COUNTRY REPORT Lebanon July 2001 The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom Lebanon at a glance: 2001-02 OVERVIEW Political tensions within the ruling troika have come to the fore, with disagreement over the prime minister’s economic reform programme, the role of the security services in political affairs, and Hizbullah’s campaign against Israel deepening pre-existing divides. The government has moved forward with its economic reform agenda, preparing the ground for vital measures including the introduction of VAT, privatisation and cuts to the public sector. There are signs that the economy has returned to growth, and inflation has remained low, although the scale of the imbalances within government finances threatens to undermine hopes for a sustained recovery. High capital and invisible inflows have offset the widening trade and current-account deficits. Key changes from last month Political outlook • The withdrawal of Syrian troops from much of Beirut is unlikely to put an end to mounting demands for an end to Syrian interference in Lebanese affairs. Israel’s decision to retaliate against Syrian troops for Hizbullah attacks against Israeli forces has increased the risk of an escalation of crossborder violence. Economic policy outlook • The government will remain committed to its economic reform programme, seeking to revive growth and restore balance to the fiscal account. The approval of the budget suggests the prime minister, Rafiq Hariri, is continuing to receive the backing of other members of the elite, but their support will come under growing strain as the reform programme moves forward. Economic forecast • The delayed approval of the 2001 budget will lower non-debt spending this year, while VAT is likely to boost revenues in 2002. The EIU has therefore revised its projections for the budget deficit downwards this year and next. However, the deficits will remain among the highest in the world as a percentage of GDP and extremely difficult to finance.
Transcript
COUNTRY REPORT
Lebanon
July 2001
The Economist Intelligence Unit15 Regent St, London SW1Y 4LRUnited Kingdom
Lebanon at a glance: 2001-02OVERVIEWPolitical tensions within the ruling troika have come to the fore, withdisagreement over the prime minister’s economic reform programme, therole of the security services in political affairs, and Hizbullah’s campaignagainst Israel deepening pre-existing divides. The government has movedforward with its economic reform agenda, preparing the ground for vitalmeasures including the introduction of VAT, privatisation and cuts to thepublic sector. There are signs that the economy has returned to growth, andinflation has remained low, although the scale of the imbalances withingovernment finances threatens to undermine hopes for a sustained recovery.High capital and invisible inflows have offset the widening trade andcurrent-account deficits.
Key changes from last monthPolitical outlook• The withdrawal of Syrian troops from much of Beirut is unlikely to put an
end to mounting demands for an end to Syrian interference in Lebaneseaffairs. Israel’s decision to retaliate against Syrian troops for Hizbullahattacks against Israeli forces has increased the risk of an escalation ofcrossborder violence.
Economic policy outlook• The government will remain committed to its economic reform
programme, seeking to revive growth and restore balance to the fiscalaccount. The approval of the budget suggests the prime minister, RafiqHariri, is continuing to receive the backing of other members of the elite,but their support will come under growing strain as the reformprogramme moves forward.
Economic forecast• The delayed approval of the 2001 budget will lower non-debt spending
this year, while VAT is likely to boost revenues in 2002. The EIU hastherefore revised its projections for the budget deficit downwards this yearand next. However, the deficits will remain among the highest in theworld as a percentage of GDP and extremely difficult to finance.
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Divides within the ruling elite will widen as the government moves forwardwith its economic reform programme and political tensions come increasinglyto the fore. Tensions on the border will rise as Hizbullah continues its guerrillacampaign, prompting periodic Israeli attacks against Syrian positions whichwill carry the risk of an escalation in crossborder violence. The government willmove forward with its economic reforms, but the deficit will remain wide,forcing it to look to foreign currency sources to meet borrowing requirements.It has the means to fund the deficit for some time, but not to fundamentallyoverhaul the debt dynamic that dominates public finances, suggesting that it isonly able to postpone the point at which the fiscal balance reaches crisis.Despite this, growth is expected to resume this year while inflation remainslow. The trade and current-account deficits will widen this year and next.
Syria has withdrawn troops from Beirut, apparently in response to mountingdemands for an end to Syrian interference in Lebanese affairs. Theredeployment will not end Syrian dominance of the Lebanese political scene,however, and after a brief respite the anti-Syrian campaign is expected toresume. Tensions on the border have risen, with a new Israeli strategy ofattacking Syrian positions in retaliation for Hizbullah raids bringing the twostates into direct conflict for the first time in 20 years.
Despite fierce opposition the government has begun to implement itscontentious economic reform programme, including public-sector job cuts andthe introduction of new taxes. Further measures are planned, with theprivatisation of telecommunications assets high on the agenda. Data show aslight improvement in the fiscal balance, but the deficit is expected to widenover the second half of the year. To reverse the trend, the government willrequire extensive support from foreign donors, with a conference of backersnow expected to take place towards the end of the year.
Available indicators suggest that the economy has returned to growth, withconsumption and investment spending showing a modest rise and tourismnumbers continuing to strengthen.
Firm local demand has pushed up import spending and widened the tradedeficit, although high invisible and capital inflows have continued to supportthe overall balance of payments. The government has issued two furtherEurobonds, and will sell additional debt this year. Negotiations for a free-tradedeal with the EU are close to completion.
Editors: Simon Williams (editor); Hania Farhan (consulting editor)Editorial closing date: July 15th 2001
All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] report: Full schedule on www.eiu.com/schedule
Based on the 1926 constitution (with amendments incorporated in 1990) and theCivil Procedure Code, the Criminal Procedure Code and the Penal Code
Under the electoral law of July 16th 1992, the unicameral National Assembly has128 seats equally divided between Muslims and Christians
Universal direct suffrage over the age of 21
August-September 2000 (legislative); next elections due by 2003 (presidential) and 2004(legislative)
The president, currently Emile Lahoud, who was elected in November 1998 for a six-yearterm by the National Assembly. Under an unwritten agreement, the president must be aMaronite Christian
The prime minister is chosen by the president after consultation with parliamentarydeputies; the government is then chosen by the designated prime minister and thepresident. Ministers need not be members of the National Assembly, but are responsibleto it. The prime minister must be a Sunni Muslim. The current government wasappointed in October 2000
Hizbullah (Shia), Amal (Shia), National Liberal Party (Christian), National Bloc(Christian), Kataeb Party (largest Christian party), Progressive Socialist Party (mainlyDruze), Syria Social Nationalist Party
Prime minister Rafiq al-Hariri (Sunni)
Deputy prime minister Issam Fares (Greek Orthodox)
Agriculture Ali Abdallah (Shia)Defence Khalil Hrawi (Maronite)Economy & trade Bassil Fleihan (Protestant)Education Abdel-Rahim Mrad (Sunni)Electricity & water resources Mohammed Abdel-Hamid
Beydoun (Shia)Environment Michel Musa (Greek Catholic)Finance Fouad Siniora (Sunni)Foreign affairs Mahmoud Hammoud (Shia)Health Suleiman Franjiyeh (Maronite)Industry Georges Frem (Maronite)Information Ghazi Arida (Druze)Interior & municipal affairs Elias Murr (Greek Orthodox)Internal refugees Marwan Hamadeh (Druze)Justice Samir Jisr (Sunni)Labour Ali Kanso (Shia)Telecommunications & post Jean-Louise Cordahi (Maronite)Transport & public works Najib Miqati (Sunni)
The outlook for Lebanon rests heavily on the ability of the prime minister, Rafiqal-Hariri, to sustain support among the political elite for the radical economicreform programme he has begun to implement. For much of its two years inoffice the previous government led by Salim al-Hoss found itself unable to act,constrained by its weak domestic standing, the growing power of unelectedsecurity officials working for the president, Emile Lahoud, and an increasinglyhostile parliament. At present, the prospects for an improvement in thepolitical process are broadly positive. Mr Hariri, who came to power in October2000, is a forceful leader and an experienced political operator. His popularstanding has remained strong since his success in the 2000 election, and he hasused this—and the increasingly apparent need for reform—to negotiate crucialsupport for his economic agenda from Mr Lahoud and the parliamentaryspeaker, Nabih Birri (the other two members of Lebanon’s governing troika).With other senior figures also offering their backing, and Syria apparentlysupporting the prime minister as well, Mr Hariri would appear to have a firmpolitical base from which to act.
As the prime minister begins to put his reform programme into effect,however, the consensus he has begun to build will be placed under growingstrain. Mr Birri, for example, may have been willing to agree in principle tocuts in public-sector employment, but when these start to have a direct impacton his Shia constituency, his support is likely to wane. His commitment willweaken particularly quickly if, as seems likely, Mr Hariri proves unable todeliver the development funds he has promised for the south, where the Shiaare concentrated. Mr Lahoud’s backing has also yet to be tested. Although heappears willing to allow Mr Hariri ostensible control of economic policy, hewill resist measures which impinge on areas that he regards as his own politicalterritory. As these include the position of the army—one of the largest drawson the public finances—there will be considerable scope for clashes. Publicdisagreements between the president and prime minister over issues such asHizbullah’s campaign against Israel in the south, and the activities of theLebanese security services, also show that political and personal rivalrybetween the two men has not been subdued. If the troika prove unable to setaside their own political interests to pursue what they have publicly recognisedas the national good—reform of the state finances—then the compromisesneeded to maintain a consensus will severely limit the impact of the reformprogramme. Alternatively, if Mr Hariri proves unwilling to compromise hiseconomic agenda, a return to the debilitating power struggles of the 1990scould ensue, potentially culminating in Mr Hariri’s resignation. As the primeminister is the only political figure who has shown the drive to addressLebanon’s economic problems, such a development would be a severe setback.
