It took more than seven months to complete the 2019 budget law, despite the pressing need to have completed it by the maximum constitutional deadline of end January 2019. Had Lebanon managed to produce the 2019 budget within the mandated time frame, it would have gone a long way toward restoring confidence in the ability of the state to complete its financial functions, which, in turn, would have had positive effects on local financial markets, and on the countries and donors that pledged loans and grants to Lebanon on the condition of fiscal reforms at the April 2018 investment conference, known as CEDRE. 

Based on figures released for the 2019 budget, the assumption of reducing the fiscal deficit to 7.6 percent from 11.5 percent the previous year is far-fetched; international financial institutions are in agreement on this. In terms of revenues, it is very difficult to achieve an increase of 8 percent to reach LL19.02 trillion ($12.7 billion) due to the passage of time, the continuing economic recession, and the fact that half the fiscal year had already passed before the 2019 budget was approved. Revenues alone are projected to reach a maximum of LL18.2 trillion ($12.1 billion), and estimates have been adjusted to reflect only the time factor—actual revenues for the first half of 2019 amounted to just LL8.67 billion ($5.8 billion).

The expenditures in the budget—estimated at LL25.8 trillion ($17.2 billion)—exclude several important budget items: the budget of the Council of Development and Reconstruction, estimated at LL500 billion ($333.3 million) annually, as well as the treasury account with a deficit of approximately LL700 billion ($466.7 million), in addition to the government obligations toward the National Social Security Fund (NSSF), that exceed LL360 billion ($240 million), and service of government arrears to the NSSF. Including these expenditure items within the budget is necessary to respect the principle of full inclusion in public accounting. With the addition of such items, total state expenditure is close to LL27.4 trillion ($18.3 billion)—perhaps even more—and the deficit increases to LL9.2 trillion ($6.1 billion) compared to LL9.1 trillion ($6.07 billion) in 2018.

But another important question to consider is Lebanon’s GDP. The deficit ratio estimated in the official 2019 budget assumed that nominal output will rise by about 6.5 percent annually in both 2018 and 2019, to reach LL90.2 trillion ($60.1 billion) this year. The actual figure issued by the Central Administration of Statistics indicates an output of LL80.5 trillion ($53.7 billion) in 2017, and official estimates are not available after that year. It is difficult to achieve a nominal growth of 6.5 percent in 2019 in the recessionary environment we are in, and income (GDP), will not exceed 3.5 percent  annually at the most. Output is not expected to exceed LL85 billion in 2019. Therefore, the deficit is very likely to be closer to 11 percent. A reasonable estimate would be to reduce the actual deficit by only 0.6 percent in 2019. 

However, deficit reductions can be achieved through default and accrual of arrears shown in the financial statements, as they are calculated on a cash-only basis, but such an approach has serious  negative implications on the economy. 

One of the important proposed tax measures in the 2019 budget is to increase the interest income  tax to 10 percent for a three-year period only. However, this tax may have a negative impact on financial markets and economic activity, as it will lead to higher nominal interest rates and discourage economic growth, especially in the real estate sector. It may also be a negative factor on financial flows to Lebanon due to the decrease in the effective interest on deposits after tax, not to mention the impact on low-income Lebanese, especially retirees. In addition, the cost of servicing the public debt may rise with the higher nominal interest rate.

Another important proposed tax measure is to increase import duties with some exceptions. Consideration should be given to its impact on trade agreements, and keeping in mind protection is not beneficial to economic growth; it may have a negative impact. Raising the tax on high salaries to 25 percent will have a limited impact as it is a narrow category. Instead, it would be more feasible to raise the corporate income tax rate to 20 percent, and apply two VAT rates: 10 percent on non-luxury goods, 15 percent on luxury goods.

In the case of expenditure, the most important item of waste has been deferred: the electricity sector. The rapid completion of the purchase of energy through a transparent power-purchase agreement (PPA) tender for the equivalent of 1000 MW, and raising the tariff rate to 15 cents per kilowatt hour; would save the treasury close to $2 billion and save the consumer $1 billion annually. It would take a few months to implement and result in annual savings of $3 billion. It must be given top priority.

