LEBANON ECONOMIC MONITOR 0.9375 cm DE-RISKING LEBANON Public Disclosure Authorized Fall 2018 The World Bank www.worldbank.org/lb Global Practice for Macroeconomics, Trade & Investment Middle East and North Africa Region The World Bank LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON PREFACE The Lebanon Economic Monitor provides an update To be included on an email distribution list on key economic developments and policies over for this Lebanon Economic Monitor series and the past six months. It also presents findings from related publications, please contact Nada Abou recent World Bank work on Lebanon. It places Rizk (nabourizk@worldbank.org). For questions them in a longer-term and global context, and and comments on the content of this publication, assesses the implications of these developments please contact Wissam Harake (wharake@ and other changes in policy on the outlook for worldbank.org) or Christos Kostopoulos Lebanon. Its coverage ranges from the macro- (ckostopoulos@worldbank.org). Questions economy to financial markets to indicators of from the media can be addressed to Mona Ziade human welfare and development. It is intended (mziade@worldbank.org). for a wide audience, including policy makers, business leaders, financial market participants, and the community of analysts and professionals engaged in Lebanon. The Lebanon Economic Monitor is a product of the World Bank’s Lebanon Macroeconomics, Trade and Investment (MTI) team. It was prepared by Wissam Harake (Country Economist) and Naji Abou Hamde (Economic Analyst), under the general guidance of Christos Kostopoulos (Lead Economist) and Kevin Carey (Global Practice Manager). Sameh Mobarek (Senior Energy Specialist) contributed on the energy sector. Mona Ziade (Communications Officer) is the lead on communications, outreach and publishing. The findings, interpretations, and conclusions expressed in this Monitor are those of World Bank staff and do not necessarily reflect the views of the Executive Board of The World Bank or the governments they represent. For information about the World Bank and its activities in Lebanon, including e-copies of this publication, please visit www.worldbank.org.lb 1 THE WORLD BANK TABLE OF CONTENTS PREFACE ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................... 1 EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................. 5 I. RISKIER LEBANON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................. 6 II. THE FUNDAMENTALS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................... 8 A. A Defective Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................... 8 B. The Shrinking Fiscal Space . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 1 0 C. The Need to be $-Attractive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 1 1 III. A MACRO-FINANCIAL ECONOMY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 3 A. Staggered Incentives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 3 B. Facing Post 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 5 C. Emerging Lebanon? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 1 7 D. Recent BdL Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 9 IV. SUMMING UP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 2 V. RECENT ECONOMIC DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 7 VI. OUTLOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 9 VII. A WAY FORWARD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 3 0 A. For a Fiscal Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 3 0 B. Electricity Sector: Reforms, Investment and Capacity Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 3 1 SELECTED SPECIAL FOCUS FROM RECENT LEBANON ECONOMIC MONITORS . . . . . . . . . . . . ................ 3 5 SELECTED RECENT WORLD BANK PUBLICATIONS ON LEBANON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 3 8 LIST OF FIGURES FIGURE 1. Large twin deficits have been a long-term vulnerability for Lebanon . . . . . . . . . . . . . . . . . ................... 7 FIGURE 2. Volatile GDP growth makes way to consistently sluggish output . . . . . . . . . . . . . . . . . . . . . ................... 7 FIGURE 3. Services are the main drivers of economic activity in Lebanon ... . . . . . . . . . . . . . . . . . . . . . ................... 9 FIGURE 4. … dominated by largely low productivity sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .................. 9 FIGURE 5. … biasing the economy toward large external deficits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................... 9 FIGURE 6. Long term structural deficiencies renders the Lebanese economy uncompetitive ................. 9 FIGURE 7. A large fiscal deficit is the norm for Lebanon … . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 0 FIGURE 8. … leading to one of the highest debt-to-GDP ratios in the world . . . . . . . . . . . . . . . . . . . . . . ................ 1 0 FIGURE 9. The regional crisis led to an overall worsening of the trade balance . . . . . . . . . . . . . . . . . . ................ 1 1 FIGURE 10. Exports of services has historically helped offset the large trade deficit . . . . . . . . . . . . ................ 1 1 FIGURE 11. The range of resources available to meet the balance of payments narrowed . . ................. 1 2 FIGURE 12. Lebanon’s NFA position has been under stress since 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 2 FIGURE 13. A staggered interest rate structure is the primary monetary policy tool … . . . . . . . . ................ 