The other issue which threatens to test domestic stability is the increasinglyvigorous debate over Syria’s role in the country. In June Syria withdrew troopsfrom much of Beirut, hoping that the move would prevent the vociferous anti-
Syrian campaign that has emerged over the last year from gaining momentum.However, the redeployment is only like to buy Syria temporary respite, withfresh demands for an end to Syrian domination of Lebanese affairs set toemerge. Unable to jeopardise vital relations with the Syrian leadership, theLebanese government has so far supported Syria’s continuing role in Lebanon.However, if anti-Syrian sentiment unifies the Christian community, thegovernment response risks exacerbating sectarian tensions, reviving memoriesof the 15-year civil war that the Christians “lost” to Syrian-backed forces. Moredangerously still, if the campaign builds on its support outside the Christiancommunity, it will become increasingly difficult for the government to ignoreits demands. As the government owes its position in large part to support fromDamascus and could not risk direct confrontation by calling for an end toSyrian domination, continued Syrian influence would erode the government’snationalist credentials and steadily undermine its popular support.
The dominant foreign policy issue over the forecast period will remain relationswith Israel and security on the two countries’ shared border. The end of Israel’s22-year occupation of the south has so far resulted in a period of relative calmin the border region. However, the peace is fragile, undermined by Hizbullah’scontinued control of the border area and its periodic guerrilla strikes againstdisputed territory on the Israeli side of the UN-demarcated blue line. In recentmonths, tension has risen further as the new Israeli government, led byveteran hard-liner Ariel Sharon, has launched air strikes against Syrianforces in Lebanon in response to Hizbullah raids. The new strategy isdesigned to force Syria to prevent Hizbullah from continuing its raids, butit is unlikely that Damascus will prove willing, or even able, to bring theguerrilla campaign to a close. As a result, there will be further clashesbetween Israeli and Syrian forces, although fears that this could lead to warbetween the two states in Lebanon appear overstated. However, as airstrikes continue to lead to Syrian losses, Damascus will come underincreasing pressure to find some way to respond, with any retaliatorymeasure it deploys likely to prompt rapid and heavy Israeli counter-strikesagainst Syrian, Hizbullah and Lebanese targets.
Economic policy outlook
Economic policy will continue to be the focus of Mr Hariri’s energies, as heseeks to move Lebanon out of recession and tries to find a means to bring theescalating fiscal deficit under control. In his first months in office the newprime minister stressed the growth element of his programme, targeting rapideconomic expansion as a means of boosting medium-term fiscal revenue.However, in recent weeks his emphasis has switched towards implementingcost-cutting measures that will slow the pace at which the fiscal deficit isgrowing. The shift is timely, and appears to reflect a growing recognition thatunless the deficit is brought under control, the resulting imbalances willthreaten the stability of the whole economy and prevent the return of localand international confidence.
The government will find it extremely difficult to make significant inroadsinto the overwhelming fiscal deficit. In fiscal 2000 the deficit rose by morethan 60% to L£5.9trn (US$3.9bn), the equivalent of almost 24% of estimatedGDP or 56% of expenditure. The draft budget for 2001 targets a lower deficit ofL£5.1trn (51% of expenditure), but even this seems overly optimistic. Revenueis unlikely to rise by the 7.6% on the 2000 outturn envisioned in the bill,given the impact tariff cuts introduced in November have already had oncustoms earnings. The modest economic growth that the EIU projects for thisyear is also unlikely to boost tax revenue substantially. The 4% fall inexpenditure reportedly targeted in the budget appears unrealistic. Even basedon a conservative projection of growth in the public debt stock, we expectdebt-service payments—the largest single item of spending—to push totalexpenditure beyond the government’s target. We have reduced our forecast forthe overall budget deficit marginally to L£5.9trn, but this reflects the delay inapproving the budget on non-debt spending rather than a significant policyachievement, and still leaves a deficit equivalent to 57% of expenditure or some23% of GDP. We expect the government to have the political strength toimplement elements of its reform strategy over 2002, including theintroduction of value-added tax (VAT) at the start of the year. Assuming it isalso able to control non-debt spending, we forecast a slight nominal fall in thevalue of the deficit to L£5.5trn over the year, still the equivalent of 21% ofGDP and by far the largest deficit of any country in the region.
Over much of the last decade, the government has relied largely on sellinglocal-currency Treasury bills to Lebanese commercial banks to generate thefunding it required. However, this period now appears to be over, with dryingliquidity forcing the Banque du Liban (central bank) to take on T-bills worthsome US$2bn over the last nine months that commercial banks were unable tobuy. Instead, the government has looked increasingly to borrow in US dollars,issuing Eurobonds on the international capital markets. These too have beenabsorbed predominantly by the commercial banks, which have sought outletsfor their large foreign-currency deposit base. The banks will continue to buysovereign dollar debt over the forecast period and, provided there is no largeoutflow of funds from Lebanon, have sufficient liquidity to cover a largeproportion of the government’s borrowing needs. The government will also berequired to generate funds from its privatisation programme, with the sale oftelecommunications assets possibly generating more than US$2bn next year.The government will also seek foreign support, possibly extending tointernational guarantees for a debt issue. This would allow Lebanon to sell debtto foreign investors who have previously been deterred by its poor credit rating.
However, if through a combination of these instruments Lebanon is able tofinance its deficit this year and next, it is difficult to see what the governmentwill achieve other than delaying the point at which its public finances reachbreaking point. Unless the government’s fiscal reform measures deliver resultsthat are substantially more marked than currently seem feasible, orinternational support dramatically exceeds expectations, the government haslittle prospect of bringing its finances under control, with the cost of servicingthe mounting debt burden outstripping any likely reduction in other spendingor increases in revenue. When the government reaches the point at which it
has exhausted local and international lending sources to bridge the recurrentdeficits, and divested itself of its public assets, it will face the prospect ofdefault and the large-scale monetising of its domestic debt. The impact on thebroader economy will be substantial, undermining growth, driving upinflation, and almost certainly breaking the Lebanese pound’s peg to the USdollar, as well as increasing the risk of widespread social unrest.
Monetary policy will remain tight, as the central bank continues to focus onmaintaining the currency’s peg to the US dollar. Given the scale of thegovernment’s borrowing requirements, there is little short-term prospect of acut in interest rates, despite pressure from the government for an easing ofrates to lower its debt-servicing costs. However, the widening differential on USrates should ease pressure for a rise in domestic rates in 2001; rates are expectedto stay at some 14-15% for the benchmark two-year T-bill.
Economic forecast
International assumptions summary(% unless otherwise indicated)
1999 2000 2001 2002
Real GDP growthWorld 3.6 4.9 2.8 3.7OECD 3.1 4.0 1.5 2.5EU 2.5 3.4 2.3 2.6
Industrial raw materials (% change in US$ terms) –4.6 13.4 –3.1 3.7
Note. Regional aggregate GDP growth rates weighted using purchasing power parity exchange rates.
We have made a marginal downward revision to our world economic outlooksince our previous report, to reflect the impact of the downturn in US growthon the global economy. At present, we expect the US economy to begin torecover towards the end of 2001, supporting stronger world growth in 2002.
The most significant element of this new outlook for Lebanon is likely to bereduced yields on US Treasury bills in 2001, which will widen the differentialon local-currency assets. However, US rates should pick up in 2002 as growthresumes, increasing pressure for a rise in Lebanese rates as the differential falls.In the light of weaker world growth, we have also revised downwards ourprojections for growth in average commodity and manufactured goods prices
in 2001. International oil prices are expected to fall by some 5% this year andnext. The positive impact of lower prices on Lebanon’s import bill will be aidedby the continuing weakness of the euro against the US dollar this year, althoughthe euro is expected to strengthen in 2002, increasing the cost of Lebanon’simports from the EU.
After two successive years in which we estimate the economy contracted, weexpect real growth to resume this year, driven by a recovery in the servicesector and steadily increasing domestic confidence, provided that Mr Haririconsolidates his hold on economic policy and begins to implement his reformprogramme. Given the scope of the reform agenda, the likely pace of growth isdifficult to judge, but we expect it to be slow, at some 1% this year and 2% in2002, held back by uncertainty associated with the parlous state of governmentfinances. The 2001 figure falls short of the official growth projection of 3-5%for this year, and may prove overly conservative if the reform programme hasthe immediate impact that Mr Hariri is hoping for. However, the most seriousrisks are on the downside, and if the fiscal deficit does push governmentfinances and the currency into crisis, the economy will return to recession.