Looking forward to the 2020 budget, it would be preferable that those budget figures be based on reality, rather than on an overly optimistic scenario.

Three sets of regional conflicts and turmoil are impacting Lebanon. The country, yet again, finds itself in the most volatile of all regions, with a weak state and a corrupt set of politicians. You would not wish this storm on your worst enemies.

The first is the ongoing turmoil emanating from the growing wealth gap, soaring unemployment, large youth demographic, and the ailing arrangements or social contracts in rentier states. The Arab region, according to a report by Carnegie Middle East Center fellow, Lydia Assouad, is by far the most unequal region in the world today, even when compared to Latin America and South Asia. This dim reality was only sustainable when governments, either oil producing or backed by an oil-producing state, grew the public sector enormously to provide employment to the widest strata of Arab societies. In Jordan, for instance, the government employs a third of the working population. Given the structural changes in oil prices and the global economic slowdown, this is no longer sustainable. Governments are now coming to terms with the need to shrink the public sector, decrease or even lift subsidies on energy and bread, and float their national currencies. This occurred in Egypt, and is being considered even in wealthier Arab states, such as Saudi Arabia. These painful changes cannot go without a serious reshuffle of the social contracts between states and their citizens. Previously, the government provided subsidies and ample public sector employment; in return, the public gave away their political rights and freedoms. Today, this is no longer sustainable. Marwan Muasher, the former Jordanian foreign minister and vice president of studies at Carnegie, rightly calls this the death of the rentier state.

At the heart of the above change lies the first and second waves of protests in the Arab region. Following eight years of conflict in Syria, another deeper economic change is taking place that will once again affect Lebanon’s stability (after causing a refugee crisis in the first instance). The European and US sanctions and the return of state cronyism have further depreciated the Syrian lira, triggering local protests, and widening the regime’s circle of troubles. (Dozens of new Rami Makhloufs—Assad’s cousin, and Syria’s “wealthiest businessmen,” at least until his rumored arrest last month—or Makhlouf-likes have emerged with major deals and contracts as the conflict has waned.) This has, and most definitely will, impact Lebanon, where politicians are now blaming the recent appreciation of the Lebanese lira on the ongoing Syrian crisis and rising demands for US dollars. 

Regional reverberations

In Sudan and Algeria, we saw protests resulting in political change; though it is too early to tell if this will change will be sustainable in the long term. Egypt now is seeing a new wave of bolder protests, which are continuing in spite of the state’s severe repression. There is an underlying domino effect, and a persistence that highlights the failure of authoritarianism’s cosmetic remedies. In 2011, following the first wave of protests in the Arab region, Lebanon witnessed some reverberations, though in a weaker and disorganized form. To be fair to the protesters, the Lebanese political class’s response was very successful in exploiting the protests, subsuming them under the country’s sectarian politics. Today, Lebanon shares with the troubled Arab nations a set of negative economic indicators and a political class that has rotted in the public imagination. One can assume that wide Lebanese protests are on the horizon.

The second regional trend is the ill-thought-out and unplanned US maximum pressure campaign on Iran. The Trump administration, which has the highest turnover of senior officials in a president’s first term in US history, has no plan. The only seemingly visible goal is maximizing the financial pain of Iran and its Lebanese ally Hezbollah. Evident is the lack of any planning for what follows. This was clear in the aftermath of the attacks on parked tankers off the port of Fujairah in the United Arab Emirates, the uptick in attacks on southern Saudi Arabia, and the destructive raids on Aramco. This is a trend that is detrimental to Lebanon. The sanctions on Iran have triggered a military escalation in the Gulf, but this is not inclusive and could spillover into Lebanon. This nearly happened in September, when one Israeli drone exploded and another fell in southern Beirut, leading to a controlled Hezbollah response. Many now think the question of a military escalation in Lebanon is one of “when” and not “if.”