1 4 FIGURE 14. … that has helped attract inflows in the form of deposits into the economy . . . . ................. 1 4 FIGURE 15. Banks’ main investment has been in sovereign assets … . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 5 FIGURE 16. … with BdL instruments increasingly dominating their portfolio. . . . . . . . . . . . . . . . . . . . . . ................ 1 5 FIGURE 17. Decelerating new deposits ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 6 FIGURE 18. … induce pressure on the NFA position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 1 6 FIGURE 19. Risk premium is highest for Lebanon … . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 1 9 2 LEBANON ECONOMIC MONITOR | AN IMBALANCE OF PAYMENTS  FIGURE 20. … but interest rates along the average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 1 9 FIGURE 21. Nominal exchange rate: TRY per US$ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 3 FIGURE 22. Real exchange rate: TRY per LBP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 3 FIGURE 23. Top 5 export destinations for Lebanon + Turkey (% of Total Exports) . . . . . . . . . . . . . ................. 2 4 FIGURE 25. Average annual tourist arrivals in Lebanon (2013-2017) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 2 4 FIGURE 24. Top 5 sources of imports for Lebanon + Turkey (% of Total Imports) . . . . . . . . . . . . . . ................ 2 4 FIGURE 26. Lebanon’s & Turkey’s CDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ 2 6 FIGURE 27. Turkey + Lebanon EMBIG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................. 2 6 FIGURE 28. Net exports assumes driver role of economy after years of being a drag . . . . . . . . . ................. 2 7 LIST OF TABLES TABLE 1. Lebanon Selected Economic Indicators, 2013-2020 ................................................................34 LIST OF BOXES BOX 1. The Impact of a Currency Crisis in Turkey on Lebanon ..............................................................23 3 THE WORLD BANK 4 LEBANON ECONOMIC MONITOR | AN IMBALANCE OF PAYMENTS  EXECUTIVE SUMMARY I. Lebanon’s macro-financial conditions IV. A rise in current spending is expected to are currently under heavy scrutiny as the drive up the fiscal deficit from an exceptionally country faces increasing challenges. The risk low 6.6 percent of GDP in 2017 to a projected profile for Lebanon is rising sharply in light of 8.3 percent in 2018. Moreover, subdued GDP the convergence of a number of negative local growth and high interest payments mean that and global factors, including global monetary the debt-to-GDP ratio is expected to persist in an conditions. Meanwhile, the utility of some of unsustainable path toward 155 percent by end- the tools used by the central bank is depleting 2018. Meanwhile, inflationary pressures continue following years of application. The central bank in 2018, driven in good part by the salary scale has responded by beefing up its stock of foreign increases in 2017, a strong rebound in commodity exchange reserves, lengthening the maturity prices, especially fuel products, and a low- of deposits and limiting the liquidity available, threshold effects after 2 deflationary years. thereby inhibiting speculation against the Lebanese Pound. V. Quick implementation of Government of the Lebanon’s commitments during II. In this issue of the Lebanon Economic CEDRE—Conférence Économique pour le Monitor (LEM), we focus on Lebanon’s macro- Développement par le Réforme avec les financial conditions. We begin by explaining real Entreprises—is key in the short-term to help economy and macro-fiscal features that underpin offset declining confidence. In this regard, fiscal these conditions. We then present a synopsis on and electricity reforms are highlighted as priorities. the intertwining monetary and financial sectors, followed by an elucidation on latest macro- VI. The government presented at the financial dynamics. Naturally, the role and activity conference a Vision for Stabilization, Growth of the central bank is given particular attention. and Employment in which it pledged “a fiscal consolidation of 5 percentage points of GDP III. WB projection for 2018 real GDP growth over the next five years (i.e. one percentage is revised downwards to 1 percent. The halt point a year). This is to be achieved through in central bank subsidized lending is having a revenue measures, including improved collection significant impact on the real economy. Indeed, and a reduction of loopholes, as well as a reduction high frequency indicators—mostly based on the in spending where possible, including through a first half of 2018 (H1 2018)—point to a deceleration reduction in the government’s transfers to EdL.” in economic activity thus far in 2018 across all but the external sector—where a 7.3 percent year- VII. The government’s vision in CEDRE also on-year (yoy) rise in merchandize exports over articulated a strong reform and investment H1 2018 neutralized higher imports to leave the program for the electricity sector. This includes trade deficit minimally varied in absolute value a more efficient power generation mix, expansion (and lower as percentage of GDP). Indicators for of power generation (both preceding steps are the real estate sector, which has been the main amenable to PPPs), reductions in technical and beneficiary of these lending facilities, point to a non-technical losses, institutional and capacity contraction in the sector, with cement deliveries building reforms to modernize EdL, as well as down by 3.4 percent (yoy) in H1 2018. tariff reforms - carefully sequenced and