20 November 2008

Report

Editor's note: Following is a report on Lebanon's economy through the third quarter of 2008, with special emphasis on the implications of the global financial crisis, prepared by Bank Audi.

Lebanon's economic activity over the first nine months of the year was buoyant. The evolution of real sector indicators of the first three quarters clearly supports the new Banque du Liban and the International Monetary Fund (IMF) output forecasts for 2008 and that put real growth at 6 percent this year. The Lebanese economy, which is emerging from a relatively depressed status over the past three years, is at its best performance since 2004, supported by the relative improvement in political and security conditions in the aftermath of the Doha agreement.

Indeed, all real sector indicators were on the rise over the nine-month period, although at varying paces and magnitudes. Among these we mention the increase in the number of tourists by 28.3 percent driven by a very favorable summer season, the growth in construction permits by 30.6 percent triggered by an improving investment environment, the rise in the value of cleared checks by 43.3 percent as a mirror image of aggregate domestic spending, the growth in exports by 30.6 percent pointing to a strong regional demand on Lebanese goods and the increase in imports by 39.3 percent as a result of a pent-up consumption and investment demand at large.

Likewise, the quantity theory of money confirms the strong economic recovery year-to-date. Over the first nine months of 2008, the annual average growth in money supply by 19.9 percent in conjunction with the growth of the velocity of money of 27.6 percent outpaced the rise in inflation which reported an annual average of 11.5 percent, leaving a strong output growth. It is worth mentioning that this year's inflation rate, which was triggered by external rather than domestic factors, is at its highest level for the past decade and a half. Although inflation is expected to be subdued over the remaining quarter of this year as a result of falling oil and commodity prices internationally, it is expected to close the year at a double-digit figure for the year as a whole.

Monetary conditions were quite favorable over the first nine months of the year. The Central Bank of LebanonCentral Bank of Lebanon managed to raise its foreign currency reserves to a new record high by September-end. The latter reached $15.3 billion, growing by nearly $5.5 billion year-to-date. Such a considerable and unprecedented growth was driven by the massive intervention on the foreign exchange market acquiring large foreign currency amounts in a market where the Lebanese Pound (LP) was strongly demanded. Such a large level of reserves covers close to 70 percent of the Lebanese Pound Money Supply, a figure that exceeds 100 percent when including gold reserves, and that highlights the immunity of the local currency within the context of a pegged exchange rate system.

With respect to the public sector, the year-to-date performance suggests a deterioration in the public finance deficit, mainly triggered by a large fuel import bill at the level of the Electricite du LibanElectricite du Liban. Public finance expenditures grew by 14.5 percent over the first nine months of this year, outpaced by the growth in public revenues of 16.0 percent as a result of improving economic conditions, yet leading to a net growth in Lebanon's public finance deficit by 10.9 percent over the period. When excluding debt servicing, the primary balance reported a surplus of LP897 billion in the first nine months of 2008, compared to LP865 billion in the similar period of 2007, an increase of 3.7 percent. In parallel, public debt grew by 8 percent over the period to $45.7 billion, the equivalent of 168 percent of Lebanon's GDP.

In parallel, the Lebanese banking sector is witnessing one of its best years ever. Consolidated deposits grew by $7.8 billion year-to date, 57 percent above the growth reported in the first nine months of last year and 2 times more than the average growth of the similar period in the past five years. Such a growth, realized within the context of significant currency conversions towards the Lebanese Pound, was coupled with a drop in deposit dollarization from 77.3 percent at end-December 2007 to 72.0 percent at end-September 2008, its lowest level since the beginning of 2005. This year also reported a significant growth in banks' lending portfolios, with aggregate lending growing by 21.4 percent year-to-date triggered by both domestic lending to an improving local economy and regional lending to Lebanese corporate with regional operations within the context of a regional boom that was prevailing over that period.

As to capital markets performance, equities and bonds performed well on the overall over the nine-month period prior to the outburst of the global financial crisis in mid-September and which generated huge security selloffs across the Globe. The Beirut Stock MarketBeirut Stock Market Index was up by 13.1 percent over the first three quarters of 2008, raising the market capitalization to a high of $13.6 billion. It is yet worth mentioning that the month of October has witnessed one of the worse performances ever, with prices dropping on average by 18.1 percent, more than wiping out the favorable performance of the nine-month period. Lebanese bonds, in parallel, witnessed an expansion in average spreads by 54 basis points over the first nine-month period, yet followed by a large widening in October raising bond yields to a record high. The in-depth analysis of the real sector, external sector, government sector and financial sector is reported in what follows.

1. ECONOMIC CONDITIONS

1.1. REAL SECTOR

1.1.1. Agriculture and Industry

The primary sector witnessed an amelioration on the external front this year, partly benefitting from spiraling food prices worldwide. According to the most recent statistics released by the Higher Customs Council, Lebanon's agricultural exports amounted to $112 million in the first nine months of 2008, up by 13.1 percent relative to the same period of 2007.

When examining this primary sector domestically, global price pressures, along with the deficiency in local crop production, have accentuated the burden on consumers, as mirrored by the 33.8 percent expansion in the agricultural trade deficit. Agricultural imports jumped by 31.3 percent year-on-year in the first nine months of 2008 to reach $1,078 million, as Lebanese agricultural traders opted to sell their products abroad, where they can benefit from higher prices. The ensuing shortage, along with notable inflation in imported food, has sent prices of food in Lebanon skyrocketing upwards.