Official data—to be treated with some scepticism—suggest that consumerprices fell by some 2% in 2000, held down by weak domestic demand and thestrength of the Lebanese pound against the euro. A return to growth willgenerate some inflationary pressures over the forecast period, but with only aslow recovery anticipated, and the economy operating well within capacity,demand-driven inflation will be modest. There will be more significantexternal pressures, with the euro strengthening against the US dollar and, byextension, against the Lebanese pound, and with average international pricesfor a range of goods forecast to rise. However, the impact on consumer prices
will be offset by cuts in customs duties, and overall we expect average inflationto remain low, at some 0.5% in 2001 and 1.5% in 2002.
We expect the Lebanese pound to stay within its trading range ofL£1,501-1,514:US$1 over the short term. Defence of this peg is the focus ofmonetary policy, and the Banque du Liban has sufficient authority overinterest rates and access to sufficient reserves to mount a strong defence.However, beyond a six-month horizon the outlook is far less certain.Confidence in the pound remains weak, and if the prime minister’s reformprogramme falters, or the fiscal deficit accelerates faster than we expect,pressure on the currency will mount sharply. In such circumstances interestrate increases would have little credibility, given the pressure that servicingcosts already place on the budget, and the 25% fall in gross reserves (excludinggold) is a reminder that even reserves as large as Lebanon’s cannot sustain acurrency indefinitely. The liquidity of the local banks provides support for thecurrency, while Mr Hariri’s allies in the Gulf may offer additional backing. This,however, cannot maintain the peg indefinitely, and a steep devaluationremains likely if the prime minister’s reform programme fails to deliver results.
Lebanon’s overwhelming dependence on imported goods will ensure that thetrade and current-account deficits remain high over the forecast period. Weexpect import spending to rise from US$6.2bn in 2000 to US$6.6bn in 2001, aslocal demand strengthens and recent tariff cuts take effect. Spending willincrease to US$6.8bn in 2002, as growth picks up and average prices continueto rise. The growth in import spending will be partly offset by expandingexport earnings, but the trade deficit will still rise steadily, from some US$5.5bnin 2000 to US$6.1bn in 2002. The complete absence of data on non-goodstransactions makes estimates of the current account highly unreliable.However, an increase in tourism-related invisible earnings should offset higherincome payments on the state’s growing external debt, and this, alongsidestronger services charges, will leave a current-account deficit of some US$2.4bnin 2001, increasing to US$2.6bn in 2002 (the equivalent of some 14.7% and15.3% of projected GDP, respectively, compared with a deficit of an estimated13.1% of GDP in 2000).
In mid-June, 25 years after first establishing their “temporary” presence inLebanon, Syria withdrew several thousand troops from positions in and aroundBeirut. Accompanied by press and television cameras, the unusually high-profile move took local and foreign observers by surprise. Even Lebanesegovernment officials were apparently unaware that it was imminent, tellingjournalists days before that the “time was not right” for Syrian troops to leave.In large part the decision to withdraw from the capital appears to be inresponse to the increasingly vociferous campaign led by the mainly Christianopposition movement demanding an end to Syrian domination of Lebaneseaffairs. Syrian support was responsible for the defeat of Christian forces in the1975-90 civil war, costing the Maronite community much of its formerpolitical power, and Christians have long resented Syria’s continuing role inLebanon. They have become more vocal in their calls for Syrian withdrawalsince the end of Israel’s occupation of southern Lebanon in May 2000—adevelopment which removed the main pretext for the continued presence ofSyrian military forces in Lebanon and opened the way for calls for all foreignforces to leave the state. The death shortly afterwards of the widely fearedSyrian leader, Hafez al-Assad, also provided a juncture for Lebanese to call forbilateral ties to be reassessed.
The Christians have begun to organise their opposition, with dozens of seniorfigures from across the community signing their support to a declarationdrawn up at the town of Qornet Shehwan in May calling for a Syrianwithdrawal. Opposition has also spread to other confessional groups, withseveral hundred political figures from across Lebanon’s sectarian divide joiningthe newly formed Democratic Forum in its calls for ties with Syria to be“normalised”. The June withdrawal was designed to prevent the campaignfrom gaining further momentum, with Damascus calculating that the removalof Syrian troops from much of the capital would also remove the most visiblesign of its continued influence over Lebanon. The withdrawal also offers aboost for the Lebanese government, particularly the Syrian-appointedChristian president, Emile Lahoud, whose reliance on Damascus has beenpainfully apparent in his rejection of populist calls for the “restoration ofLebanese sovereignty and dignity”. The pull-out has allowed the president toargue that the Lebanese state is working behind the scenes to normaliserelations with Syria. Mr Lahoud’s credibility is so badly damaged, however, thathis domestic position is unlikely to strengthen substantially. The withdrawalmay also have been timed to coincide with the visit of the Syrian president,Bashar al-Assad, to Paris in late June. France has close links to Lebanon and issensitive to—if not openly supportive of—calls for Syrian withdrawal. It alsofollowed a lull in anti-Syrian campaigning, offering Damascus some scope toclaim that it was not forced to pull out but was acting of its own volition.
As the first evidence that Syria is responding to Lebanese pressure for areassessment of relations, the redeployment is significant, and appears to marka change of style under the new Syrian regime. However, the withdrawal does
not weaken Syria’s hold on Lebanon, or necessarily mark a change in thesubstance of the relationship. Even after the withdrawal, Syria still has morethan 20,000 troops stationed at strategic points in the Beqaa Valley and themountains that leave them in effective control of the country and well placedto reoccupy positions in Beirut should the need arise. A large number of Syrianmukhabarat (military intelligence) officers also continue to operate in thecapital, ensuring that Damascus remains close to events. Moreover, while thecontinued presence of troops is a reminder of Syria’s grip on Lebanon and theultimate guarantor of its influence, it is not the central means by which itexerts its influence. Rather, Syria controls affairs through the compliant Beirutelite whose members owe their positions to support from Damascus and acceptSyrian leadership on all key political and security issues.
Recognising that Syria’s control is institutional rather than military, theresponse among the opposition movement to the withdrawal has beenlukewarm. Cardinal Nasrallah Sfeir, the spiritual head of the Maronitecommunity, and figurehead of the mainstream anti-Syrian movement,welcomed the redeployment as a first sign of change but called for other stepsto follow soon to allow Lebanon to reclaim control of its own affairs. As well asfurther troop withdrawals and an end to interference in domestic politicalappointments, Christian groups are seeking concrete measures, including theintroduction of controls on the currently unregulated flow of goods and labourfrom Syria to Lebanon, and the deployment of Lebanese troops on the borderwith Israel. This appears highly unlikely in the near term, with Syriadetermined to protect its political and strategic position in Lebanon, andmaintain commercial advantages that accrue to the Syrian economy as awhole, as well as to members of Mr Assad’s elite. As a result, the withdrawal islikely to buy Syria and the Syrian-backed elite in Lebanon some breathingspace, but it will not put an end to the anti-Syrian campaign. This seemsalmost certain to re-emerge with renewed energy in the near term, with theSyrian pull-out from Beirut interpreted by some as a sign of weakened resolve.
Relations with Lebanon’s other neighbour have also continued to weighheavily on the domestic political scene, with Hizbullah continuing its sporadiccampaign against Israeli forces. The Shia political movement, backed by Syriaand Iran, led the guerrilla war that forced Israel to end its 22-year occupation ofsouthern Lebanon in mid-2000. However, Hizbullah has since persisted withoperations, targeting Israeli forces in the Shebaa Farms region—a sliver of landat the eastern end of the southern border which Israel, backed by the UN,claims was formerly Syrian, not Lebanese, territory. Lebanon, Syria, andHizbullah, however, claim that the land is Lebanese, and the guerrilla group’songoing campaign in the area reflects a genuine belief that Shebaa is occupiedLebanese territory that must be liberated. However, the Shebaa dispute alsooffers Hizbullah a means by which it can maintain its military role, and add totheir regional reputation as the Arab world’s most successful armed force. Syria,which sets the strategic framework within which Hizbullah operates, has alsoencouraged the continuation of the campaign, seeking to use low-levelviolence in Shebaa as a means to remind Israel that it cannot be assured of
peace on its border until it makes peace with Syria and returns the occupiedGolan Heights to Syrian control.
In the first months after the Israeli withdrawal, the periodic Hizbullah raidsprompted only modest Israeli retaliation, but since the veteran hardliner ArielSharon was elected prime minister in February, Israel has adopted a moreaggressive stance. In April a Hizbullah attack that killed an Israeli solider inShebaa prompted an Israeli air raid against a Syrian radar station in centralLebanon, killing four Syrian soldiers. After a two-month lull, Hizbullahattacked Israeli positions in Shebaa again, prompting an Israeli air strike againstanother Syrian post, with Israel warning Damascus that further attacks wouldfollow if Hizbullah was not brought under control. The Israeli air strikes werethe first direct clashes between the two states in almost two decades and marka fundamental shift in strategy as Israel seeks to hold Syria—rather than itsproxies—directly responsible for its policy in the region. Mr Sharon’scalculation is that Syria’s fear of being drawn into a conflict with Israel will leadDamascus to rein in Hizbullah. However, the approach is high risk and far frombeing guaranteed success. Syria’s relationship with Hizbullah is more complexthan the Israeli leadership recognises, and it is unclear that Damascus would beable to compel the guerrilla group to give up its campaign for the ShebaaFarms. Moreover, Mr Assad does not appear to be sufficiently secure at home tobow down to Israeli pressure, which would damage his standing in the eyes ofthe military old guard whose support he needs to maintain. Furthermore, bybringing peace to the border, Syria would lose a valuable bargaining counter inits unsuccessful peace talks with Israel.
