDP, over the same period of 2003, to 2.5% of annual GDP. VAT receipts have been particularly buoyant, but revenue performance has been strong across the board. Non-interest budgetary expenditure was contained effectively. Owing to a sizeable reduction of interest charges and a projected increase in the primary balance of payments the overall government balance could decline from 14.6% of GDP in 2003 to about 8% of GDP in 2004, provided recent trends are sustained. On this basis, the debt-to-GDP ratio would decline to 178% of GDP by year end thus bringing the ratio back to its level in 2002. The decline in the interest bill (by 5.5% of GDP in 2004) reflects the effects of Paris II refinancing and low global interest rates, but also a continued decline of interest rate spreads vis-à-vis international rates. Based on recent trends, the primary budget surplus is projected to rise by about 1 percentage point to 4.5% in 2004. However, this is short of the authorities’ primary surplus target of 6% of GDP under Paris II. The positive revenue trends of the first half of 2004 will be offset in the second half of the year by the cost of a newly established cap on gasoline prices and anticipated additional transfers to the loss-making electricity company Electiricité du Liban. The downward revision to the wage bill for 2004 reflects lower than projected outlays in the first half of the year due to a nominal wage freeze. Lower outlays for other current spending are based on sizeable savings in subsidies and health care spending in the first half of 2004.
The situation of the Electricité du Liban remains a fly in the ointment. Government expenditure and revenue efforts are being undermined by the losses of EDL and imbalances in two of the social security funds. The operating losses of EDL reflect not only a gap between operating costs and the tariff structure, but also production inefficiencies; large non-technical losses, due to theft and non-collection; and governance problems. Although the government has covered operational losses of EDL, the central bank has also provided about $300 million in loans since June 2003. The central bank loans are unlikely to be repaid and thus constitute a contingent liability for the government. Total financial assistance to EDL from the government and the central bank amounted to 2.6% of GDP in 2003, and is projected to be 2.3% in 2004. Another source of contingent liabilities comes from the imbalances in the health and family allowance arms of the social security system. The deficit (1.1% of GDP in 2003) is being financed by drawing down social security reserves and is masked by the surplus in the pension fund (1.8% of GDP). In a word, don’t sell your generators.
The overall picture of the Lebanese economy, one of improvement, is clearly at risk from the political side. If authorities do not act quickly to protect the gains achieved, those gains can quickly evaporate and the fragility of our system can be exposed almost overnight. In order to protect recent achievements on the budgetary front, expenditure pressures will have to be contained, and the risks from open-ended transfers and contingent liabilities will need to be addressed. Continued expenditure discipline is required. The IMF recently expressed concern that expenditure discipline would weaken in the election period, particularly in regard to capital spending. The authorities seem confident that they would be able to contain spending, but this remains to be seen.
The problems of EDL require urgent attention. Ongoing efforts to reduce operating costs and improve collection should reduce losses at the margin. However, restoring the financial health of EDL will require deeper restructuring, political action to address widespread nonpayment, and possibly tariff adjustments. According to the authorities, a broad political consensus for reform needs to emerge for such measures to be taken.
As a first and immediate step, the IMF mission urged that EDL be made more accountable about its financial situation and that the financial support to EDL be made more transparent, rather than disguised as central bank lending. In this regard, an external assessment of EDL operations and finances would be desirable. The incorporation of EDL as a joint stock company and its removal from direct political tutelage are also key to improving governance and eventually privatizing EDL. In a sense, a depoliticizing of EDL is urgently needed, as it is both a symptom and a cause of the current impasse in many respects.
Social security imbalances should be addressed before they snowball. The gaps in the family allowance and health funds reflect a combination of unfunded mandates and escalating health costs. Some measures are being taken to contain health expenditure, but more fundamental reforms will need to be identified to protect the government budget from these growing contingent liabilities. Plans are under way to extend social security coverage in the form of minimum pensions and health insurance for retirees.
The government’s draft proposal to fund the bulk of the added benefits through increases in contributions, rather than shifting the burden to the state is a step in the right direction, but implementation will depend on the timing needed to secure parliamentary approval.
One is almost tempted to think that the improvements in the Lebanese economy are a fluke, since there does not seem to be the political will to strengthen the economy going forward, but more a continuation of the wrangling, and an attitude of denial and neglect vis-à-vis international pressures and obligations. The cornerstone of the economy in 2004 was the confidence of investors from abroad. Maybe they look through the short term political dynamics, but the fact is, without a clear path of reform on all fronts, and a drive to strengthen Lebanon’s institutions, the improvements witnessed in the year will dissolve, and we will be facing, head on, a fiscal nightmare with no one credible at the helm of power. One must look at 2004 as a year where hope triumphed, but credible policy remained illusory. The next step is for a political improvement to match the statistical one, and a clear focus on Lebanon’s economic sovereignty.