As to manufacturing activity, it saw a robust performance in terms of foreign demand. Over the first nine months of 2008, industrial exports increased by a momentous 31.5 percent relative to the same period of 2007 to reach $2.5 billion. Imports of industrial machinery that reflect investments made in the industrial sector, increased by 6.8 percent(Latest data available) in the first eight months of 2008 to reach $119.1 million, noting that up until end-April 2008, the value of these imports recorded a year-on-year decline. However, the four months extending between May 2008 and August 2008 saw a healthy double-digit year-on-year growth of 20.3 percent in these imports, thereby reflecting a revival in the industrial investments in Lebanon, following the political amelioration. The distribution of imports of industrial machinery by origin shows that Germany was the largest exporter of industrial machinery to Lebanon as it accounted for about 25.6 percent of the total, and was followed by Italy with 24.6 percent, China with 15.4 percent, and the United States with 5.3 percent.

Despite the growth in exports, it is worth highlighting that Lebanese manufactured goods are facing high barriers to enter foreign markets, especially that they remain at a comparative disadvantage relative to other Arab and Gulf energy producing countries. Furthermore, long-lasting obstacles hinder industrial development, like the restraining licensing system, infrastructure limitations, and the relatively high cost of skilled labor in comparison to the region. Within this context, as free trade agreements come into effect and Lebanon's accession to the World Trade Organization (WTO) is drawing nearer, the country needs to build on its comparative advantage in the secondary sector. With a high cost of production in a relatively small country, the advantage should come from superior quality standards, brought about by government-set policies aimed at raising awareness of the private sector and training industrialists.

1.1.2. Construction

The property sector boom persisted through the third quarter of the year, with an even stronger momentum compared to previous months of the year, as the political resolution reached in May 2008 reinforced investors' confidence in the Lebanese economy in general, and the real estate sector, in particular. All indicators point to escalated demand, be it local or by Lebanese residing abroad, or even Gulf investors.

The number of property sales operations, according to the figures released by the Directorate of Real Estate, increased by 26.2 percent in the first nine months of 2008 relative to the same period of the previous year, to reach 58,532 operations. The total value of property sales and the average value of each property sale, also climbed, as a result of both more transactions but also as a result of higher prices. The total value increased by 81.4 percent when comparing the first nine months of 2008 to those of 2007, as it reached LP6,784.2 billion. The average value per sale became LP56.5 million, 67.8 percent higher than the average of the first nine months of 2007, again under the impact of the price hike. The excess demand of property in Lebanon has pushed the price ceiling of real estate in Lebanon upwards by around 30 percent according to preliminary estimates, almost half of it being in the summer months after the political agreement was concluded.

The majority of property sales in the said period were in Beirut with 28.4 percent of the total amount, followed by the Baabda area with 22.9 percent. The Metn area took a considerable 19.3 percent and Keserwan took 13.0 percent. The North accounted for 6.7 percent, followed by the South with 6.0 percent, and the Bekaa took 3.0 percent. This hike in property sales was coupled with a major rise in property tax receipts of 73.6 percent to reach LP466.6 billion in the first nine months of 2008.

One should bear in mind that during the summer months, Arab Gulf investors joined the non-resident Lebanese in investing in the sector, as they became more confident about the political situation. In fact, this latter category revived the luxury and upper scale realty that was lagging behind, as most demand has been rather coming from the Lebanese Diaspora targeting medium scale property. As a matter of fact, this was mirrored by a year-on-year surge in the average value per property sale of 54 percent and 65 percent during August and September.

Looking at the supply side of the sector, the variation in newly issued construction permits, a leading indicator of building activity, confirms the fact that property developers continued to launch new projects to meet this superfluous demand and to benefit from it at the same time. Permits totaled 8,323,502 square meters in the first nine months of 2008, up by 30.6 percent from the same period of the previous year. The third quarter of the year witnessed an even more heightened construction activity as total permits went up by 39.3 percent relative to the same quarter of 2007. Cement deliveries, another coincident indicator of building activity, went up by almost 7.2 percent over the first eight months of 2008 relative to the first eight months of 2007, as per the latest data available.

To sum up, despite the adverse shocks hitting global real estate markets, the property sector boom in Lebanon is persisting. It might moderate to a slower pace than that currently predominant, but it is not expected to be reversed. The high demand and the fact that there is shortage in supply in a relatively small country, should keep the sector revived in years ahead.

1.1.3. Trade and Services

The third quarter of 2008 brought about resurgence in trade and services' activities, especially in hospitality and tourism, which are by nature very susceptible to political and security conditions. Indeed, the political breakthrough reached in May 2008 came right in time for the country to benefit from the positive spillovers usually associated with the summer season that affect the trade and services sector at large, and the tourism segment, in particular.

The number of tourists that visited the country in the third quarter of the year reached 510,011, up by 43.8 percent relative to the same quarter of 2007. The vigorous summer season of 2008 pushed the number of tourists up to 983,585 in the first nine months of 2008, rising by 28.3 percent from 766,680 in the corresponding period of 2007, noting that up until end-May 2008 tourism activity was 1.8 percent lower than the first five months of 2007. As a matter of fact, the revival in tourism following the Doha agreement was rigorous enough to push the first nine months of 2008 to a peak since 2005. Further, if tourism activity in Lebanon continues at a sustained pace, the number of tourists in 2008 could come close to or even surpass the 1.28 million visitors that came to Lebanon in 2004, especially that many airlines already have their trips to Lebanon fully booked for the end-of-year holidays.