So far, Syria has threatened to retaliate against Israel for the strikes against itsbases in Lebanon, but has yet to act, recognising that to do so directly wouldlead to a rapid escalation of the conflict. However, if the next Israeli air raid inresponse to a Hizbullah raid were to be more substantial—killing a largenumber of Syrian soldiers, for example, or destroying key assets—pressurewould grow for a military response. This could be delivered directly orindirectly through Hizbullah, which has an arsenal capable of reaching muchof northern Israel. Such attacks would spark massive retaliatory Israeli strikesacross Lebanon, destabilising the domestic and regional political environ-ments, and damaging hopes for economic recovery. At present, such anescalation appears unlikely, especially with Israel absorbed by the ongoingPalestinian intifada (uprising) in the West Bank and Gaza. However, there arefears among local analysts that once that conflict begins to ease, the hawkishMr Sharon will turn his full attention to the situation in Lebanon, seeking toput a “final end” to threat on the border through the use of force, much as hefirst attempted when he led the Israeli invasion of 1982. Some even suggestthat Mr Sharon will deliberately generate a crisis in the area that would offer apretext for Israel to attack, seeking to defeat the only Arab force that has beatenit on the battlefield, and restore the prestige the army lost when it withdrewfrom Lebanon last year.
Unease at the escalation of violence that Hizbullah raids could trigger has alsowidened divides within the Lebanese elite, most notably between the guerrillagroup and its supporters on the one hand, and the prime minister, Rafiq Hariri,
on the other. In February divisions over the Shebaa Farm campaign becamepublic when the prime minister allowed his Al-Mustaqbal newspaper to criticisea Hizbullah raid, claiming that it threatened Lebanon’s economic revival (April2001, page 15). Although the criticism was restricted to comments on the“timing” of the raid, his opposition to the continuing of hostilities ostensiblyto regain control of such a small piece of territory is clear. His comments onthe group’s activities also break the reported conditions under which he wasallowed to return to office in October 2000, which required him to focus oneconomic policy, and not engage in issues of foreign policy or defence.However, with Lebanon’s ability to attract international investment and, moredirectly, foreign aid being closely linked to security on the border, the divisionbetween economic and foreign policy affairs is slender.
Disagreements between Mr Hariri and Hizbullah are only likely to increase incoming months, polarising the political elite. As an example of its effect on thefunctioning of the government, the pro-Syrian labour minister, Ali Kanso,provoked reformers to walk out of a recent cabinet meeting when he statedthat if he had to choose between liberating occupied land, and a loaf of bread,he would always opt for the land. Mr Hariri travelled to Teheran to hold talkswith the reformist president, Mohammed Khatami, in June on Hizbullah, andheld frequent meetings with Mr Assad, quietly urging that economicdevelopment be given priority. Yet Hizbullah has maintained its politicalautonomy, and a showdown with the organisation appears to be drawingcloser. In recent skirmishes, Hizbullah has opposed lay-offs at the nationalairline, while pro-Hariri MPs have indirectly claimed Hizbullah members aredefrauding the state of up to US$300m a year by operating illegal switchboardsoffering cheap international calls. Mr Hariri, a seasoned political operator, willseek to ensure any direct confrontation with Hizbullah takes place over anissue of his choosing, with the economic debate over privatisation the mostlikely occasion. This would theoretically assure him of backing from Damascus,but if that support were not forthcoming, the prime minister could be forced toconsider resignation.
The splits within the ruling troika (Mr Lahoud, Mr Hariri and theparliamentary speaker, Nabih Birri) have also been exacerbated by debate overthe power of the security services. Since Lebanon fell under Syrian control, thepower of the security services has grown to the point where Jamil Said, thehead of Sûreté Générale (one of the internal security services), is answerableonly to Damascus, and stands well beyond the control of the political elite. Theappointment as president in 1998 of Mr Lahoud—a military figure who rose toprominence as head of the Lebanese Armed Forces—saw this trend accelerate,and senior politicians including Mr Hariri and Mr Birri have now alleged thattheir telephone conversations are being monitored by the security forces. Theissue of telephone bugging has become symbolic of the role of the securityservices within the political system, and came to a head in June during theparliamentary budget debate when the president faced bitter attacks from pro-Hariri MPs for failing to curb the problem. One MP suggested Mr Hariri had solittle power that he appeared to be simply “another pole of the opposition”.Supporters of Mr Birri, meanwhile, say he is also troubled by the strong
Prime minister wins Syriansupport over budget debate
backing offered by the security services to Hizbullah, which rivals his own Shiamovement, Amal.
As the dispute escalated, Mr Lahoud responded by seeking to block the debateon the 2001 budget—a remarkable decision given the severity of the fiscalproblems Lebanon faces and the fact that Lebanon has spent the first half ofthe year without an approved budget. The situation was resolved only with thedirect personal involvement of the Syrian vice-president, Abdel-HalimKhaddam, and Syria’s intelligence chief in Lebanon, Ghazi Kenaan, whopersuaded all parties to put the issue aside for the moment. The speedyresolution of this dispute can also be seen as offering some comfort toreformers, underlining that Syria not only seeks to settle political rows quickly,but also on occasions in Mr Hariri’s favour.
Battles between the president and the other two members of the troika have atleast had the advantage of improving ties between Mr Hariri and Mr Birri. Thisrelationship is central to the government’s efforts to implement its radicaleconomic reform agenda, which has already begun to generate substantialopposition in parliament and outside. Over recent months Mr Birri has seemedready to support the economic initiatives, although as pressure has mountedhis backing has appeared to waver. In late May for example, Mr Birri accusedthe state of failing to live up to its part of the Faqra Accord—an agreementreached between the two men in February which set out the terms of theeconomic reform programme. As opposition grows to the reform programme—and in particular to the large-scale job cuts that are associated with it—thealliance will be tested more severely still.
While Mr Hariri can afford to lose popularity because of his broadconstituency, Mr Birri needs to maintain his support among Lebanon’s ShiaMuslim community to retain his influence. However, his position among theShia has been eroded by Hizbullah, whose military prowess, coupled with therange of social services they provide, has drawn in support. Hizbullah has nowdirectly begun to threaten Mr Birri by supporting the Shia Muslim workers inMiddle East Airlines who are being made redundant (see Economic policy).These workers—and many others like them—have supported Mr Birri becausethey received their posts as a result of pressure from the speaker. However, hisdecision to accept their dismissal has provided Hizbullah with the opportunityto establish itself as the most effective protector of their interests. If he is not tofind himself marginalised, Mr Birri must find another means of deliveringeconomic prosperity to his own community and channelling patronage to hissupporters. Mr Hariri has provided guarantees of increased spending inMr Birri’s heartland in return for the speaker’s support for reform, but unless itmaterialises soon, Mr Birri will be forced to choose between continuing to backrestructuring or losing still more support to the rival Shia group.
Despite the distractions of local and regional political developments, economicpolicy has remained at the top of the government’s agenda, emergingincreasingly as the key preoccupation of the political elite and the widerpopulation. Since returning to office in late 2000, the prime minister, RafiqHariri, has begun to implement a wide-ranging economic reform programmedesigned both to restore growth within the moribund Lebanese economy andarrest the rapid deterioration of public finances. Mr Hariri has argued that thetwo elements of the programme must be pursued simultaneously, claimingthat Lebanon can only restore fiscal balance in the long term by increasing thesize of the economy and the value of revenues the government accrues as aresult. However, to enjoy the long-term benefits of a return to growth, thegovernment has also recognised that it must implement radical short-termmeasures to cut costs and boost the tax yield if the catastrophic effects of acollapse in public finances are to be avoided. The government also recognisesthat unless it is seen to be implementing painful economic reforms, it has nohope of receiving the financial support from the international community iturgently requires.
Fiscal performance chart(L£ bn unless otherwise indicated; % change year on year in brackets)
Note: Figures may not add up exactly due to rounding up. a Includes Treasury spending and revenue.Sources: Ministry of Finance; EIU.
The scale of the problems in public finances is apparent in the most recentfiscal performance reports issued by the Ministry of Finance. Over the first fivemonths of the year, the deficit stood at L£1.41trn (US$932m), the equivalent of43% of expenditure. Payment on public debt dominates the fiscal profile,accounting for more than half of all spending over the first part of the year.Debt-servicing costs also accounted for 98% of all fiscal revenue generated bythe government over the period—a proportional relationship not approached
by any other country covered by the EIU, and one which ensures that thegovernment will generate large deficits once payments on salaries, services andother public goods are made.
