Lebanon's public finances have worsened in 2018 and risks to the medium-term sustainability of government debt have risen. We forecast that the 2018 budget deficit has widened significantly to 10.6% of GDP, from an average of 8.2% of GDP in 2012-2017, because of hikes in public sector salaries, higher electricity subsidies and interest payments and a pick-up in capital spending. We forecast that the budget deficit will remain above 10% of GDP in 2019-2020, on the back of higher interest rates, weak economic growth and a lack of material fiscal reform. Lower oil prices and the higher corporate tax rate introduced in 2018 will help marginally. We project that government debt/GDP will reach 158% in 2020 and will continue rising, to 169% in 2023.
The salary scale adjustment in September 2017 has been the primary driver of the larger deficit. In 1H18, personnel costs (which include wages, end of service and pension payments) were 26% higher than a year earlier. The cost of the adjustment has outweighed revenue-raising measures introduced in 2018 to offset the salary scale. Other spending lines have also pressured the budget in 2018, notably transfers to Electricite du Liban (EDL), the loss-making state-owned electricity company, which rose 33% yoy in 1H, in line with global oil prices.
Government interest payments grew by around 8% yoy in January-September, held in check by the fact that Banque du Liban (BdL, the central bank) agreed in May to buy the equivalent of USD5.5 billion in Lebanese pound T-bonds at a rate of just 1%. In 2019, higher interest rates will feed through more strongly into domestic debt auctions and add further upward pressure to government interest payments, which we expect will equate to 49% of government revenue.
Lebanese and international stakeholders agree that the budget deficit needs to narrow, but a credible, actionable plan for achieving this is still lacking and it remains unclear if political dynamics will allow for a concerted fiscal adjustment. At the CEDRE conference in April, Lebanon gained USD11 billion in pledges for concessional financing, which is loosely conditional on Lebanon reducing the budget deficit by 5% of GDP over five years, by reforming subsidies to EDL and improving tax compliance. However, these are long-standing aims in Lebanon and reform of EDL is unlikely to yield savings in the near term. Agreement on the 2019 budget is stuck until a new government is formed (following the election on 6 May).
Higher government borrowing requirements and rising international interest rates are placing extra pressure on Lebanon's financing model and risk undermining confidence in its sustainability. Deposit inflows are a key element of the Lebanese financing model, traditionally supported by confidence in the currency peg against the US dollar due to high BdL reserves, free movement of capital and attractive spreads on US dollar-deposits over US interest rates and on Lebanese pound-deposits over local US dollar-deposits. Deposit growth is used for government financing by domestic banks and FX deposits also support foreign reserves.
However, private sector deposit growth in commercial banks has slowed, despite rising interest rates, with the total stock up by USD3.7 billion in January-October, compared with a rise of USD5.9 billion in 2017 and an annual average increase of USD8.7 billion in 2011-2017. Deposit dollarisation has also inched up, to 69%, although it remains lower than during previous periods of stress, notably in 2005-2008.
BdL's gross FX reserves remain high, despite persistently large current account deficits (23% of GDP in 2017), but face downward pressure. They were USD34.6 billion at end-October and likely dropped to USD33.1 billion at end-November following repayment of maturing Eurobonds. BdL had gold reserves of USD11.2 billion and other foreign assets of USD8.5 billion (including USD4.5 billion of Lebanese Eurobonds). FX reserves have fallen from USD35.8 billion at end-2017, but in October still were equivalent to 66% of Lebanese pound deposits. BdL does not report a figure for net FX reserves. We estimate that BdL's US dollar liabilities to Lebanese commercial banks (USD56 billion-USD68 billion assuming 50%-60% dollarisation) are larger than its foreign assets, although these liabilities (banks' US dollar deposits at BdL) are locked into long maturities. Nevertheless, the customer deposits used to fund them have much shorter maturities.
BdL has increasingly supported the economy and financial system since 2011, including via unorthodox financial operations and stimulus programmes. The extent of financial operations in 2016-2018 by the BDL reflects the pressure the Lebanese economy has been under, with weak growth, political headwinds, persistent twin deficits and lack of fiscal consolidation.
Lebanon's 'B-' IDRs reflect the very weak public finances, difficult political environment and anaemic economic performance. The ratings also reflect the unblemished track record of public debt repayment and the depth of the financial system (deposits in commercial banks are around 300% of GDP)
Public debt is predominantly held by the country's large banking sector and monetary authority and non-resident depositors are mostly diaspora Lebanese. This close-knit nature of the financial sector has helped the government manage its large burden of debt over an extended period of time. Lebanon has had very few episodes of deposit outflows in the last 15 years. Average maturities of deposits at commercial banks and of commercial bank deposits at BdL have lengthened, as has the maturity profile of government debt.
Growth prospects remain modest without improvements in the external environment, a stronger reform programme or a boost to investment through the implementation of CEDRE projects. Growth averaged 1.5% in 2011-17, since the outbreak of the Syrian war, an extremely weak performance relative to the historical trend. In 2000-2010 real GDP growth averaged 5.3%. GDP per capita and broader human development indicators are well above 'B' category peers and more in line with the 'BBB' median, although governance indicators are weaker than 'B' category peers.
Domestic and international politics weigh on the ratings. The factional nature of domestic politics renders the country vulnerable to periods of political vacuum and policy inertia. Most recently, Lebanon has been struggling to form a government for more than six months since the 6 May election. Spillovers from regional instability continue to weigh on the economy and geopolitical risks persist, for example, related to enmity between Hizbollah and Israel, US policy against Iran and the rivalry between Saudi Arabia and Iran.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Lebanon a score equivalent to a rating of 'B' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
- Structural features: -1 notch, to reflect governance issues and political and security risks not fully captured in the SRM, related to the delicate sectarian balance in Lebanese society and politics, spillovers from regional instability and other geopolitical risks.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that could, individually or collectively, lead to negative rating action are:
-Inability of the domestic banking sector to continue to attract sufficient deposits to keep funding the government and greater reliance on unorthodox central bank policy to help fund the government
-Inability of BdL to maintain sufficient gross FX reserves to retain confidence in the currency peg.
The main factors that could, individually or collectively, lead to positive rating action are:
-An improvement in public debt dynamics, whether through fiscal tightening or improved economic performance.
-Improved outlook for non-resident deposit inflows into the banking system
-Greater confidence in the sustainability of the domestic political environment and greater regional stability reducing risks of spillover into Lebanon.
Fitch assumes that international oil prices will average USD65/b in 2019 and USD62.5/b in 2020.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at 'B-'; Outlook revised to Negative from Stable
Long-Term Local-Currency IDR affirmed at 'B-'; Outlook revised to Negative from Stable
Short-Term Foreign-Currency IDR affirmed at 'B'
Short-Term Local-Currency IDR affirmed at 'B'
Country Ceiling affirmed at 'B-'
Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'B-'
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