Bank Audi: Lebanon among few countries with sustained large capital inflows

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BEIRUT: Over the past few months, the problematic debt issues of Greece and a number of European countries resurfaced, putting massive pressures on the governments to adopt unprecedented austerity measures to try get their way out of their public finance conundrum.

European sovereign CDS spreads peaked at significantly high levels, were the corollary of this, leading to spread widening across the world.

Similarly, the average spread on the stock of Lebanese Eurobonds outstanding contracted by 18 basis points since end-2009 to mid-2010 (455 basis points since end-2008) to hit 272 basis points in June 2010, almost its lowest level for four years.

The reasons for such a relative sovereign debt resilience are various, among which the most important are the following:

(1) Although Lebanon still has high debt ratios, the dynamics were in favor of the country over the past few years.

(2) The debt profile of Lebanon has recently improved in terms of currency structure.

The foreign currency portion of total debt has dropped from more than 50 percent in 2007 to less than 40 percent today, with what this entails in terms of redemption capacity on behalf of the Lebanese government that has full control over its local currency.

(3) The country today benefits from a very good external position. The net foreign assets of the Central Bank exceed $22 billion (including net reserves and gold), a new historical high, which surpasses Lebanon’s foreign currency debt.

(4) Contrarily to the countries that are facing debt issues, Lebanon’s debt is domestic to a large extent, with the portion of the debt held by Lebanese individuals and institutions accounting for 88 percent of total debt. Those Lebanese investors are well acquainted with Lebanese risks, a fact that avoids quick and massive exits.

(5) It was particularly noticeable the unique resilience of Lebanese banks that sustained activity during periods of domestic and external turmoil. Supported by strict regulatory regime and well diversified conservative structures, such successful episodes of historical resilience are likely to further protect the banking industry in front of potential future shocks in a short to medium term horizon.

(6) Lebanon rises among the very few countries with sustained large capital inflows over a long period, emanating mainly from a large diaspora of Lebanese, keeping strong ties with the home economy.

Such inflows represent an important buffer that offsets public finance vulnerabilities. Lebanon’s capital inflows to GDP averaged above 20 percent over the past couple of decades, supporting the country’s balance of payment at all times. As a matter of fact, the annual ratio of capital inflows to trade deficit moved from a minimum of 80 percent to a maximum of 160 percent since the early 1980s till nowadays.

(7) It is particularly the resilience of the Lebanese public finances that made empirically all international rating agencies upgrade Lebanon recently, of which we mention Moody’s, Fitch and Standard and Poor’s.

Although those ratings remain relatively low, the upgrades came in a period where considerable downgrades came to the fore as a result of the growing sovereign concerns.

(8) The outlook for Lebanon’s debt dynamics is favorable in the case of a continuing healthy growth. The current debt to GDP ratio might fall to less than 120 percent in a three-year period if the real economy grows by 6 percent or more. The Lebanese economy is still operating at only 70 percent of full capacity, which leaves room for a continuing solid growth over the next few years if the politico-security stability is maintained.

This is not to say that there are no challenges to Lebanon’s sovereign credit at the horizon. Susceptibility to event risks, of which political or security shocks remains high and rises at the top of vulnerabilities. Likewise, the issue of public indebtedness and fiscal deficit rises among the most critical issues facing Lebanon nowadays.

Despite the improvement in debt ratios over the past few years, Lebanon’s debt to GDP still stands at close to 150 percent, i.e among the highest in the world, imposing an annual deficit of not less than 10 percent of GDP.

Drastic structural reforms need to take place in an attempt to ensure a soft-landing scenario for public finance conditions.

Drastic reforms are becoming increasingly urgent in a period where Lebanon’s public sector can count less on international assistance because of the wealth contraction phenomenon observed around the globe as a result of the international financial crisis. Within this context, we believe that Lebanon cannot adopt an expansionary fiscal policy, like the one somehow suggested in the 2010 budget proposal.

It is quite essential that any additional public spending be coupled at all times with tangible measures to boost public revenues in an overall policy mix targeting soft landing, i.e reinforcing resource mobilization, rationalizing public spending and strengthening debt management.

The measures targeting Lebanon’s resource mobilization might not necessarily levy new taxes but at least enhancing revenues’ collection in a country where fiscal evasion is estimated at around $2.5 billion or around 7 percent of GDP.

At the spending level, Lebanon ought to follow tight budgetary spending policies, in order to send positive signals to Lebanese, Arab and foreign investors on its public finances’ outlook, leaving for the private sector the task to secure the necessary economic value added in the near term.

As to debt management, Lebanon is today facing a golden opportunity resulting from the structural changes in money supply. The opportunity is mainly tied to the possibility of resorting to local currency financing of the state and the private sector, instead of US dollar financing, as a result of important conversions of US dollar holdings into Lebanese pounds. As these conversions go on, markets are witnessing increasing local currency liquidity surpluses that should be effectively channeled to finance the private and public sectors.

The local currency financing of the public sector, as an alternative to foreign currency financing, would reduce foreign currency public debt to GDP that represents the main vulnerability indicator for Lebanon’s sovereign indebtedness.

In conclusion, the debt crisis in eurozone countries should indeed provide an important lesson for Lebanon about the imminent necessity of economic and fiscal softlanding.

The renewed sovereign concerns have highlighted again the fact that sovereigns around the world can default and that rigorous management of public finances are required at all times to avoid financial crisis that can put at stake the countries’ momentum for years to come. It is to the fortune of Lebanon that such an external alarm came at a time of buoyant domestic macroeconomic conditions and in a context of regained confidence in the country’s outlook and prospects, giving some breathing space for Lebanon to embark on a much needed mix of structural and fiscal reforms at large.