Difficult choices ahead

By the same token, regional strife will impact Lebanon’s economy. The impacts of the attacks on Saudi Arabia, and the region, will affect the Lebanese diaspora and their remittances to Lebanon—a fifth of which come from Saudi Arabia. The US sanctions on Hezbollah have accelerated the already deteriorating financial situation in Lebanon. The element of surprise, with numerous announcements on sanctions and the escalating threats to individuals and institutions—in spite of the central bank’s full cooperation with the US treasury department—had its impact on trust in the financial system. Sanctioning the subsequently liquidated Jammal Trust Bank also shocked the system. The threatening and uncautious rhetoric against Hezbollah and its allies (presumably a majority of the Parliament) by visiting US officials has created a tense atmosphere, increasing the country’s fragility and exposure to danger. Lebanese politicians had thought that many months separated them from economic collapse, and one can assume the US sanctions and escalation pulled the date closer, taking the Lebanese by surprise and contributing toward today’s chaos.

A third, though less visible trend, is the regional and international struggle over gas production in the Eastern Medditerranean. The most visible roles are those of the Egyptians, Russians, and Turks. As it embarks toward exploration steps in Block 4 this December, Lebanon has to make difficult choices, and appeasing all sides might not be sufficient. Recent political tensions with Turks, and closer ties to Egypt, signal that Lebanese politicians are already realigning themselves. These choices might bring about some troublesome reactions.

In all cases, Lebanon seems to be entering a perfect storm, albeit with the worst possible crew in charge.

A lot of rumors have been circulating lately regarding the economic situation in Lebanon. Every citizen, whether an economic expert or not, is worried about the liquidity in the system and is trying to analyze the different scenarios and probabilities of occurrence of an economic and/or financial crisis.

On the economic front, growth in the Lebanese economy was capped between 0 percent and 0.5 percent in the first nine months of 2019, as indicated by the BLOM Purchasing Managers’ Index (PMI) level, and inflation remained subdued (see table below). The PMI shows private sector activity stalled at an average of 46.8 by September 2019, capped below the 50-mark separating contraction from growth. Meanwhile, inflation eased to 2.77 percent by August 2019, down from last year’s 6.29 percent, mainly owing to a 10.7 percent annual downtick in oil prices to $64.8/barrel.

Within an environment of high interest rates and persistent slowdowns, markedly in real estate and the housing market, tourism was the only sector pulling up growth. Tourism was a bright spot in 2019 as it grew by an annual 8.3 percent to 923,820 tourists in the first half of 2019, close to 2010’s highs. However, the number of real estate transactions, which may include one or more realties, dropped by a yearly 18.30 percent to stand at 31,131 transactions by August 2019. In turn, average interest rates on loans in lira and in US dollars that reached highs of 11.13 percent and 9.9 percent by July 2019, compared to 9.97 percent and 8.57 percent, respectively, in December 2018, contributed to the crowding out of the private sector. These high rates make many projects unprofitable, discouraging companies from taking loans. Banks would prefer to place their money at the central bank as it would be less risky than in the private sector. 

Understanding patterns

A historical perspective on the Lebanese economy may help understand the current economic and financial situation. Since the 1960s, the partial dollarization of deposits has always existed in Lebanon, fluctuating between 25 percent and 30 percent before the 1975 war. The dollarization rate reached 86.2 percent in 1987, following a period of hyperinflation and a deterioration of the exchange rate, and stayed above 70 percent until 1993.

The successive governments following the civil war were never able to restore investors’ confidence to pre-war levels. Dollarization rates never went below 50 percent and, most of the time, interest rates were much higher than their US counterpart. During episodes of shocks, like in 1995, interest rates went up to 38 percent, while in 2005, 2006, 2008, and more recently, credit default swaps (CDS) crossed the 1,000 basis points. (CDS are an insurance against the risk of default of the Lebanese government. When their price increases, it means that the risk of default is going up. Theoretically, the five-year CDS should be equal to the difference between five-year Lebanese Eurobonds and five-year US bonds.) 