The distribution of tourists by origin in the first nine months of 2008 indicates that the majority of visitors were from Arab countries with 40.2 percent of aggregate visitors, followed by visitors from Europe with 26.6 percent, visitors from the Americas with 13.9 percent, visitors from Asia with 13.5 percent, visitors from Oceania with 3.2 percent, and visitors from Africa with 2.7 percent. In terms of individual countries, Jordan accounted for the largest number of tourists in the first nine months of the year with 129,644 visitors, or 13.2 percent of the total, followed by France with 68,478 visitors (7.0 percent), then Iran with 66,894 visitors (6.8 percent), the United States with 64,320 visitors (6.5 percent), and Canada with 51,361 visitors (5.2 percent).

The recovery in tourism had positive overflows on the hotel industry in Lebanon. Indeed, the hotel benchmark survey conducted by Ernst & Young indicates that although hotels were struggling in the Lebanese capital with a low average occupancy of 37 percent in the first five months of the year, their performance bounced back in the summer, following the Doha agreement, with an occupancy of 61 percent during June, 69 percent during July and a record high 91 percent during August. The dynamic tourism activity also enhanced spending patterns in the country as figures released by Global Refund, the firm that reimburses VAT to tourists at the Lebanese points of entry, showed that the growth of spending on tax-free purchases during the first nine months of 2008 compared to the same period of 2007 was 53 percent.

Airline activity mirrored tourism activity in the first nine months of 2008, with the third quarter of the year naturally rising, in line with the surge in tourism. Figures released by the Hariri International Airport (HIA)Hariri International Airport (HIA) demonstrate that after a 29.3 percent year-on-year surge in the third quarter of 2008, passengers' activity witnessed an 18.9 percent increase in the first nine months of 2008 relative to the same period a year ago. In total, 2,978,103 passengers used the HIAHIA in the first nine months of 2008. Departing passengers increased by 18.2 percent to reach 1,488,683 whereas arrivals went up by a higher 19.5 percent relative to the same period of the previous year and totaled 1,489,420. Aircraft movements at the airport also improved during the said period by 11.5 percent to reach 32,685 flights, which were divided into 16,350 arriving planes and 16,335 departing planes.

As for key indicators of maritime transport services, they reflect a forceful overall nine-month trade activity over a five-year period. Figures released by the Port of Beirut registered a five-year high in the first nine months of the year in terms of the number of containers loaded and unloaded at the port, the tons of goods transported and revenues generated by the port. The number of containers at the Beirut Port increased by 17.5 percent year-on-year in the first nine months of 2008 to reach 379,188 containers , while the tonnage of merchandise unloaded at the port went up by 13.2 percent to reach 4,425 thousand tons. Likewise, revenues generated by the port recorded a yearly rise of 11.1 percent to reach $94 million during the said period.

Finally, the value of cleared checks in the banking system, a coincident indicator of overall spending patterns in the economy, showed a steady strong growth in the first nine months. Total cleared checks amounted to $39,414 million in the first nine months of 2008, up by 43.3 percent from the corresponding period of the previous year. This increase is the result of a 12.1 percent increase in local currency denominated checks that totaled LP10,410 billion, and a 52.3 percent growth in foreign currency denominated checks up to $32,509 million.

1.2. EXTERNAL SECTOR

The external sector progressed in terms of aggregate activity since the beginning of the year, but merchandise continued to pose a constraint on the performance of the sector, as the goods trade deficit persisted in its expansionary trend. Figures released by the Higher Customs Council show that the aggregate value of imports and exports totaled $14,487 million in the first nine months of 2008, up by a major 37.6 percent from $10,528 million in the same period of 2007.

As such, this advancement, driven mainly by an improvement in aggregate demand for goods and services, was also due to a an appreciation in the value of imports due to oil prices which were still relatively high up till end-September 2008, with the barrel of Brent crude oil averaging $111.5 per barrel throughout the first nine months of the year. Also, during the period, the value of the US Dollar against the Euro was still registering a depreciation, another boost to the value of imports. In parallel, the trade deficit widened by 42.0 percent, from $6,480 million in the first nine months of 2007 to $9,201 million in the same period of this year.

In details, exports activity grew by 30.6 percent, to reach $2,643 million in the first nine months of 2008 versus $2,023 million in the same period of the previous year. Demand for Lebanese products continued to benefit from the regional market boom as most Lebanese exports are targeting regional countries that have witnessed very high growth rates this year.

When it comes to imports, on which Lebanon is heavily dependant, the exchange rate movement had an adverse effect as their prices went up, noting that Euro-denominated Lebanese imports are almost two times US Dollar denominated imports. Growth in imports surpassed that of exports as it was at 39.3 percent leading to a total of $11,844 million in the first nine months of 2008, as compared to $8,505 million in the same period of 2007. The increase in imports, within the context of a lower rise in exports, led to slight drop in the export-to-import coverage ratio from 23.8 percent in the first nine months of 2007 to 22.3 percent in the same period of 2008.

The breakdown of Lebanese exports by country of destination for the first nine months of 2008 indicates that Switzerland was the country with the greater part of Lebanese exports with $265 million, or 10.0 percent of the total. It was followed by the United Arab Emirates with $251 million (9.5 percent), then came Iraq with $183 million (6.9 percent), Turkey with $171 million (6.8 percent), and Syria with $164 million (6.2 percent). Aggregate exports to these countries accounted for almost 40 percent of total exports.