mitigated for the poor. 5 THE WORLD BANK I. RISKIER LEBANON 1. Lebanon is once again in political 3. In the absence of a government, inertia, unable to mobilize for impending commitments made by Lebanon in CEDRE, challenges. Following a series of significant which include reforming the electricity sector achievements—including the election of a and lowering the fiscal deficit, are not able to president; passage of 2017 and 2018 budgets; progress. a fruitful donors conference in Paris (CEDRE); liberation of areas along the border with Syria 4. More urgently, a confluence of factors, that were held by ISIS and AL Qaeda affiliates; local and global, are weighing down on already and successful parliamentary elections based on fragile macro-financial conditions. Increased a new election law—there was hope that a quick local discord over governance issues are interacting formation of government would usher in a new with heightened geopolitical tensions, re-enforcing era of continued achievements. However, after internal schisms; the Syrian war and its spillovers over 100 days of political disagreements that have into Lebanon, albeit progressively more containable, prevented formation of a new government, the continue with no end in sight; the persistently positive confidence boost that was generated in sluggish economy is taking a toll on private and public the aftermath of a successful CEDRE conference balance sheets, further slowing economic activity; has waned1. In its place, a familiar reality of political rising risk premia for Lebanon is generated from discord and serious macro-financial challenges increased exposure to emerging market volatility have reassumed prominence. that is driven by global monetary conditions. 2. The potential for Lebanon to regain the 5. Macro-financial fragility stems from confidence of its people and investors is evident a frail macro-fiscal framework underpinned from recent parliamentary accomplishments. by unsustainable debt ratios and persistent In the absence of a new government, parliament and sizable fiscal and current account deficits held its first legislative session on 24 September (Figure 1), exposing the country to significant 2018, passing a bundle of important bills, in refinancing risks. Attracting sufficient capital, the first legislative session since parliamentary and in particular deposits, to finance significantly elections in May 2018. During the session, bills on larger budgetary and current account deficits e-transaction and personal data, judicial mediation, is proving challenging in light of slower deposit waste management were passed as well as some growth. This is especially so in light of rising anti-corruption draft laws on whistleblowers U.S. interest rates. Meanwhile, there is a near- protection and transparency in the oil and gas complete void of government initiative to address sector. Additionally, parliament also endorsed two macroeconomic imbalances and other structural World Bank projects, namely, Health Resilience, bottlenecks such as power generation in Lebanon. Roads and Employment, and a project preparation Instead, progressively potent interventions by the advance for Strengthening Fiscal Governance. In central bank, the Banque du Liban (BdL), to actively addition, Lebanon is likely to benefit from the manage economic and financial challenges facing recent re-opening of Syria-Jordan Nassib border the country, even when successful, offer only crossing, which was a main gateway for Lebanese temporary reprieve, and are not without additional exports into the GCC and Iraqi markets. macro-financial risks. 1 Government had yet to form by the time this publication went to print. 6 | Riskier Lebanon LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Current Account Deficit, Fiscal Deficit, 6. In this note, we focus on Lebanon’s and Public Debt (% of GDP) macro-financial conditions. We begin by 45 200 explaining real economy and macro-fiscal features 40 180 160 that underpin these conditions. We then present 35 140 (% of GDP) (% of GDP) 30 a synopsis on the intertwining monetary and 25 120 financial sectors, followed by an elucidation on 20 100 80 latest macro-financial dynamics. Naturally, the 15 60 10 role and activity of BdL is given particular attention. 40 5 20 0 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Current Account Deficit Fiscal Deficit Public Debt (rhs) FIGURE 1. Large twin deficits have been a long-term vulnerability for Lebanon Sources: BdL and WB staff calculations. Real GDP Growth (%) 12 10.1 10 9.3 9.2 8.0 8 6.3 6 3.8 3.9 3.8 4 3.4 3.2 2.7 2.8 2.7 1.7 2.0 1.7 1.5 2 1.3 0.9 0.2 0 -0.8 -2 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 FIGURE 2. Volatile GDP growth makes way to consistently sluggish output Sources: CAS and WB staff calculations. Riskier Lebanon | 7 THE WORLD BANK II. THE FUNDAMENTALS A. A Defective Growth services at 7.3 percent of GDP. All but financial services are low value-added sectors and do not Model generate high skill employment opportunities. Additionally, all but wholesale and trade of the 7. Over the past few decades, highly aforementioned sectors, lend themselves to rent- volatile and uneven growth has characterized seeking. Lebanon’s economy, partially as a result of frequent political and security shocks, but also 9. On the demand side, the economy due to structural problems. Real GDP grew on is strongly biased towards a large structural average by an estimated 5.6 percent annually from external deficit position. Lebanon’s economy 1993 to 2010, but these figures mask the impact is heavily consumption based, with private of the many shocks (domestic, international, consumption averaging 88.4 percent of GDP political) Lebanon faced over this period (Figure over the 2004-2016 period (Figure 5). The main 2). Since 2011, traditional drivers—real estate, supply-side sectors identified above—real estate, construction, finance and tourism—have suffered trade, public administration etc.