Excluding debt payments, the budget actually generated a primary surplus, andperformance for the first five months of the year is stronger than that over thesame period last year, when the deficit had reached L£1.95trn, the equivalentof almost 52% of expenditure. However, the improvement is misleading, andwe continue to expect the budget target to be exceeded. Much of the gain overthe first part of the year, for example, is a product of a sharp fall in non-debtspending, which fell by 17% on its 2000 levels. However, this is in large part aresult of the six-month delay in approving the budget for fiscal 2001, whichrestricted new disbursements. Now that the budget has been passed, non-debtspending is likely to rise quickly given the government’s commitment tohigher development and infrastructure expenditure, as well as its spendingobligations to political allies (see The political scene).
The improved spending figures also reflect what appears to have been adeliberate effort at the end of 2000 to cram disbursements into that fiscal yearrather than the 2001 accounting period. This led to a 70% increase indisbursements in December 2000 compared with December 1999, distortingperformance figures for the current fiscal year. Some spending items have alsobeen moved permanently off-budget by allowing state companies such asElectricité du Liban to issue their own debt for advance purchases of fuel oil.Reconstruction projects carried out by the Council for Development andReconstruction are also financed in part by loans from foreign governmentsand organisations, which have remained largely outside official figures fornational debt. Similar loans will also be used to finance end-of-service packagesfor civil servants and employees of state-owned companies and will not appearin the headline deficit figures.
Revenue flows also appear to have been distorted, falling by 45% over the lasttwo months of 2000, before increasing sharply in the first two months of 2001as non-tax revenue (mostly receipts from the telecommunications companies)were brought on to the books. If these extraordinary figures are removed, thenthe trend for the first part of the year shows a 1% deterioration, rather than the4.5% gain currently being recorded. The downturn, which will become moreapparent as the year progresses, reflects the weakening of customs revenuefollowing the government’s decision in late 2000 to reduce tariffs in order toboost trade. Customs revenue for the first five months fell by 15%, accountingfor 32% of total earnings, compared with almost 40% at the same time lastyear. Total tax revenue also saw a modest fall to L£1.2trn, down by 1.2% overthe same period.
The 2001 budget, which finally gained parliamentary approval in late June,targets a year-end deficit of 50.9% of expenditure. Its projections differ littlefrom those submitted in the draft at the start of the year, and appear overlyoptimistic. Revenue is targeted to rise by 7.6% on last year’s outturn, whilespending is expected to fall by more than 4% to less than L£10trn. Evenassuming that the delay in passing the budget keeps non-debt spending low
over the remainder of the year, and taking into account the manner in whichthe year-end accounts were manipulated, a deficit of some 56% appears a morelikely outturn (April 2001, page 19).
Government budget, 2001(L£ bn unless otherwise indicated)
% of % change % change onBudget total on 2000 2000 outturn
Balance –5,075 – 35.88 –13.56 % of GDP –20.3 – – – % of expenditure –50.9% – – –
Sources: Ministry of Finance; press reports.
The budget is also of less significance to the prospects for government financesthan the reform programme Mr Hariri is seeking to establish alongside it (seebox). In recent months, the government has begun to implement its agenda,fighting political battles to press forward with privatisation, cost-cutting andrevenue-generation policies that previous administrations have lacked theenergy to address. In June, for example, Mr Hariri finally gained cabinetapproval for the introduction of a value-added tax (VAT). The measure was firstproposed in 1997 to generate revenue and offset the fiscal impact of cuts tocustoms duties demanded by the EU as a condition for Lebanon’s entry into afree-trade agreement (see Foreign trade and payments). Each finance ministersince 1997 has made a commitment to bringing the tax into effect, but hasfailed to do so, largely because of widespread opposition to the additional coststhe tax will impose and fears that the deficient tax-collection system would beunable to cope with the new burden.
Under the draft law, VAT will be collected at a rate of 10% from companieswith an annual gross turnover of more than L£500m (US$333,000). This isestimated to include some 7,000 establishments, 92% of which are believed tobe in Beirut. The lowered threshold represents a victory for the Ministry ofFinance as opponents of the tax had sought a minimum turnover level ofL£1bn. Estimates of the additional revenue the tax will yield vary, withconsensus projections pointing to a figure equivalent to some 3% of GDP(US$500m), although others suggest the total could be as high as 5%.
To escape the debt trap Lebanon has entered, within which high debt-service costsgenerate large deficits, requiring higher borrowing and still higher servicing costs, thegovernment has identified several key policies.
Cutting expenditure: Spending is dominated by recurrent expenditure on salaries anddebt. To reduce it, the government has committed itself to the following.
• Reducing the size of the public sector by rationalising employee numbers in the mainministries and state owned companies, and contracting service provision to the privatesector where possible.
• Reducing debt-servicing costs by increasing the proportion of the debt stock held inforeign-currency Eurobonds. These bonds carried interest rates some 200-400 basis pointsbelow local-currency debt, pushing down servicing costs. The government is also seekingto swap existing short-term debt for long-term instruments, reducing the frequency withwhich it has to return to the market to roll over maturing debt.
• Strengthening the credit rating for Lebanese debt by persuading other countries orinternational organisations to guarantee it. An improved rating will allow the governmentto borrow at lower cost and ease its servicing costs.
Raising revenue: Successive governments in the past five years have sought to increasetax rates and introduce more forms of taxation, as well as improve collection. The currentadministration continues to pursue this policy, but has placed a greater emphasis onmarket-oriented measures.
• Boosting growth to drive up long-term tax yields. Mr Hariri has unveiled a raft ofliberalising policy initiatives designed to drive up domestic and foreign investment, boosttrade and support additional consumption.
• Lowering tax rates to allow the private sector to prosper and encourage greater taxmorality. Cuts to customs duties and the national insurance rate have already beenintroduced, and are to be supported by improved tax-collection mechanisms.
• Introducing new taxes, beginning with VAT at the start of fiscal 2002. At a rate of10%, the government estimates the tax could boost revenue by as much as 4% of GDP. Aflat-rate “professional tax” is also planned.
• Privatisation of state assets to end the drain on the public purse of loss-makingcompanies and generate substantial capital to pay down the public debt stock. Candidatesfor privatisation include Middle East Airlines, Intra Investment and the public utilitycompanies. Mobile phone licences will also be sold.
• Drawing in direct international aid to help fund the budget deficit, financereconstruction work and cover costs associated with the restructuring of the public sector,including redundancy costs. The government is also seeking to persuade multilateralagencies that have already set aside funds for Lebanon but have yet to release them (largelybecause Lebanon has yet to meet the conditions associated with the support) to do so.
Questions also surround the government’s ability to bring the bill into effect atthe start of 2002 as it currently plans. The legislation will not be submitted toparliament until September, where it is likely to become caught up in thebroader controversy surrounding the government’s reform plans and couldface delays. Differing accounts have also been offered of the readiness of taxofficials to administer the VAT system, although the EU has been sponsoring along-term training programme for tax officials. In late June the Ministry ofFinance insisted preparations were well advanced and, given the importanceMr Hariri has attached to the reforms, there is optimism in Beirut that the lawwill be implemented on time.
As well as seeking to introduce controversial tax reforms, the government hasalso begun to move forward with even more contentious proposals to cutemployee numbers within the public sector, and prepare state companies forprivatisation. Like VAT, previous administrations have committed themselvesto introducing similar measures, but have backed away or found their pathblocked when political opposition rose. Mr Hariri gave a first indication that hewas more committed, however, when he oversaw the dismissal of employeesfrom the Ministry of Information and in February ordered the dismissal of 500workers from the loss-making state television company, Télé-Liban (April 2001page 22). After remaining closed for several months, the company reopened inJune with a much-reduced staff and an undertaking to operate on a morecommercial basis.
The first test case for the public-sector restructuring programme, however, hasbecome the reform of the national airline, Middle East Airways (MEA). Thecompany, in which Banque du Liban (the central bank) took a 99% stake in1996, is notoriously overstaffed, employing 4,500 workers, including 160pilots, despite operating only nine aircraft. MEA runs at an annual loss of someUS$40m a year, and has been identified as a lead candidate for privatisation. Toprepare for this, and to cut the recurrent draw on the public purse, thegovernment has pledged to cut the workforce substantially. The issue ispolitically contentious as many of the surplus employees are politicalappointees, largely from the Shia community, who were given their postsduring the civil war as rewards for their loyalty to confessional leaders, and toensure a sectarian balance among the workforce.
Because the issue is so politicised, other administrations have backed awayfrom seeking to reform the airline. However, Mr Hariri has moved furtherforward, issuing redundancy notices to 1,200 airline employees in early June.Half of the workers identified for redundancy are close to retirement age, andmany travelled to work only to collect a pay cheque. The World Bank-supported redundancy package offered to the dismissed workers is alsoextremely generous, with each employee receiving an average of US$37,000,plus six months’ salary. Yet despite the scale of the rewards being offered, andthe overwhelming argument in favour of reform, the redundancies have beenrejected by the labour unions and, in its role as a representative of the Shiacommunity, Hizbullah. Opposing the redundancy, the unions—backed byHizbullah—led protestors into several days of civil unrest and strikes, whichgrounded MEA flights and forced management to retreat to barbed wire-
protected offices and seek police escorts for their security. As this report went toprint, the bitter dispute was continuing, with both the government and theopponents of economic reform ready to make the lay-offs a test of strength,setting the tone for debate on the entire reform agenda. Given that the issuefalls squarely within Mr Hariri’s economic portfolio, the prime minister shouldemerge victorious from the tussle, although Syrian intervention may berequired (see The political scene).