As for the breakdown of imports to Lebanon by country of origin, it reveals that the United States retained the largest share of exports to Lebanon with $1,276 million, or 10.8 percent of the total. It was followed by China with $1,025 million (8.6 percent), France with $1,023 million (8.6 percent), Italy with $883 million (7.5 percent), and Germany with $709 million (6.0 percent). Aggregate imports from these countries accounted for around 42 percent of total imports in the first nine months of 2008.

Lebanon's primary exports in the first nine months of 2008 were base metals, as they accounted for 17.4 percent of total exports. Jewelry, which comprised 16.9 percent of the total, came in second, due to the surge in gold prices, followed by electrical equipments and products with 14.7 percent, chemical products with 12.4 percent, and prepared foodstuffs with 8.3 percent. Those five categories accounted for 70 percent of total exports in the first nine months of 2008.

Mineral products, which accounted for 26.7 percent of total imports, continued to retain the lion's share of imports during the aforementioned period as they include oil products whose prices continued to be relatively high when compared to other products. Electrical equipments and products came in next with 10.2 percent, followed by transport vehicles with 9.8 percent, base metals with 9.1 percent, and chemical products with 8.4 percent. The said categories represented approximately 64 percent of total imports.

As such, the above mentioned figures for the first nine months of 2008 clearly reflect the burden of Lebanon's free trade regime. However, in spite of the merchandise trade load, Lebanon's economic regime allows it to enjoy the benefits of the continuing stream of remittances and capital transfers from non resident Lebanese as well as non-Lebanese, mostly Arabs. According to the World Bank, remittances from Lebanese abroad into Lebanon hover at around $6 billion a year. As for Lebanon's FDI, it totaled $2.8 billion in 2007, more than six times its annual average over the past decade.

Net capital inflows amounted to $11.4 billion in the first nine months of this year, surging by a significant 61.6 percent from $7.0 billion reported over the same period of 2007. This hefty influx of capital into the country not only managed to fully cover the growing trade deficit, but also resulted in a momentous cumulative balance of payments surplus, which reached $2,213.1 million yearto-September, against $580 million in the first nine months of 2007. The cumulative surplus is the result of a rise of $5,504.9 million in net foreign assets of the Central BankCentral Bank, which offset by far the decline of $3,291.8 million in those of banks and financial institutions.

1.3. PUBLIC SECTOR

The fiscal performance over the first nine months of 2008 improved slightly relative to the same period of the previous year, partly the result of a modest amelioration in overall economic conditions during the summer season, although still much below the requirements of a soft landing in public finance conditions. This slight amelioration is noted at the level of the ratio of total deficit to total expenditures, which reached 28.5 percent in the covered period, versus a higher 29.4 percent in 2007 and 35.5 percent in 2006 during the same periods.

In details, public revenues, which include budget and Treasury receipts, reached LP7,612.7 billion, up by 16.0 percent relative to the same period of 2007. In fact, budget revenues moved up by 16.5 percent to reach LP7,034.0 billion, purely due to a 25.1 percent increase in tax revenues, which totaled LP5,210.7 billion, as non-tax revenues dropped by 2.6 percent to reach LP1,823.3 billion. As for Treasury revenues, they edged upwards by 9.2 percent to LP578.6 billion.

The growth in tax revenues stems mostly from the amelioration in aggregate private consumption relative to the previous year, as reflected mainly by the increase of 28.1 percent in the value added tax receipts to reach LP1,861.3 billion. Customs revenues, in parallel, increased by a smaller 10.7 percent to become LP1,038.3 billion.

On the spending side, government expenditures went up by a slightly lower 14.5 percent to LP10,644.7 billion including budgetary and Treasury spending. Budgetary spending went up by 6.5 percent to reach LP7,970.6 billion while the major lever of the increase in total spending were Treasury expenditures, which jumped by 47.5 percent, due to increased transfers to the electricity company. Transfers to EDL went up by 48.4 percent to LP1,690.3 billion, noting that the company is posing serious constraints on the government's Treasury.

Within budgetary spending, interest expenditures crawled up, while the government managed to relatively squeeze its non-interest expenditure. Interest payments (excluding reimbursement of FC debt) increased by 6.3 percent to reach LP3,647.4 billion. This rise was due to the growth in local currency interest payments of 8.1 percent whereas foreign currency debt service rose by a lower 3.9 percent. In contrast, other budget expenditures rose by 4.0 percent to LP4,041.3 billion.

On the whole, although the percentage rise in fiscal revenues fairly surpassed that of fiscal expenditures, this could not lead to a contraction in the overall fiscal deficit of the first nine months of the year. The increase in volume of government expenditures was relatively greater than that of revenues, thus the fiscal balance expanded by LP297.4 billion, or 10.9 percent in the first nine months of the year to reach LP3,032.1 billion. When excluding debt service, a primary surplus of LP897.1 billion is reported, 3.7 percent higher than that of the same period of 2007.

The global public deficit was still financed through debt issuance. Gross public debt reached LP68,859 billion, or $45.7 billion, at end-September 2008, up by 8.7 percent from LP63,364 billion, or $42.0 billion at end-2007. Net public debt, which excludes public sector deposits in the banking system from overall debt figures, went up by 4.8 percent in the first nine months of the year to reach LP61,648 billion. As a percentage of GDP, public debt stood at 168 percent as at end-September 2008.

