November 19, 2018An Expert’s Take on Lebanon’s Economic and Financial Stability: An Interview with Dr. Marwan Barakat
Speculation is rife across Lebanon over the future of the national economy, the banking sector, and state finances. As part of its efforts to spur constructive dialogue on pressing national issues, LCPS conducted a series of interviews with economists who have varying perspectives on Lebanon’s economic, fiscal, and financial future. In this installment, we interviewed Dr. Marwan Barakat, Group Chief Economist and Head of Research at Bank Audi. He offered measured optimism concerning the state of the banking and monetary sector but notes there is a need to stimulate private investment, grow Lebanon’s export sector, and improve infrastructure across the country. We invite you to read the following transcript of the interview, which has been edited for clarity.
In recent months, Lebanese news has been dominated by rumors concerning the sustainability of the national economy. How do the economic challenges Lebanon is currently experiencing differ from the challenges of the past, both in terms of internal and external factors?
If I were to summarize the situation in a few words, I would say that the real sector of the Lebanese economy is not doing well but the banking sector remains sound and the monetary sector remains buffered.
At the level of the real sector, growth is running at a low pace of less than 2% when compared to an average long-term growth of 5% in Lebanon and compared to an average of 9% per annum in the boom era of Lebanon, i.e. in the second half of the past decade. Investment is contracting in real terms, with a delay in major investment decisions. Investors that want to open a hotel, a restaurant, or a business are simply delaying their investment decisions as evidenced by the drop in bank loans to the private sector. Unemployment is also rising, with a doubling of the unemployment rate over the past half-decade to reach more than 20% today, with almost no jobs created for the 30,000 Lebanese who join the labor force each year. Inflation is on an upward trend, moving from a rate of nearly nil in 2016 to 4.5% last year and to approximately 8% this year. The rise in inflation this year is tied to the effects of the public sector wage scale along with its tax measures and its impact on education fees, notwithstanding the effects of the upward correction in oil prices on transport costs. This suggests that the economy is close to a stagflation status (stagnation along with inflation).
At the monetary level, however, the buffers in Lebanon—or the defense lines—are still at a solid level despite the weakening economy. The first defense line is against conversions of Lebanese Pounds to foreign currencies (or monetary risk) and the second defense line guards against transfers of deposits abroad (or financial risk). Regarding the first defense line, the foreign exchange reserves at the Banque du Liban (BDL) stand at about $44 billion, the equivalent of 81% of the Lebanese Pound Money Supply, bearing in mind that under the previous stress periods—namely upon the late Prime Minister Hariri assassination in 2005 and the Israeli invasion in 2006—a maximum of 30% of LP holdings were converted into foreign currencies. Today, Lebanon is covered up to 81%, two times the average of similarly rated countries. For the second defense line, the primary liquidity of banks in foreign exchange represent more than 50% of their foreign exchange deposits. So, in the event half of depositors want to leave Lebanon and transfer their money abroad, the banks have enough liquidity at hand to meet their needs. We should bear in mind that during the 2005 and 2006 shocks, a maximum of 4% of the deposit base was transferred abroad. Therefore, in the event that shocks like those in 2005 and 2006 are repeated, Lebanon’s financial sector would be still on the safe side.
What are the three key economic variables by which you would define a crisis in Lebanon, and by which indicators would you measure them?
Early warning signals of a crisis would center on (1) a significant drop in BDL foreign exchange reserves, (2) a considerable decrease in banks deposits, or (3) a large deficit in the balance of payments. These three ingredients are not present today, despite relative uncertainties that emerged recently. BDL reserves have been hovering at close to their record high over the past few months, with quasi-stability in BDL‘s foreign assets. Deposits recorded a rise of $4.6 billion year-to-August, or a growth rate of 4.2% in annualized terms, which is still sufficient to finance the private and public sector’s economy. The balance of payments recorded a deficit of $1.1 billion over the first eight months of the year, equivalent to 2% of GDP, which is still at a manageable level. This follows a relative balance in 2017 and a surplus in 2016 driven by BDL financial engineering operations.
The long-term track of the Lebanese economy and markets reinforce the belief that the economy is governed by cyclicality. There is no reason to lose faith when the environment goes through an adverse trend and no reason to become euphoric when environment forces get relatively better. Blind optimism or enduring pessimism prove to be unfounded in an economic environment of recurring cyclicality at large. It is still important to recall that long-term bets on the Lebanese markets thus far have proved beneficial. The realized returns proved to be attractive relative to the risk premiums involved. Over the past two decades and a half, the investor who chose to bear the Lebanese exposure and risks generated on average (since 1993) 11% per annum on a Lebanese Pound Treasury bill and 8% on a US Dollar Lebanese Eurobond. These returns were certainly attractive relative to those reported in emerging markets at large, all in a Lebanese market that did not witness depreciation of the national currency or any default on behalf of the sovereign on any of its engagements (both in Lebanese Pounds or in foreign currency) over the long term.
International financial organizations repeatedly voice concern about the sustainability of Lebanon’s economic situation. If these concerns do not make clear the necessity of reform in the minds of political actors, is there a tipping point that could facilitate political collaboration on necessary reforms?
The tipping point would be reaching a situation in which Lebanon’s fiscal imbalances are so unsustainable, that Lebanon would fall in a debt trap situation. Public finances remain the most important vulnerability of the current economy. Fiscal ratios are considered quite elevated by comparative global standards, with the debt ratio of 150% today being the third-most elevated worldwide and with the deficit ratio of about 8% of GDP standing among the top decile worldwide.
As fiscal adjustment is increasingly considered a prerequisite for the resilience of the Lebanese economy and markets in the medium- to long-term, there are a growing number of questions about where the major fiscal effort must originate in an economy that has the third-highest debt ratio in the world and has a public finance deficit that falls within the top decile of deficit ratios worldwide.