The reason why stress is increasing in the financial markets is related to the length of the current shock—which began with the onset of the Syrian war—when compared to the previous ones. The previous shocks had a limited time span of around three months on average, while the current one has been ongoing since 2011. Many shocks have hit the system since 1993. First, the 1996 Israeli aggression called Operation Grapes of Wrath remained for several weeks. Second, the assassination of prime minister Rafik Hariri in 2005 led to an outflow of capital for several months. Third, the 2006 Israeli war paralyzed the economy for more than three months. Finally, the 2008 global financial crisis had a very short impact on Lebanon as the Lebanese banks were not exposed to the subprime market of the US. The economy’s shock absorption capacity  was never tested for more than a few months. 

The balance of payments (BOP) surplus accumulated from 2006 to 2010 has been wiped out in the last eight years (see table above). Lebanon recorded a surplus of $19.5 billion from 2006 to 2010, while the BOP (the difference in total value between payments into and out of a country) turned into negative grounds from 2011 onward, recording a cumulative deficit of $18.5 billion by end July 2019. 

An aggregation of shocks

What took place since 2011 is a combination of multiple shocks that led to a progressive drying up of capital inflows and investments in Lebanon. The Syrian war cut the land routes of exports, pushed ISIS into the Lebanese territory, and instigated an unstable political and security environment. Then, the economic slowdown in the GCC countries following the large decline in oil prices since 2014 and the war in Yemen exhausted the resources of countries involved, and tensions in the region increased to levels not seen in the last decade. In addition, the two-year long presidential vacancy and the crisis of the sudden (and since rescinded) resignation of Prime Minister Saad Hariri in November 2017 weighed heavily on investors’ confidence.      

The result was a deficit in the BOP and an increase in the financial stress. The BOP deficit has increased drastically since 2018 when it registered $4.8 billion; in the first seven months of 2019 it reached $5.3 billion. Other financial stress indicators such as credit default swaps and spreads with international interest rates have also deteriorated substantially, particularly following the downgrades of the sovereign by two ratings agencies. 

In order to preserve the peg, Banque du Liban (BDL), Lebanon’s central bank, intervened repeatedly in the market and increased interest rates to continue attracting capital. BDL used financial engineering schemes to boost the returns for commercial banks placements and allow them to provide higher interest rates to their customers at a time of low international interest rates. 

The central bank adopted a tightening of monetary policy in order to halt the increase in money supply. The latter declined by 0.67 percent in the first seven months of 2019, compared to an average increase of 5.8 percent from 2013 to 2017. BDL tried and succeeded in sucking most of the liquidity from the market through its financial engineering schemes, starting in 2016 and implemented repeatedly since then. In order to reduce money creation, BDL terminated the subsidies program for housing loans and offering high returns to banks that place their excess reserves with it. Banks were no longer interested in lending to the private sector or even to the government. Loans to the resident private sector declined by 9.5 percent or by more than $5 billion between end 2017 and July 2019.

Since banks’ liquidity was placed at the central bank for medium to long term, maturity mismatch between their assets and liabilities increased. Although banks were able to increase the average maturity of deposits from 45 days in the past 20 years to six months by the end of 2018, it remains far lower than the average maturity of their placements at BDL. As the economic situation deteriorated and demand for dollars outstripped the offer because of the negative balance of payments and the erosion of confidence, banks reduced their foreign assets, particularly over the past two years, to face the demand for dollars.  

As both the central bank and commercial banks are keen to keep their foreign assets at levels that preserve confidence, some shortage in dollars appeared on the markets, which led, in the past two months, to the creation of a very thin parallel foreign exchange market. Some of the restrictive measures adopted by some banks were to counter the abuse of the system exercised by some customers that began to exploit the arbitrage opportunities presented between the official and the parallel market. The latter constitutes less than 2 percent, in size, of the official market, and the exchange rate used in this parallel market is less than 5 percent higher than the rate used in the official market. 

