Uncertain times ahead

What effects will President Emile Lahoud

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There has been much speculation surrounding the implications of the presidential extension, especially given the reservations articulated by international leaders, the UN, and prominent members of the Arab League, including the GCC and Jordan.

Lebanon’s economy is highly fragile and vulnerable to local and regional political developments. Historically, times of uncertainty led to economic downturns, with slowdown in production, exports, and tourism, with only local consumption supporting the economy. Today, however, local consumption has been hit by a drastic deterioration in the standard of living in the country, flaring concerns about the economic implications of the Lahoud extension, the potential departure of Hariri, changes in the relationships with Syria and the incumbent developments in foreign relations, especially with the US and Europe. While no crystal ball is available to foresee the new Lahoud era, and no logical reasoning can prove Lahoud’s claims that his new term will be “different,” Lebanon’s economy continues to shoulder a massive public debt, recurring budget deficit, and delays in reforms. Public spending and budget deficit

Government spending on infrastructure and other public expenditures has historically been a main driver for economic growth in Lebanon, at least under the various Hariri governments. The market clearly recalls an economy on the verge of collapse during the Selim el Hoss government in 2000, when the government at the time put a lid on expenditures by blocking many infrastructure projects. Over the past years, the Hariri and Lahoud camps have been balancing each other out on the issue. Hariri’s camp, much more inclined towards spending, has been pushing for more and more infrastructure projects, while the Lahoud camp’s more conservative approach managed to keep the resulting budget deficit from blowing through the roof. Hariri seems sincere about his intention to quit the government if Lahoud stays in power. Should this be the case, the country may witness a serious shift in policy on government expenditures on construction and infrastructure. With no clear sign of who the incoming new prime minister would be, it is anyone’s guess as to what the budget would look like one year from now, and what the economic impact of a major change would reveal.

Alternatively, government public revenues would also be seriously affected by a change in policy. The Hariri government’s policy has typically been in favor of raising taxes and custom duties as a means to improve government revenues, especially as no serious plans for privatization or securitization are in the pipeline. The reason why such plans have not yet been implemented is because of differences of opinion between Hariri and Lahoud, differences of opinion that would no longer exist should one of them depart. Does this mean privatization and securitization are to take place if Lahoud stays and Hairi leaves? Why it may be the case, no one can really predict the outcome of such a development, and if it would obtain the optimal valuations.

Interest Rates

Changes in government policies regarding revenues and expenditures would surely affect the government ability to borrow funds, and ultimately interest rates. Recent efforts by the Hariri government to lower interest rates in an effort to boost economic growth and reduce the debt-servicing burden on the budget have been haled as somewhat successfully. On the other hand, however, interest rates are mainly a function of two parameters in Lebanon: the demand for money, mainly resulting from government borrowing, and the market’s assessment of the risk associated with lending.

Over the past 18 months, the government has managed to keep a tighter lid on borrowing, and has successfully swapped some long-term debt into another at cheaper rates. With Lahoud’s typically conservative view on spending, the upcoming government might just be successful at keeping a tab on borrowing. The problem, however, may fall on the other side of the equation. Basic economics stipulate that nominal interest rates in any economy are a function of the market’s risk assessment of lending, among other things. Uncertainly yields higher risk, and the uncertainty surrounding Lahoud, a new government, the UN resolution, the US stance on Syria, and the Syrian military presence in Lebanon create an unmatched recipe for uncertainty. Let alone international lenders to the Lebanese government, local lenders – large Lebanese banks – have recently showed reluctance to lend to the government, as illustrated by the significant shrinkages in the government securities portfolios of the banking sector in Lebanon. As such, interest rates are likely to raise, providing a more attractive risk premium to attract potential local and international lenders. Would this adversely affect economic growth and to what extent remains unclear, but a sudden rise in interest rates just as the Lebanese economy may be clawing itself out of recession would probably shove it back into it rapidly.

The banking sector

So how would the famed Lebanese banking sector be affected by such political developments, and how would it respond their various financial and economic implications? As mentioned earlier, banks in Lebanon have been recently reluctant to lend money to the government, thereby reducing their exposure to government securities and the Lebanese pound. While the latter may not be at risk due to the more than sufficient foreign exchange reserves of the central bank, a continued support for the domestic currency, inevitable during times of uncertainty and ill confidence, would seriously strain such resources.

Therefore, the first bank to be affected by such developments would be the central bank, which is likely to struggle to keep the Lebanese pound afloat.

Commercial banks, on the other hand, face a much higher risk. Political instability is often associated with capital flight from the country host to the instability. The extension to Lahoud’s term and the ensuing international upheaval are again casting a blanket of uncertainty over the country, and would, if sustained, drive away funds belonging to Lebanese as well as other Arabs. It is no secret that money follows safety, and a deep rift among the Lebanese people, Syria, the US, the UN, and the rest of the Arab world is far from being a good prescription for financial safety and stability. Aside from potential capital flight, another risk, relating to banks and associated with recent political developments is the cost of sources of funds. Banks in Lebanon have been reluctant to extend corporate loans, and as they are now reducing investments in government securities, they are struggling to find optimal uses of funds for their excess liquidity. Lower interest rates over the past year have failed to create a significant jump in corporate loans and credit facilities, making the task of finding optimal uses of funds even more difficult.

Making things worse, a rise in interest rates would increase the banks’ cost of funds, as rates in deposits would no doubt increase substantially. As such, higher cost of funds coupled with more scarce investment opportunities are likely to adversely impact the sector’s profitability and liquidity. That is, unless, we fall back into the vicious circle where the banks are forced to swallow government debts, the latter is forced to raise interest rates to keep borrowing, and ultimately reach a point where banks are overexposed to country risk and the Lebanese Pound, and the private sector is completely crowded out or unable to function at such high interest rates.

Time, along with Mr. Lahoud, Mr. Assad, Mr. Annan, and Mr. Bush, will tell.