There is no doubt that Lebanon’s resource mobilization (actual public revenues to GDP ratio) of about 20% over the past year is low relative to international norms (36% for advanced economies and 26% for emerging market and developing economies). This is partly explained by Lebanon having relatively lower tax rates. More importantly, this is tied to the large fiscal evasion gap that Lebanon suffers from. While it is increasingly difficult to raise taxes in a slowing real sector environment, the reinforcement of resource mobilization should come from fighting tax evasion, which is a prerequisite for any fiscal soft landing scenario for Lebanon.
As a matter of fact, we estimate Lebanon’s fiscal evasion gap at about $5 billion in 2017, the equivalent of almost 10% of GDP. Such a gap is almost equivalent to Lebanon’s budget deficit and it mainly stems from a number of taxes, such as income taxes, VAT and custom duties, EDL revenues, and property taxes.
As the state has committed to a reduction in the fiscal deficit by 5% of GDP over the next five years, bridging one-quarter of the fiscal evasion gap over that period would ensure about 50% of the fiscal adjustment target that Lebanon needs to achieve over the next half decade to enable a much-needed soft landing in its public finances, which remains the most significant vulnerability of Lebanon’s economy.
What are your top three policy recommendations for a new government?
The recent international support conferences were seemingly successful in terms of results, specifically by sending positive signals to the investor community and markets while supporting Lebanon’s financial buffers looking ahead. But this remains insufficient to move Lebanon from a period of sluggish economic growth—which the country has been experiencing for the past seven years—to a long-awaited period of economic recovery, as the latter requires structural and financial reforms that have been delayed in Lebanon and would be key to strengthening Lebanon’s economic stability in the post-international conferences period. While it’s true that the government committed to an ambitious reform agenda in Paris, the real challenge is implementing this agenda, a task which the forthcoming government will be faced with and will only be successful in if it is able to overcome the hurdles of domestic politics.
The main economic conundrum prevailing nowadays is putting an end to the cycle of sluggish growth, following an average real GDP growth of 1.8% per annum over the past seven years. What are the basic ingredients to raising real GDP growth from its current level to an average of 5% annually over the next five years necessary for the shift into a more productive and efficient economic cycle? To that end, we resorted to a simultaneous equation output model integrating a range of requirements over the next five years, which lead us to the following results.
The first challenge in terms of boosting real GDP growth concerns how best to stimulate private investments, while recognizing that investment has the largest impact on growth through the investment multiplier effect. Lebanon needs to raise the private investment to GDP ratio from 20% in 2017 to no less than 33%—after having reached 31% in 2010—to generate an average of $20 billion of private investment per annum in the next five years. Private consumption would follow, with 7% growth in private consumption per annum. This would be driven by better consumption behavior among Lebanese residents, growing incoming of Lebanese non-residents, and improving touristic activity. Investment growth would reinforce the job component of growth that calls for the creation of job opportunities to absorb more than 30,000 Lebanese who join the labor force every year. Today, the latter is among critical issues facing the country, given that the unemployment rate has doubled over the past half-decade to reach 20% today. The stimulation of private investment is linked to the improvement in the business environment through the reduction of operating costs and the improvement of the ease of doing business in Lebanon.
Second, at the external level, what is required is ensuring a 15% yearly rise in exports after the net decline in exports witnessed over the past seven years. Following significant growth in Lebanon’s trade deficit over the past seven-year period, the issue of foreign constraints comes back to the fore. This was exacerbated by consecutive deficits in the balance of payments of $9.6 billion over the past six years. It is thus essential to adopt measures that promote domestic production, i.e. stimulate import substitution goods and export oriented products in an attempt to reduce Lebanon’s trade deficit that amounts today to about 31% of GDP. It is important within this context to improve and expand the scope of existing export support programs and introduce new incentive programs and promotional campaigns targeting Lebanon’s high value added sectors with low investment to value added ratios.
Third, realizing adequate economic growth is to be met with a gradual upgrading of basic infrastructure to ensure such growth requirements. Lebanon now needs to address bottlenecks in its basic infrastructure, with significant requirements in sectors like energy, telecommunications, transport, and water. It is necessary to double the public investment in infrastructure to GDP ratio from less than 2% to more than 4% at the horizon, which is still below the average of 6% in emerging markets. The evident challenge facing the government is to ensure the functionality of necessary infrastructure, by upgrading it without putting at stake fiscal consolidation requirements. Hence, the success of the CIP is key in this respect.
What would be the role of international actors—both states and international organization—in mitigating the crisis, and under which conditions?
Members of the international community comprising states, international organizations, and financial institutions, would have a key role to play in mitigating macro pressures. At the political level, global powers and regional heavyweights—mostly governments, the UN, and the Arab League—can exert their influence and provide a political/diplomatic cushion that can serve as a basis to chart a pathway to recovery. High-level diplomacy can help viewpoints converge regarding the need to stabilize the country, especially given the massive presence of Syrian refugees in Lebanon. The international community has always shown support for the Lebanese economy and has additional reasons to continue to do so as an unstable Lebanon would risk displacing refugees who would potentially flee in large numbers toward their borders. At the economic/financial level, those states can help through granting donations or loans to the country. International reference organizations and financial institutions such as the IMF, the World Bank, and the IFC and many other funds, would therefore participate and help channel funds to Lebanon, unlocking billions of dollars when and where needed, perhaps toward specific projects. Political lobbying and high-level financial support are also likely to encourage major global investment banks to enhance their involvement in Lebanon. Last but not least, the wealthy and geographically diverse Lebanese diaspora remains apt to extend its support—especially in tough times—and channel funds toward their families and their home country.