The rise in gross public debt throughout the first nine months of the year was mostly triggered by local currency debt, which reached LP36,555 billion at end-September 2008, up by 16.5 percent from LP31,373 billion at end-2007. This increase was mainly coming from the debt held by financial institutions, in particular commercial banks, who remain the main carriers of the domestic debt portfolio holding around 60 percent of it at end-September 2008. Foreign debt underwent a relatively small increase, reaching at end-September 2008 $21,429 million, up by 1.0 percent from $21,221 million at end-2007. Lebanon's foreign debt remains mainly in the form of market-issued Eurobonds. This category's share out of total foreign currency debt stands at over 80 percent as at end-September 2008. The other important components of foreign currency debt are Eurobonds related to aid received during the donors' conference meeting Paris II and other multilateral loans. As for more recent aid received at the Paris III conference, it has not translated into significant debt so far.

When shedding the light on the recently released draft 2009 budget law proposal, a further deterioration in government deficit is noted. A 31.3 percent rise in overall public expenditures is noted from the 2008 budget law, while this increase would be at 18.3 percent when looking at actual 2008 figures, annualized based on nine-month performance. This increase is mainly triggered by a surge in public sector wages by LP830 billion as a result of the recent wage adjustment. As for public revenues, they are expected to be boosted by a lower 21.9 percent relative to the budget of 2008. It is worth highlighting that on the revenues' side, the government does not account for any increase in the VAT rate, but merely a rise in interest income tax from 5 percent to 7 percent.

With public expenditures targeted at LP15,071 billion in the draft 2009 budget, and public revenues set at LP10,200 billion, the 2009 deficit of LP4,871 billion would lead to an increase in deficit-to expenditure ratio from an estimated 27.1 percent in 2008's budget and an estimated 28.9 percent based on this year's actual figures to a projected 32.3 percent in 2009's budget. This draft law remains subject to final approval of the council of ministers and the parliament.

1.4. FINANCIAL SECTOR

1.4.1. Monetary Situation

Monetary stability and the absence of market pressures remain the main features characterizing the monetary conditions during the first nine months of 2008, within the context of continuous conversions in favor of the Lebanese Pound and ample local currency liquidity available at hand. Accordingly, the overnight interbank rate, a major benchmark for monetary conditions, didn't shift its stance during the first nine months of this year, standing at its low official level of 3.5 percent.

Under these favorable conditions, the Central BankCentral Bank continued to intervene as a buyer of the green currency surpluses and reduced continually its FX intervention rate to reach LP/$1,501 in the third quarter of the year, i.e the bottom of the intervention band prevailing since the end of nineties. Driven by the Central BankCentral Bank's massive intervention on the FX market, the Bank's foreign assets surged by $5.4 billion during the first nine months of 2008 to hit a record high level of $17.8 billion at end-September. The latter accounted for 81.2 percent of the Lebanese Pound money supply, a figure that rose to 118.4 percent when including gold reserves estimated at $8.2 billion. Even when deducting the sovereign Eurobond holdings of the Central BankCentral Bank estimated at circa $2.5 billion, the gross foreign currency reserves stood at a high of $15.3 billion, the equivalent of 70 percent of the LP money supply.

Moreover, the abundant local currency liquidity on the money market combined with the impressive rise in the commercial banks' LP deposits during the first nine months of 2008 triggered a growing demand for LP Treasury bills. In fact, commercial banks were increasingly heading towards LP Treasury bills, as mirrored by a surge in the banks' LP Tbs portfolio of LP4,875 billion, from LP15,664 billion at end-December 2007 to LP20,539 billion at end-September 2008. In addition, the Tbs portfolio held by the public increased from LP5,613 billion at end-2007 to LP5,774 billion at end-September 2008.

At the level of disintermediation, the share of direct Tbs subscriptions by the public to LP Money Supply (M2 LP) registered a decline year on-year. The ratio fell from 22.5 percent at end-September 2007 to 17.3 percent at end-September 2008, due to a relevant rise in LP money supply of 33.3 percent and a tiny increase of 2.5 percent in Tbs portfolio held by the public. As for crowding out effects, the share of state in bank credits decreased from 54.6 percent at end-September 2007 to 53.7 percent at end-September 2008, thus capturing a less significant share in bank uses.

Based on the Ministry of FinanceMinistry of Finance's decision to lower interest rates gradually after the Doha agreement, the average yield on the six-month and one-year categories retreated by two basis points to 7.22 percent and 7.73 percent respectively, while the average yield on the two-year category declined by ten basis points to 8.40 percent and the average yield on the three-year category decreased by twenty six basis points to 9.06 percent. In parallel, the average yield on the three-month category remained unchanged at 5.22 percent.

The analysis of the monetary situation shows that the overall increase in money supply over the first nine months of 2008 was LP9,969 billion, versus a lower increase in money supply of LP7,592 billion over the first nine months of 2007. The growth in money supply during the first nine months of 2008 compares to a money creation of LP8,314 billion, resulting from a LP116 billion increase in the State's indebtedness towards the banking system and a staggering LP4,813 billion rise in bank lending to the private sector, within the context of an increase in net foreign assets (excluding gold) of LP3,385 billion. The difference between the growth in money supply and money creation in Lebanese Pound, amounting to LP1,655 billion, reflects a monetization of finan cial claims during the first nine months of 2008.