Misplaced fears

The problem is summarized into a vicious cycle of self-fulfilling expectations whereby the lost confidence is the starting point, and people are aggravating the situation by acting, all of them, in the same direction. Individuals are afraid to lose their deposits, thus some of them are withdrawing their money from banks and keeping it at home and others are opening accounts abroad and transferring part or the total of their deposits to Europe.

However the cushion that the banking system holds is more than sufficient in the foreseeable future. The central bank foreign assets, excluding gold, cover 75 percent of lira deposits, and the banking system foreign assets cover more than 40 percent of dollar deposit. Therefore, the situation is not as bad as portrayed in the media.

The banking sector has the ammunition to defend the peg, which has served the economy well, and opinions about de-pegging the currency are misplaced. In a region full of uncertainties and shocks, any policy that ensures some stability and a clearer vision for consumers and investors may have a positive effect on growth. The importance of the peg is in its ability to provide a stable business environment when it comes to anchoring inflation expectations.

Moreover, evidence from economic research indicates that “floating exchange rates are far from a panacea for emerging markets and that this policy advice misses a number of important real world considerations that are crucial for developing countries” (see Guillermo A. Calvo and Carmen M. Reinhart 2000 paper at the National Bureau of Economic Research). As stated in my own research paper, co-authored with Andy Khalil last year: “Large exchange rate volatility in emerging and developing countries, such as large depreciation has a recessionary impact. When investors’ confidence is lost, domestic interest rates volatility will become chronic and exchange rate swings seem to be more damaging to trade with the pass-through to inflation far higher in emerging and developing economies than in developed countries.” 

Hence, whatever the cost of pegging the exchange rate, it will remain more advantageous for emerging economies when compared to a pure floating regime. In fact, as noted in the 2018 paper,  “currency crises become credit crises as sovereign credit ratings often collapse following the currency collapse and access to international credit is blocked.” Studies agree that if trade consists of a large fraction of a country’s GDP, i.e. the country is small and open, the costs that come with currency instability are substantially higher in the aggregate.

To restore investors’ confidence, the government has to set a clear timetable for reforms, as opposed to simply mentioning a list of projects and a 1 percent decline in fiscal deficit per year. Until now, the situation is blurry for investors about the necessary reforms that, if implemented, will unlock CEDRE funds pledged by international donors in April 2018, but contingent on fiscal reforms.

To turn the cycle

In this context, the government has taken some important measures that unfortunately have passed unnoticed by investors. The Parliament has approved a law that updates and modernizes the code of commerce. The government has also passed a decision to stop hiring in the public sector for the next three years. It has started to tackle state pensions by imposing a tax on highly paid pensioners. The authorities increased some taxes like VAT and the tax on interest income in the 2019 budget and reduced some expenditure. Moreover, cabinet approved an updated electricity plan to tackle the sector’s deficit, on which some progress has been made. Aside from the CEDRE funds, the government has approved several infrastructure projects to reduce traffic congestion in Beirut. The government has also filled vacancies in the judiciary sector to accelerate the work related to fighting corruption in the public sector.

If these measures had been outlined in a clear work program, within a clear time frame, their impact on investors’ confidence would have been tremendous. The reforms should have been prioritized and spelled out in a program that would show, on a quarterly basis, which reforms are to be implemented. This would keep the government to a set schedule that can be monitored by investors on a regular basis, and if kept will result in donors distributing funds.

Setting and monitoring such reform programs is the bread and butter of the International Monetary Fund (IMF). The IMF would tick a box whenever the government implemented a reform and inform donors and investors, on a quarterly basis, about the progress achieved. When the government is on the right track and is respecting its commitments, the IMF will give a green light for donors to disburse money.

An important game changer will remain the drilling for oil and gas that will start before the year’s end, especially if oil and gas are discovered from the first drill. In this case, consumers’ and investors’ expectations will change drastically with a likely positive impact on the economy but, more importantly, it will be able to turn the vicious cycle into a virtuous one.