Lebanon: Downgrade from 6/7 to 7/7 for medium- to long-term political risk

Political turbulence impeding economic reforms

After the May 2018 elections, Saad Hariri was appointed for a third term as Prime Minister by the Lebanese President and Parliament and charged with forming a new government. However, since his appointment, formation of a government has been at an impasse. The fact that Hariri’s party lost ground in the last election, and that his main political rivals, Hezbollah and the Christian Free Patriotic Movement, won seats and have put demands on the table that Hariri has not been willing to accept is causing the impasse. The current situation reflects the political infighting and sectarian tensions that have marred the country for years. Additionally, regional tensions have added to the instability. The fact that Hezbollah (backed by Iran) has been a dominant political and military player is a thorn in the side of Saudi Arabia. Adding to the instability, Mohammad bin Salman, for example, tried to force Hariri to resign in November 2017 in a failed attempt to reduce Hezbollah’s power in the country. Lastly, the spill-over effects from the conflict in Syria are impacting the political situation in Lebanon and clouding the economic outlook. Lebanon hosts an estimated 1.25 million Syrian refugees, in a population of just 6.1 million, which is an additional factor putting significant pressure on the weak public finances. Looking ahead, when the government is formed – as is expected in the coming months – political stability will still be a challenge given that a continuation of the domestic infighting and regional tensions is expected.

Lack of reforms weighing on economic performances

Due to the challenging political environment, it has been difficult to implement any significant economic reform such as the urgently needed consolidation of public finances. Historically, Lebanon has struggled with large fiscal deficits that have averaged 8.4% in the last 15 years. In 2018 this is even estimated to have been 9.7% of GDP. This has led to a ballooning public debt to GDP ratio, which reached 150% in 2018. Given that without fiscal reform, public deficits are expected to rise further in the coming years, the public debt to GDP ratio is likely to continue to rise. The public interest payments remain extremely large (they represented more than 40% of public revenue in 2018).

The lack of reforms and difficult domestic and external (war in Syria) political environment have also weighed on real GDP growth: while it averaged 6.9% in the period 2004-11, it has been subdued since 2011 given that in the period 2011-17 it averaged just 1.7%. The expected stabilisation of the conflict in Syria is likely to have a positive impact on GDP growth, as it is considered to be one of the factors supporting growth in the medium term.

Large external imbalances

Aside from deteriorating public finances, the country is struggling with increasingly large external imbalances. The current-account deficit has deteriorated in the last few years and reached 25.6% of GDP in 2018. This sharp deterioration started in 2012 when tourism income and private transfers (especially from the Lebanese diaspora working in the Gulf countries) declined. Given the very large current-account deficit, Lebanon is in constant need of attracting foreign capital. This happens mainly by attracting non-resident deposits in the banking sector.

Given the challenging domestic and external environment – high public debt, current-account deficit and low growth (real GDP growth was just 1% in 2018) – the Lebanese Central Bank has struggled to maintain stability and resorted to what they call ‘financial engineering’. Since 2016 they have launched a number of measures in coordination with the commercial banks that have supported the Central Bank’s foreign-exchange reserves, allowed the government to borrow at a discounted rate and increased the profit margins of the commercial banks, thereby ensuring stability in the short term.

Thanks to the financial engineering, the Central Bank’s reserves have remained large and sufficient to cover around 12.6 months of imports given that the commercial banks have transferred part of their foreign-currency deposits to the Central Bank. It has also led to the banks increasing their exposure to Lebanese government bonds. Additionally, the position of the Lebanese banking sector with regard to net foreign assets has become increasingly negative over time (from a USD 3 bn deficit in 2011 to a deficit of more than USD 20 bn at the end of 2017), given that they have reduced their foreign-exchange liquidity that they previously held abroad. While a large inflow of non-resident deposits has strongly increased external liabilities since 2012, external assets have slightly decreased. For the Central Bank, the financial engineering has led to a strong increase in its foreign-currency liabilities. However, given that the Central Bank does not publish data on its foreign-currency liabilities it is not possible to know the size of the Central Bank’s net foreign currency position neither is it possible to know what the maturity structure is of the foreign-currency liabilities.
 
Moreover, in recent years the large external imbalances have led to a significant rise in the external debt level, especially when compared to current-account receipts. World Bank data show a strong rise in the total external debt level, especially when expressed as a share of total current-account receipts. Also, the short-term external debt to current-account receipts ratio has risen by more than 60% since 2011 to about 40% of total current-account receipts in June 2018. The rise in external debt ratios has led to an increase in the total external debt service. According to World Bank data, in 2018 Lebanon spent more than 60% of its current-account receipts on servicing its MLT debt compared to around 40% in 2011.

Aid package attached to stringent conditions

As a result of this Credendo has decided to downgrade Lebanon’s medium-/long-term political risk classification to category 7. This is also motivated by the fact that the future rise in interest rates could pose additional risks to Lebanon. Given that the Lebanese pound is pegged to the US dollar, the country will need to follow US monetary policy. Furthermore, it will need to continue offering attractive interest rates in order to keep non-resident deposits flowing into the country. The consequence of this will be that it will force the government to pay a higher interest rate when refinancing its public debt. This will put further pressure on the already weak public finances. Considering the deteriorating outlook for Lebanon, it is uncertain whether the country and its banking sector will continue to be able to refinance their external debt in an environment of tighter global financial conditions.

On the positive side, it should be noted that Lebanon faces the prospect of access to an aid package that donors committed to in April 2018 at the CEDRE conference in Paris. The package consists of USD 10.8 bn of concessional loans and USD 0.86 bn of grants, to be spread over the next 12 years to fund infrastructure investments. However, the country can only access the funds if it forms a government and implements deep structural reforms. Lebanon has received access to similar funds in the past. This happened for the first time in 2001, when EUR 500 m of aid and grants was raised, and a second time in 2002, when EUR 4.2 bn was raised by 23 countries. Thirdly, in 2006, around USD 980 m was promised. Lastly, a fourth time in 2007, an additional number of (non-concrete) loans were promised. Recently, Qatar and Saudi Arabia have both pledged support to the Lebanese economy, Qatar in the form of a USD 500 m aid package.

For western donors, these conferences serve as a way to increase support for the pro-western governments (of which Saad Hariri is part) as opposed to Hezbollah. Each time, however, the loans have come attached to the promise to implement significant reforms, something that has not happened in the past. This seems to have led to frustration among donors, which in return has led to more stringent conditions being attached to the current loans. At the same time it is difficult to assess how stringent they will turn out to be if reforms are again not being implemented. This is important as Hariri is not expected to fully meet the conditions of the programme due the difficulty in finding a political consensus. Even if a coalition can be formed in the coming weeks or months, it is unlikely that this will result in structural reforms being implemented. Indeed, the coalition is expected to be relatively weak and reflect a continuation of the status quo. Additionally, while the size of the CEDRE aid package might seem large in absolute value, it is relatively small when compared to the size of the economy and more importantly when compared to the refinancing needs that the country faces over the time horizon of the aid package. If a confidence crisis erupts and non-resident deposits drop significantly, it will most likely need a bailout package several times larger than this.

Analyst: Jan-Pieter Laleman – jp.laleman@credendo.com