When adjusted for currency fluctuations, net foreign assets of the banking system (Banks and Central BankCentral Bank) reported an increase of $2,213.1 million during the first nine months of 2008, resulting from a drop in commercial banks' net foreign assets by $3,291.8 million against a rise in the Central BankCentral Bank's net foreign assets by $5,504.9 million.

1.4.2. Banking Activity

The Lebanese banking sector registered a remarkable performance over the first nine months of 2008, with all major aggregates reporting a solid progression. Total assets grew by LP14,291 billion between December 2007 and September 2008, the equivalent of 11.5 percent, against LP11,078 billion or 9.9 percent in the first nine months of 2007. By comparison, the average first nine months of the previous five years reported an average growth of LP5,998 billion, the equivalent of 6.5 percent.

Activity growth was triggered by customer deposits which rose from LP101,435 billion in December 2007 to LP113,259 billion in September 2008, the equivalent of $75.1 billion. These deposits do not account for medium and long term banks deposits estimated at $2.0 billion at end-September 2008. Based on domestic commercial banks figures, customer deposits accordingly recorded the most significant nine-month growth in volume ever reported.

By the end of September 2008, the banking sector domestic assets reached nearly 340 percent of Lebanon's GDP, one of the highest ratios among peers at the regional and international levels. Customer deposits, which account for 82 percent of total assets, represented 276 percent of GDP at end-September 2008. Such a large banking dimension relative to the country's economic dimension acts as a normal support to the regional expansion strategies undertaken recently by Lebanese banks.

The most spectacular increase remains that of net loans. Loans grew by LP6,585 billion, the equivalent of 21.4 percent, i.e the most significant growth in volume and percentage terms ever. The growth in loans which is almost double the growth reported in the corresponding 2007 period was aimed at meeting growing domestic demand needs in view of improving economic conditions but also at meeting increasingly regional corporate needs with the expansionary regional corporate policies adopted by large banks in the country. Out of the total rise in loans, around 27 percent was tied to non-residents in the first nine months which accounts for those loans booked in Lebanon but intended to finance regional operations.

At the level of State exposure, the first nine months of the year reported a decrease in the ratio of sovereign eurobonds to customer deposits in FX. The ratio dropped from 21.3 percent at end-December 2007 to 19.6 percent at end-September 2008.

The first nine months of 2008 reported a

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net decrease in liquidity, although the latter remains very high by comparative regional and emerging markets standards. The ratio of net liquid assets to customer deposits dropped from 81.0 percent in December 2007 to 77.9 percent in September 2008. The most significant liquidity indicator remains that of primary liquidity in foreign currency. The ratio of the latter to customer deposits in foreign currency slightly declined from 50.0 percent to 48.8 percent. The decline in primary liquidity in the first nine months of 2008 is tied to the significant growth in net loans, with the loans to deposits ratio reaching a 5-year high of 33.0 percent at end-September 2008.

Last but not least, the first nine months of 2008 was quite profitable for banks in Lebanon. Despite the drop in foreign benchmark rates and which impacted the return on primary liquid uses for Lebanese banks profitability was favored by the growth in loans in addition to the impact of regional expansion, as new subsidiaries are increasingly turning into profitable entities after their effective launch in previous years. It is worth mentioning that the aggregate results of the listed banks grew by 34.1 percent over the nine months of 2008 relative to the corresponding 2007 period.

1.4.3. Equity and Bond Markets

The prevailing sentiment on Lebanese capital markets varied between general optimism regarding the stable local political and security conditions that prevailed after the Doha agreement on May 21, and concerns driven by the outburst of the global financial crisis in mid-September 2008.

On the Beirut Stock Exchange, the strong momentum that was observed after the Doha agreement eased on news of crashes hitting the global equity markets since the second half of September. In fact, as investors started liquidating their market positions in order to offset losses in other markets, the price index went down from 196.84 at end-June 2008 to 168.69 at end-September 2008, yet still reporting a positive change of 13.1 percent over the first nine months of 2008. The total trading value amounted to $1.4 billion during the first nine months of 2008 as compared to $573 million during the corresponding period of 2007, mainly driven by the favorable mood that swayed over the BSE after the Doha agreement. The turnover ratio, measured by the annualized total trading value to market capitalization, rose from 7.4 percent during the first nine months of 2007 to 14.0 percent during the first nine months of 2008, and the average daily trading volume index increased from 180 during the first nine months of 2007 to 385 during the corresponding period of 2008, which sheds light on the staggering increase in activity during the current year.

In relative terms, the Lebanese equities' price performance was much better than that of other emerging markets. In fact, the Morgan Stanley Capital International Emerging Markets Free Index (MSCI EMF), comprising 26 emerging markets stock indices from all over the world, indicated that prices of emerging equities tumbled by 36.8 percent since the beginning of the year. Likewise, Lebanese stocks performed better than other Arabian markets, as reflected by a drop of 26.9 percent in the Morgan Stanley Capital International Arabian Markets Index during the first nine months of 2008.

As to the Eurobond market, investors that showed appetite for Lebanese debt instruments after the Doha agreement adopted a cautious attitude after the outburst of the global financial crisis while a foreign offer started to float on the surface. The average yield declined by 18 basis points since the beginning of the year to reach 7.95 percent at end-September, while the average spread expanded by 54 basis points to 512 basis points due to a decrease in Lebanese yields and a wider drop in benchmark yields.