While the restructuring of MEA ahead of a planned privatisation has becomesymbolic of the reform programme, its effect on government finances will belimited. The recurrent losses are relatively small and off-budget and revenuesfrom privatisation—should a buyer ever be found—is unlikely to be substantialgiven MEA’s poor asset base and ongoing commercial problems. The state’stelecoms assets, however, are expected to generate substantial revenue throughthe auctioning of two long-term mobile phone-operating licences and the saleof the government-owned fixed-line network (packaged with a third mobilephone licence). The mobile phone system was established in 1994 under a ten-year build-operate-transfer (BOT) contract by two private-sector companies,Cellis and LibanCell, both of which include substantial foreign holdings. Thesystem has proved to be far more successful than the government or thecompanies imagined when it began in 1994, with each user making an averageof 700 minutes of calls a month—one of the highest averages in the world.
Given the pressure on government finances, and the substantial sums Cellisand LibanCell have proved able to generate, successive governments havesought to increase the state’s share of the companies’ income. In 2000, forexample, Salim al-Hoss’s government claimed that the companies hadbreached their original contracts by operating too many lines, and demandedmore than US$600m in “fines”. Amid deteriorating relations between thecompanies and the government, and with their BOT due to expire in 2004,Cellis and LibanCell attempted to firm up their position within the state, eachoffering to pay US$1.35bn for 20-year operating licences. The offer wasrejected, and the dispute continued until the new government was appointed.
As Mr Hariri was the man who selected Cellis and LibanCell, there had beenwidespread speculation that a deal would be reached quickly. Instead, after sixmonths of talks, negotiations broke down, and in early June the governmentannounced that it had cancelled the original BOT contracts and would beputting the new licences out to international tender. The announcementprovoked anger at Cellis, which accused the government of reneging on anagreement in 1997 to scrap the six-month cancellation clause in the originalBOT contract in return for an increased share of company revenue. Thegovernment said that it had taken the decision to cancel the contract andmove straight to an auction for operating licences to encourage competitionamong international bidders and thus ensure that it received the maximumpossible value for the licences. There may be some truth to this argument, withCellis and LibanCell possibly refusing to offer a full market price for thelicences, recognising that the government cannot afford to wait until 2004 torealise funds from the sale. An alternative explanation, however, is that thegovernment has overvalued the licences, not recognising that downward
trends in the international telecoms market make it unlikely that any companywill be willing—or even able—to match the US$2.7bn that was offered in early2000. The slump in the telecoms sector, coupled with the manner in which thecurrent operators have been treated, also makes it unclear how many foreignfirms will even look to participate in the tender.
Instead Cellis and LibanCell remain the most likely bidders for the licences,despite their strong criticism of the cancellation of the BOT. Not only have thecompanies invested heavily in Lebanon, but they are also politically wellconnected. Cellis, for example, is one-third owned by a company belonging tothe transport minister, Najib Miqati, with the remainder held by the influentialFrance Télécom, while LibanCell is largely owned by associates of the primeminister and Gulf Investors, with 11% held by Finland’s Sonera. Thecompanies’ close connections to the elite make it even more difficult todetermine why negotiations failed, although some local analysts havesuggested that a deal has already been reached with the two companies, with around of international tendering being used as a means to create an appear-ance of competition and justify the low price that will finally be generated.This appears to be an unnecessarily elaborate and expensive process, however,given the damage the fracas has inflicted on Lebanon’s reputation as adestination for foreign investment, and the scale of the compensation thegovernment will have to pay to the companies once an international arbitratorhas determined the value of the years of the BOT that have been cancelled. Thegovernment can only hope that the political risks brought out by the disputeand the delays that will now occur until a deal is struck do not result in thelicence sale returns falling further.
As well as seeking to raise new funds from the existing Global System forMobile Communications (GSM) networks, the administration is also midwaythrough restructuring the state landline provider, which is to be packaged witha third GSM licence and offered to private investors. Government officials nowsay that a strategic international investor will be sought before year-end for theresultant state telecoms company—LibanTelecom—leading to immediaterevenue flows for the Ministry of Finance later in the year.
The vigour with which the government has approached policymaking in itsfirst months in office is impressive, and had the new administration inheritedeconomic circumstances less dire than those they currently face, the reformprogramme would have every prospect of success. In the current environment,however, even if the government is successful in implementing its full packageof proposed reforms as quickly and effectively as it hopes, it is difficult to seehow they can be sufficient to do more than slow the pace at which publicfinances are heading toward crisis.
In the most optimistic scenario, the introduction of VAT at the start of 2002,coupled with stronger growth is unlikely to push year-end revenue aboveL£5.5trn (21% of GDP). If the government managed to resist all demands foran increase in non-debt spending, and was able to hold its borrowing costs to aminimum through the sale of additional Eurobonds (and assuming that therewas no increase in the premium—itself an unlikely development given
Reforms are insufficient toend public finance crisis
Lebanon’s mounting risk premium and the widely anticipated increase in USrates next year), there would still appear to be little prospect of moving totalgovernment expenditure below L£10trn (39% of GDP). The resulting deficit ofL£4.5trn would stand 23% below that projected for the current fiscal year, butwould still amount to more than 17% of GDP. Financed through the sale ofadditional debt, servicing costs would begin to rise once again the followingyear at a pace that would almost certainly exceed growth in revenue, drivingthe deficit steadily higher.
The government has pledged to use its privatisation revenue to slow thegrowth of the debt stock, although it has yet to set a target for the total valueof the sales. However, if the divestments exceeded most local analysts’expectations and generated as much as US$4.5bn over 2002, the resultingfunds would have a limited impact on a debt stock which is expected to reachat least US$26bn by the end of 2001. There are a number of ways in which thegovernment could use the revenue, but if it were to use it directly to retireexisting debt, the 22% fall in debt spending that could be expected to accruewould still leave a deficit of close to L£4trn, the equivalent of 15% of GDP. Theadditional borrowing required to fund this shortfall would begin the upwardcycle in the debt stock and servicing costs once again, returning Lebanon to itscurrent position within two years, as revenue growth proved unable to keeppace with mounting expenditure. Alternatively, the government could use therevenue to finance a debt payment holiday with the sale of the governmentassets funding the deficit for as much as 18 months. Once the revenue isexhausted, however, the deficit would resume its rapid upward path.
Although the government continues to talk up the prospects for its reformpackage, in private most officials concede that, in itself, it can only delay theinevitable and buy the government time before its finances reach breakingpoint. To fundamentally change the dynamics of the fiscal account, thegovernment is instead relying on winning substantial financing support fromabroad. Having returned from Paris earlier in the year with a pledge of €500m(US$443m) in aid (April 2001, page 31) Mr Hariri has since made high-profiletrips to Washington and Paris, holding meetings with representatives ofgovernments and international organisations including the World Bank. Adonor meeting—dubbed “Paris II”—is now planned later in the year, withFrance, Canada and the World Bank already committed to attending.
The government will go to the meeting seeking support on a number of fronts.In addition to further commitments of financial support for public-sectorrestructuring, the government is hoping to secure an agreement that will leadto international guarantees on its foreign-currency debt. If successful, the dealwould lead to an improvement in the credit rating for Lebanese sovereign debt,lowering service charges. An underwriting agreement would also give Lebanonaccess to foreign investors who have so far judged the sovereign debt to be toorisky. To make a significant difference, however, the support package wouldhave to be substantial. According to our calculations, even with full VATrevenue and the utilisation of privatisation revenue to retire domestic debt,even a 25% reduction in projected foreign-debt payments would still leaveLebanon with a deficit of close to 14% of GDP in 2002—a figure which would
steadily climb in subsequent years as debt-stock (and debt-servicing) growthoutstripped revenue growth. One option which has been discussed in localcircles is the sale of zero-coupon bonds—bonds sold at a heavy discount totheir face value and offering no coupon, only profit from the gradual increasein price as the bond moves closer to its face value on maturity—which wouldease servicing costs. If they were to have a significant impact on the fiscalposition, however, they would have to be sold in large quantity, have a longmaturity and receive explicit international guarantees.
At this stage it is impossible to judge how likely aid is to be forthcoming, andwhat scale it might reach. The efforts the government has made to kick-startthe reform programme have gained it plaudits abroad and could open the wayfor international support, especially as there are those in the West who fearthat a breakdown in government finances could trigger instability that wouldthreaten not just Lebanon, but the wider region. However, there are alsoconcerns that Lebanon will not be able to meet the political and economicconditions of an aid package, with some suggesting that donors would demandthe floating of the currency or (as a requirement for tacit US support) thedeployment of Lebanese troops on the border with Israel—neither of which thegovernment would be able to countenance. The government’s call for moresupport from the international community is also hindered by its failure tomeet the terms for aid pledged in the mid-1990s, which remains undisbursed.