As to the Lebanese sovereign debt's ratings, the local political stalemate that prevailed before the Doha agreement pushed Standard & Poor's lower at end-January its long-term sovereign credit rating on Lebanon from "B-" "CCC+", while maintaining a stable outlook. However, the International rating agency lifted back Lebanon's long-term credit risk to "B-" at early-August 2008 on account of an improvement in political risk. In addition, maintained at early February Lebanon's sovereign rating at "B3" with a "stable" outlook.

On the other hand, the Ministry of FinanceMinistry of Finance concluded successfully three swap operations during the first nine months of 2008 to settle part of the maturing bonds this year. In the first swap operation, the Ministry of FinanceMinistry of Finance exchanged a $700 million sovereign bond maturing in March for a new 5-year sovereign bond issue of $875 million yielding 9.25 percent. The second swap operation took place in April, through which the Ministry of FinanceMinistry of Finance exchanged 58.5 percent of the remaining bonds maturing in 2008 and totaling $1.25 billion. The said operation amounted to $732 million and resulted from exchanging 93.1 percent of a $250 million bond maturing in May and 59.2 percent of another $250 million bond maturing in June and 46.8 percent of a $750 million bond maturing in August. Moreover, the Ministry of FinanceMinistry of Finance issued additional cash tranche of $150 million. In the third swap operation, the Ministry of FinanceMinistry of Finance exchanged a $399 million sovereign bond maturing in August for a new 7-year sovereign bond issue of $500 million yielding 8.625 percent. Accordingly, the total bond portfolio reached $17,249 million at end-September 2008 versus $16,686 million at end-December 2007.

2. CONCLUSION: The macroeconomic challenges facing the new presidential era

There is no single doubt today that the most critical development in our recent contemporary history is the spread of the World financial crisis that actually began 13 months ago but that has entered a new, far more serious phase by the end of the third quarter of this year. It is thus quite important for us to spare some time to try to overview the current international financial crisis and its impact on Lebanon's economy and financial system at large. The first part of this conclusion would be dedicated to discuss the background of the international financial crisis and its most recent spillovers. The second part would be dedicated to analyze the performance of the Lebanese economy and financial system during the crisis era and the various reasons behind its relative resilience to the severely contagious financial woes.

As spillovers of the subprime crisis are being extended to the entire financial system, global markets are probably facing today their worst crisis since the great crash of the 1920s. What are the roots of the problem? Let us start by the identification of this contagious disease before discussing its spillovers. It is actually called "deleveraging", or the unwinding of debt as the World's largest Central BankCentral Bank and Treasury officials chose to name it. During the credit boom of the current decade, both financial institutions and households took on too much debt. Between 2002 and 2006, household borrowing in the United States for instance grew at an average annual rate of 11 percent, far outpacing overall economic growth. Borrowing by financial institutions in parallel grew by a significant 10 percent annualized growth rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices in the US. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're very hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets. But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital, thus leading to a self-feeding loop or a "financial accelerator."

Deleveraging started with subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. It is estimated that in the past year, financial institutions around the world have already written down $690 billion worth of assets and raised $706 billion worth of capital. But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory.

Debt-driven financial traumas have a long history, from the Great Depression in 1929 to the Savings & Loans crisis in the late 1980s to the Asian financial crisis of the late 1990s. Neither economists nor policy makers have easy solutions. This crisis is now even more complicated by innovative financial instruments that financial markets created and distributed. They're making it harder for officials and executives to know where the next set of risks is hiding and also contributing to the crisis spreading impact. In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.

As credit is tightening for consumers and business, the financial crisis is impacting the real economy, shrinking growth at large and leading within the context of rising inflation this year to stagflation in various economies around the globe. Credit crunch indeed freezes hiring and expansion. When businesses and individuals can't get loans, job growth and economic expansion stall. The US Jobless claims have indeed reached last month near 14-year high. The IMF believes the U.S. economy will probably contract in the final three months of this year and the first three months of next year, meeting a classic definition of a recession, i.e two consecutive quarters of negative real GDP growth. Worldwide, the global economists' optimistic scenario is a couple years of recession or painfully slow economy growth.

Within this context, one has to wonder if our local economy is immune to a crisis of such a magnitude. Let us thus look at the performance of our economy and financial system during the crisis era, and more specifically over the past year.

At the real sector level, while the global economy is expected to slowdown from a real growth of close to 5 percent in 2007 to around 3.7 percent in 2008 as a result of the widening financial crisis, Lebanon is expected to report this year its highest real GDP growth in four years, exceeding for the first time in recent years the 6 percent threshold as per the recent post-crisis global economic projections of the IMF. Such a growth, which was definitely helped by a revival in confidence in the aftermath of the Doha agreement last May, comes in a period where signals of a recessionary environment are emerging in the different corners of the World within the context of sluggish consumption and investment spending in the aftermath of the worst financial crisis in decades. While Lebanon's growth is expected to moderate slightly to 5 percent in the year 2009 (as per the IMF figures) mainly as a result of a slowdown in the economies of its foreign trade partners with a corollary slowdown in exports growth, it will remain above the global growth of 2.2 percent for the year ahead and well above the advanced countries growth of 0.3 percent as forecasted by the IMF.

In parallel, Lebanon's financial sector has witnessed in fact over the past year one of its best performances ever. Between September 2007 and September 2008, banks assets grew by 13 percent, driven by customer deposits which accumulated $9.5 billion over the period. The growth in banking activity clearly highlights the strong confidence in the Lebanese banking sector within the context of perfect capital mobility across borders and with capital fleeing to the least affected financial sectors across the World. Net capital inflows towards Lebanon over the first nine months of 2008 were up by 62 percent relative to last year's corresponding period, leaving a large balance of payments surplus of above $2.2 billion.

The reasons why Lebanon was relatively insulated from the global financial crisis are various, ranging from the regulatory and supervisory regime to the conservative practices of Lebanese banks and to structural economic factors such as the recurrence and non-speculative nature of capital inflows towards Lebanon supported by a large pool of offshore savings around the Globe.

At the macroeconomic level, the Lebanese financial system benefit from a stable deposit base supported by recurrent capital inflows, the bulk of which is constituted of remittances from a large pool of Diasporas all over the World. With annual remittances of close to $6 billion, Lebanon has the highest ratio for remittances per capita in the World. Such remittances, which have been sustainably growing year-after year over the past decades, are not likely to receive a significant hit as a result of the current crisis, and are expected to remain in the worst circumstances above 20 percent of Lebanon's GDP. These remittances, which empirically proved to be non-volatile in nature, originate from a large pool of Diasporas well diversified by sector of activity and country of residence around the globe.

More importantly, Lebanese banks are well regulated by international standards. The financial industry is very well regulated by the Central BankCentral Bank and the Banking Control Commission, which imposes significant regulatory measures for risk management and control. Banks are subject to strict capital requirements and are not authorized to extend lending exposures beyond pre-set limits. Lebanese banks are not able to expand recklessly, to lend carelessly, and to run themselves unwisely. Supervisory powers and techniques are keeping pace with deregulation. On the other hand and at the market level, future and forward markets do not exist in Lebanon, which precludes the short selling on capital markets.

Four years ago, a circular issued by the Central BankCentral Bank prevented banks from investing freely in structured products. As a result, the subprime crisis did not reach Lebanese banks as they have no positions and thus no losses in the subprime instruments. More recently, the Central BankCentral Bank issued a circular limiting banks to lend only up to 60 percent of the cost of a real estate project in order to preemptively protect the financial sector from excessive speculation that could end up with negative spillovers.

Lebanon's banks do not have large housing exposures, while keeping in mind that such exposures were at the origin of the subprime crisis. According to ABL figures, total housing loans are close to $1.7 billion, or less than 2 percent of the total assets of banks in Lebanon. In addition, real estate prices have witnessed significant hikes over the past few years, contrary to the downward trend reported in the United States and Europe and which has accelerated the crisis. Notwithstanding the fact that the securitization of these loans is practically non-existent in Lebanon.

Moreover, bank lending has always been covered by a significant amount of collaterals. Such a high collateralization is linked to the conservative nature of lending policies and practices at Lebanese banks. Total advances against guarantees amount to 76 percent of the aggregate loan portfolio of the banking industry. More specifically, local banks ask any investor seeking a loan for a real estate project to provide collateral worth at least twice the amount of the desired loan.

In addition, Lebanese banks have very high liquidity levels. Primary liquidity in foreign currency as a percentage of customer deposits in foreign currency stood at 49 percent by end-September 2008, one of the highest levels in the World and by far exceeding regional and international benchmarks. While it is true that lending to the private sector represents close to 80 percent of the size of the domestic economy, such a lending is constrained to a small portion of the large bank resources, with loans to deposits standing at a mere 33 percent. In parallel, Lebanese banks have a high capital adequacy level, i.e an acceptable leverage level in a period where the recent crisis has underlined the threat of excessive indebtedness on behalf of banks. They are all considered deposit-rich banks where the deposit base constitutes 82 percent of their total funding at large.

Furthermore, Lebanese banks have a positive external position, i.e the Lebanese financial sector is a net lender to the outside World. Net foreign assets in Lebanon are positive, as foreign assets exceed foreign liabilities by U$4 billion. In other words, the Lebanese banking sector is not indebted to the outside World in a period where deleveraging is causing a liquidation of the placements of some international financial institutions to offset their losses at the assets side. Within the same context, the market rests primarily on Lebanese investors and depositors, while non-resident deposits represent a mere 15 percent of the total deposit base. It is also worth mentioning that the foreign assets of Lebanese banks consist mainly of well diversified placements in highly rated OECD commercial or universal deposit-rich banks that were relatively not exposed to the crisis.

Finally, although the recent global financial crisis revolves around excessive private sector indebtedness rather than sovereign indebtedness, the observed Lebanese resilience is not equivalent to financial immunity. The Lebanese resilience to crisis cannot last, in the long term, unless drastic structural reforms take place in an attempt to ensure a soft-landing scenario for Lebanon's public finance conditions. Such reforms are becoming increasingly urgent in a period where Lebanon's public sector can count relatively less on international assistance and foreign support because of the wealth contraction phenomenon observed around the Globe as a result of the international financial crisis. Following the Doha agreement among political leaders, the long awaited election of a new president, the formation of a government of national unity, and the launch of national reconciliation among political parties and fractions, it is now time to launch long awaited structural reforms that should ensure a gradual reduction of sovereign indebtedness and public deficit levels to fundamentally sustainable levels with respect to the size of the national economy. It is actually then that we can comfortably say that Lebanon could be a unique model of immunity serving as a viable example to a large number of countries in the region, in the emerging countries arena and across the Globe at large.

This publication is undertaken in the aim of informing and should not be considered as an encouragement to any form of financial or commercial activity. Although Bank Audi Sal considers the contents very reliable, it declines any responsibility for any action or decision based on contents herein.

© Copyright The Daily Star 2008.

 

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