Setting up the Paris II meeting also carries considerable risks for thegovernment, with failure to secure a substantial aid programme—or the“postponement” of the meeting if no agreement can be reached beforehand—likely to have a devastating impact on local confidence, which remains fragile.The clearest indicator of this has been the steady shift of deposits away fromthat the central bank will be unable to maintain the local currency’s US dollarpeg. The trend can be traced back to August 2000 when the depositdollarisation rate (the proportion of commercial bank deposits held in USdollars) rose above 63%. It has since continued to climb, exceeding 70% inApril, despite government hopes that the development of its reformprogramme would begin to restore faith in the local economy. The shift hasalso been apparent in monetary data which show a remarkable 20% drop invalue of money supply, M2, in the year to the end of April, while dollars nowaccount for more than 66% of M3.
Movement away from the pound has put further strain on the currency, forcingthe central bank to intervene on the market to fulfil unmet demand for dollars.The result has been a further drawdown on the central bank’s net foreign assetposition, which has fallen by US$2.4bn over the 12 months to the end of April.Gross reserves (excluding gold) stood at US$5.4bn at the end of April—theequivalent of more than nine months of import cover, which remains one ofthe highest ratios in the region. However, their value has now fallen for 15consecutive months, and stands at 25% below their April 2000 levels, withreports suggesting that reserves fell further to US$5.18bn by mid-June.
The central bank has few tools at its disposal to stem the outflow of reserves.The bank is in no position to increase interest rates to widen the premium onpound deposits, as to do so would increase the government’s own debt-servicing costs, adding to the fiscal pressures which have driven downconfidence in the pound. There are also few prospects that the central bankcould reform the exchange-rate regime by widening the trading band. Themaintenance of the current peg (currently at L£1,501-1,514:US$1) has becomesymbolic of Lebanon’s stability, and would provoke a political outcry if it wereto be abandoned. Confidence in the currency is also so fragile that the benefitsof reducing the pound’s value would soon be overcome by a further shifttoward dollar assets. Instead, the central bank has had to satisfy itself withdrawing on its reserves, while the government has sought to add to its foreignasset base by drawing in deposits from abroad, particularly the Arab Gulf states.In April, for example, Oman agreed to deposit US$50m, adding to an existingUS$200m from Kuwait and US$500m from Saudi Arabia.
A further consequence of weakening confidence in the Lebanese pound hasbeen a steady drop in demand for local-currency government debt. Thecommercial banks have long been the primary source of funding for thegovernment, increasing their holding of Treasury bills from L£8.3trn at the endof 1995 to a peak of L£20trn in June 2000. Since that point, however, the valueof their holdings has eased, falling to a low of L£17.7trn at the end of April.Despite the precariousness of public finances, the weakening of demand doesnot appear to mark a slump in the commercial banks’ confidence ingovernment debt, with the main commercial banks continuing to buy intosovereign Eurobond issues and claiming that they still wish to buy T-bills.However, the shift in their deposit base toward dollars has dried up theirLebanese pound liquidity, leaving them unable to meet government demandfor fresh funding.
As a result, the central bank has been forced to buy up T-bills that have notbeen taken up by the market, and by the end of April held some L£3trn—theequivalent of 11% of the outstanding T-bill stock. Banque du Liban remainsconfident that the bills will be reabsorbed by the market in due course(government debt build-ups at the central bank have occurred periodically in
the past) and is beginning a new swap programme to encourage demand.However, previous build-ups in 1995 and 1998 have never been as prolongedas that currently under way, nor approached the same value. Unless thegovernment’s reform programme restores confidence in the pound, the build-up will not be reversed, and the government’s ability to issue local-currencydebt will not be renewed, leaving the government with access only to theforeign-currency market.
Treasury bill demand(L£ trn unless otherwise indicated)
2000 2001May Jun Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr
Total value 25,574 27,012 26,327 26,777 26,373 26,215 26,720 26,963 27,572 27,541 27,467 27,569
Commercial banks Value 18,800 19,980 19,273 19,620 19,165 18,299 18,460 18,667 19,132 18,999 18,426 17,671 % of total 73.5 74.0 73.2 73.3 72.7 69.8 69.1 69.2 69.4 69.0 67.1 64.1
Central bank Value 304 636 644 641 656 12,94 15,98 15,98 1,610 1,624 2,107 3,028 % total 1.19 2.35 2.44 2.39 2.49 4.94 5.98 5.93 5.84 5.90 7.67 10.98
Others Value 6,470 6,396 6,410 6,516 6,552 6,622 6,662 6,698 6,830 6,918 6,934 6,870 % of total 25.3 23.7 24.3 24.3 24.8 25.3 24.9 24.8 24.8 25.1 25.2 24.9
Source: Banque du Liban.
The domestic economy
Economic trends
The absence of consolidated GDP data continues to impede efforts to offerreliable analysis of trends within the domestic economy. However, availableindicators issued since the EIU’s last report appear to confirm earlierexpectations that the economy will generate modest growth this year. GivenLebanon's small manufacturing base, and consequent heavy reliance onimports, trade flows and cargo activity offer useful indication of domesticconsumption trends. Over the first four months of the year, import spendingrose by some 16% on its 2000 levels (see Foreign trade and payments), whileimport volumes rose by more than 17%—a strong indication that theadditional demand was not a product of higher prices. Confirming this view,data also show an 11% increase in the number of vessels docking in the firstquarter, and a 14% increase in the number of containers passing through thefacility to 25,708. Freight traffic at Beirut airport, which offers an indication oftrade in perishable and high-value goods, also increased in the first quarter, upby 17.31% to 15,300 tonnes on the same period of 2000.
Lebanon’s construction sector has also shown signs that it may be moving outof recession. Figures for cement deliveries—an indicator of current activity inthe sector—rose by more than 20% over the first four months, while those for
construction permits—a useful proxy for planned activity—increased by morethan 17%. Both data sets have been volatile over the past year, and untilseveral more months of data have been issued, the appearance of an upwardtrend should be treated with caution. The totals also fall far short of thosegenerated during the boom years of the mid-1990s, with construction permitsissued for 8.24m sq metres over the first four months of 1995 compared withjust 2m sq metres this year. However, if the initial evidence is confirmed, itwould point not only to the start of a recovery in the construction sector, butalso a possible strengthening of broader domestic confidence and investmentlevels for which construction activity is often a leading indicator. The view issupported by figures from the Ministry of Industry, which reported theformation of 142 new companies over the first three months of the year, up56% on 2000, with starting capital spend of some L£24bn, up by 26.3%.
Real economic indicators, 2001
Jan Feb Mar Apr
Construction permits 427,897 439,817 393,425 769,450 % change year on year 48.4 –3.1 –39.6 74.1 % change year to date 48.4 16.9 –9.5 10.6
Cement deliveries 179,310 138,618 199,346 235,131 % change year on year 103.1 –15.1 25.0 9.4 % change year to date 103.1 26.4 25.8 20.2
Imports (tonnes) 408,515 334,553 536,697 405,203 % change year on year 20.9 –12.0 41.9 18.6 % change year to date 20.9 3.5 16.7 17.2
Airport arrival 69,864 75,789 108,294 94,765 % change year on year 3.8 36.3 9.1 13.4 % change year to date 3.8 18.5 14.3 14.0
Total value cleared cheques 2,388 1,967 2,085 1,964 % change year on year 6.4 –6.1 –5.6 0.5 % change year to date 6.4 0.4 –1.6 –1.1
Coincident indicator 205.1 187.3 211.5 n/a
Source: Banque du Liban.
New monthly figures also suggest that performance in the service sector ingeneral and the tourism industry in particular has continued to strengthen.Despite ongoing regional political uncertainty, the sector has seen a steadyrecovery in the past decade, with increasing numbers of visitors, and risingspending. In April alone, the number of arrivals at Beirut International Airportrose by 13% on its 2000 levels, pushing arrival numbers for the first fourmonths of the year to almost 350,000, an increase of 45,000 on the year-earlierperiod and 60,000 above 1999 levels. The number who described themselves as“tourists” on entry cards saw an even sharper rise, by 28% during the firstquarter of 2001. The increase will also encourage the government, which hasidentified the tourism sector as one of the core areas in which it hopes itsliberalisation programme will generate growth. In late 2000 it introduced an“open skies” policy, for example, which removed many of the additional costsand restrictions that had previously been imposed on foreign airlines to protectthe national carrier, Middle East Airlines. Provided there is no deterioration inLebanon’s security environment, the upward trend is expected to continue
over the crucial summer season (June-September) when typically more thanhalf of the whole year’s visitors arrive.
Signs of strengthening growth are also supported by the “coincident indicator”of the Banque du Liban (the central bank). The weighted index of more than adozen sectoral activity indicators reached a record high of 211.5 at the end ofthe first quarter, an increase of 12% on the previous month, and 6% year onyear. A more considered economic model operated by the well-regardedEconomic Analysis Unit at Banque Audi also points to growth, estimating thatthe economy expanded by an annualised 0.5% in the first quarter. Given thescope of the reform agenda, and the expected increase in government spendingin the remainder of the year, we continue to project full-year growth of some1% in 2001, rising to 2% in 2002.
Although the figures suggest that the economy has begun to move out ofrecession, the growth rate remains weak and falls far short of the 3-5%expansion government officials believe can be achieved this year and next.Among the range of factors holding growth in check are the uncertaintiesgenerated by domestic and regional political tensions. These continue to deterdomestic and foreign investors from committing long-term capital.
Fear of instability associated with the chronic fiscal imbalances alsoundermines confidence, while the government’s borrowing requirement notonly keeps interest rates high, but also crowd the private sector out of thecredit market. The commercial banks’ total claims on the private sectorincreased by only 3.6% in the year to the end of March, while those on thepublic sector increased by almost 5%, despite the enforced fall in Treasury-billholdings. The consolidated balance sheet of the commercial banks also showsthat the value of claims on the public sector in Lebanese pounds aloneexceeded total claims on the private sector in local and foreign currencies.When the undisclosed proportion of the banking sector’s foreign assets that areactually Lebanese Eurobonds are added to the public sector claims, thegovernment’s share of total bank credits is likely to rise to as much as 60-65%.Weak private-sector credit growth reflects other shortcomings within theeconomy, not least concerns over asset quality following two years of recession.However, it also marks the shortcomings evident within many of thecommercial banks, which became so accustomed to the guaranteed returnsoffered by the large T-bill market that they have not sought opportunities inthe private sector as actively as would otherwise have been the case.
Inflationary pressures have remained weak over the past quarter, with domesticdemand strengthening only slowly, and two years of recession leaving theeconomy operating well below capacity. The strength of the dollar-linkedLebanese pound against the euro has also helped to minimise importedinflationary pressures. According to figures collected by the Ministry ofEconomy and Trade, prices rose by 0.9% over the first four months of the year.However, there are widespread doubts about the methodology employed bythe ministry, whose figures sit uncomfortably with those produced by theprivate-sector Consultation and Research Institute which suggested prices fellby 0.2% at the end of the first quarter.
Import spending accelerated sharply over the first four months of 2001according to fresh data issued by Banque du Liban (the central bank), reachingUS$2.24bn compared with US$1.93bn in the year-earlier period. The 16.6%increase in large part reflects strengthening domestic demand (see Thedomestic economy: Economic trends) rather than price effect, with theLebanese pound remaining firm against the euro (most recorded Lebaneseimports originate within the euro zone) and oil prices down slightly from lastyear’s highs. It also, however, seems likely to reflect the impact of tariff cutsintroduced at the end of 2000, which have reduced the final cost of importedgoods, adding to demand. Exports remained stable over the period, rising byUS$12m to US$237m. The figure accounts for only slightly over 10% ofLebanon’s import spend and left an increased trade deficit of US$2bn,compared with US$1.7bn in the year-earlier period. The figure not onlyunderlines how reliant Lebanon is on non-trade flows to hold its externalaccounts in balance, but also how vulnerable Lebanon is to fluctuations in theinternational price of commodities, and changes in leading exchange rates,with total trade amounting to 45% of estimated GDP during the period.
External account trends, 2001(US$ m unless otherwise indicated)
Change in net foreign assets Central bank 28.3 84.4 –750.3 –393.0 –1,030.6 Commercial banks –52.7 183.7 652.0 244.0 1027.0
a Year on year.Source: Banque du Liban.
Although a detailed breakdown of quarterly payment flows is unavailable,overall balance-of-payment figures point to a sharp positive increase in theaggregate balance of invisible trade, transfers and capital inflows for the fourmonths of 2001. These rose by more than 26% to US$2bn over the period,compared with US$1.59bn in 2000. Strong inflows of capital—much in theform of transfers of income and profits from the country’s large diaspora—is atraditional feature of Lebanon’s balance-of-payment account, typicallyoffsetting the equally large visible trade deficit. This has remained the case thisyear, with large non-trade inflows leaving the overall balance of payments witha deficit of only US$3.6m, compared with a deficit of US$110m in the year-earlier period. Although the figures show that the concerns over the stability ofthe domestic economy have not yet prompted net capital outflows, they alsoshow the effect that weakening local confidence in the Lebanese pound has on
the Treasury. Over the first four months of the year, central bank net foreignassets fell by over US$1bn, while those of the commercial banks rose by asimilar amount.
After several years of stalled negotiations, the government is close to agreeing afree-trade deal with the EU. The agreement will offer Lebanese exporters accessto new markets, and make the country eligible for fresh EU funding. It formspart of the EU’s Euro-Mediterranean programme, launched at the BarcelonaSummit in 1995, to link 12 Mediterranean states in a free-trade area with theEU by 2010. Bilateral talks began in 1996 but have proved slow, held back inpart by Syrian opposition to Israeli involvement in the Euro-Med programme.Other obstacles have been Lebanon’s historically high trade barriers, its requestfor the EU to open up to agricultural imports, and demands for budgetaryassistance. The EU has resisted these calls, fearing that opening to Lebanon’ssmall agricultural sector would set a dangerous precedent, and insisting thatfinancial assistance must be project-based, rather than direct fiscal support. TheEU has also demanded access to Lebanon’s service sectors, and, given Lebanon’sporous border with Syria, required accurate state of origin procedures to ensureproducts exported as “Lebanese” are indeed of domestic origin.
The impasse was broken with the large tariff cuts introduced in late 2000following Rafiq al-Hariri’s return to office, and the development of his broadermarket-oriented reform programme which sits well with the free tradeagreement. The EU have also welcomed the opportunity to reach an agreementwith Lebanon and revive the flagging Euro-Med programme which has lostmuch of its energy as prospects for a regional peace have faded. After the tenthround of talks in early July, EU officials privately said they expected a deal bythe end of that month—before the EU breaks for summer recess—with asigning ceremony later in the year, although this may be optimistic. The initialagreement will cover the phasing out of tariffs on industrial products, with theservice sector to be addressed later. Because of Lebanon's dramatic tariff cuts inlate 2000, there are suggestions it will be given a long grace period beforefurther reductions are required.
At the end of May, an international credit rating agency, Standard & Poor’s,revised its outlook on Lebanon’s long-term ratings from stable to negative, andcut the long-term local currency issuer credit rating to B+ from BB-. The agencysaid that the downgrade reflected its concerns over the scale of public debt andthe deteriorating budget balance, warning that fiscal measures announced bythe government to reduce the deficit would only have limited impact in 2001.It said that the reform measures would be insufficient to halt the growth in thepublic debt, adding that Lebanon’s ratings are likely to remain underdownward pressure until there is a fiscal correction substantial enough toreverse the trend.
Despite Lebanon’s sub-investment grade credit rating, the government hasfound few difficulties selling debt on the international market. In April thegovernment sold a five-year US$1.15bn dollar-denominated Eurobond—itslargest ever single issue. Originally set at US$600m, it was raised to US$1bn,
then US$1.15bn on strong local demand and carried a coupon of 9.88%,equivalent to 536 basis points over similar US treasuries. In part the bondreplaced a maturing three-year US$500m issue which carried a cheaper 8.13%coupon, with the remaining US$650m accruing as new borrowing. Some 80%of the issue was placed locally, with investors from the Gulf and Europe takingthe remainder. Since its first foray into the Eurobond market in 1994, Lebanonhas proved capable of placing large issues at rates well below similarly ratedcountries, largely because of the captive local banking market, which has alarge dollar deposit base which it is barred from using to purchase Lebanesepound assets, making the relatively-high yielding sovereign bonds attractive.
In late April, the government issued a second bond for a further US$400m,lifting its total sales for 2001 to US$1.75bn and placing it within the top fiveemerging market Eurobond issuers worldwide. The bond was presented as amore serious test of the market confidence in Lebanon, having a 15-year tenure(Lebanon’s longest ever) and targeted at foreign investors only. The bond waslead managed by Credit Suisse First Boston, and reportedly increased from aninitial US$300m on strong demand. The issue, maturing in 2016, carried acoupon of 11.63%, equal to 640 base points over ten-year US treasuries andcompares favourably with recent launches by similarly rated countries, such asa Turkish 2010 bond with a spread of 1,040 points, and an Argentinian 2010bond with a spread of 930 points. The government portrayed the successfullaunch as a sign of confidence, and said that the bond was boughtpredominantly by North American and European investors. However, theclaim has been treated with some scepticism locally, with many suggesting thatthe purchases in the west were executed on behalf of Lebanese investors.
Further debt sales are expected over the remainder of the year, with the 2001budget allowing the government to contract up to US$2bn in fresh foreignborrowing. Reports shortly after the budget was passed suggested that theMinistry of Finance planned to issue a seven-year Eurobond of US$300m toUS$400m in the third quarter, possibly to replace elements of its local-currencydebt. The government was also said to be preparing the ground for a US$1bnzero-coupon bond, which would be sold at a large discount to the face valuerather than carrying regular coupon payments and have a long tenure.However, this landmark issue move will be dependent on obtaining suitableinternational guarantees at the Paris II donor conference expected later in theyear (see Economic policy). In the immediate future, Lebanon will not have toreturn to the market to roll over maturing bonds until June 2002, when aDM250m issue comes up for renewal, which is the single maturing paper ofthat year. This means most borrowing in the next 18 months will be freshadditions to the current debt portfolio.