—do not produce greatly from the regional turmoil. This combined the consumption goods in demand, which are with significant interruptions in governance and instead largely imported. This renders the external near-complete absence of economic reforms in sector a large net negative on output, averaging the face of large shocks led to persistently sluggish -24.4 percent of GDP over the 2004-2016 period. real GDP growth that averaged 1.7 percent Meanwhile, total investments at 23 percent of GDP annually. Additionally, it is likely that the informal has mostly been focused on a non-productive, economy has expanded in the wake of the Syria rent-seeking, real estate sector. war in a manner that might not be accounted for in the National Accounts statistics. 10. Lebanon ranks as one of the least competitive economies, both globally and 8. Lebanon’s real GDP growth has regionally. The Global Competitiveness Index decelerated sharply since 2010, but its main (GCI) by the World Economic Forum ranks Lebanon drivers have remained services characterized 105th of 137 countries, ahead of only Yemen by low productivity and low employability in the region (Figure 6). Moreover, Lebanon’s potential for high-skill labor. The service sector backslide in competitiveness has been the most constituted 72.4 percent of real GDP over the marked in the region over the past decade. The 2004-2016 period, while industry and agriculture leading drags on Lebanon’s competitiveness made up a much less 14 percent and 4.3 percent have been its macro-economic environment, a of GDP, respectively (Figure 3). Real estate is the dilapidated infrastructure and weak institutions largest service sector, averaging 13.7 percent and governance. of GDP over the same period (Figure 4), and increasing to 17.3 percent if combined with 11. As a result, the economy has struggled construction. Wholesale and retail trade is also to reduce widespread poverty and to generate a principal output for the economy, making up inclusive growth, as job creation has been 13.4 percent of GDP. This is followed by public weak and poorly distributed. The long-run, administration at 9.4 percent of GDP and financial employment-growth elasticity is estimated 8 | The Fundamentals LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Contribution to RGDP: Supply Side Contribution to Real GDP Growth: Services 20 Real Estate - Avg=13.6 % of GDP Services - Avg=72.6 % of GDP Wholesale & Retail Trade -Avg=13.5 % of GDP Industry - Avg=14.0 % of GDP 8 15 Public Administration - Avg=9.4 % of GDP Agriculture - Avg=4.3 % of GDP 7 Financial Services - Avg=7.4 % of GDP Net Taxes on Products - Avg=9.2 % of GDP 6 Transport - Avg=3.3 % of GDP 10 Real GDP Services Percent (%) 5 Percent (%) 4 5 3 0 2 1 -5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -1 -10 -2 FIGURE 3. Services are the main drivers of economic FIGURE 4. … dominated by largely low productivity activity in Lebanon ... sectors Sources: CAS and WB staff calculations. Sources: CAS and WB staff calculations. Contributon to RGDP: Demand Side 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 91/144 103/148 113/144 101/140 101/138 105/137 Public Consumption - Avg=12.9 % of GDP 20 Net Exports - Avg=-24.9 % of GDP 1st pillar: Institutions 18 Real GDP 7 Private Consumption - Avg=89.0 % of GDP 12th pillar: Innovation 2nd pillar: Infrastructure 6 15 Total Investment - Avg=23.0 % of GDP 5 13 11th pillar: Business 3rd pillar: Macroeconomic 4 sophistication environment 10 3 Percent (%) 8 2 10th pillar: Market 1 4th pillar: Health and 5 size primary education 3 0 9th pillar: Technological 5th pillar: Higher education 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017e -3 readiness and training -5 8th pillar: Financial market 6th pillar: Goods market efficiency -8 development 7th pillar: Labor market Lebanon 2017 -10 efficiency MENA FIGURE 5. … biasing the economy toward large external FIGURE 6. Long term structural deficiencies renders the deficits Lebanese economy uncompetitive Sources: CAS and WB staff calculations. Sources: WEF Global Competitiveness Report. to be 0.2 (World Bank, 2012)2, much lower Thus, and in mirroring the structure of the than an estimated MENA average of 0.5 (IMF, economy, relatively low productivity activities 2014).3 Meanwhile, the employment that has dominated employment growth, while growth been generated has been concentrated in low in productive activities such as communications, productivity activities as those involving higher agriculture and manufacturing was marginal. productivity have not grown proportionally. Over Moreover, since foreign labor dominated low the past decade or so, domestic trade accounted skilled (less productive) activities, high GDP for about 47.3 percent of all new employment, growth rates have not translated into significant public and private services for 34.7 percent and job creation for the Lebanese. construction for nearly 10 percent (ILO, 2015).4 2 World Bank (2012), “Republic of Lebanon—Good Jobs Needed: The Role of Macro, Investment, Education, Labor and Social Protection Policies”, December, Washington DC. 3 IMF (2014), Article IV Consultation and Selected Issues, July 2011, Washington DC. 4 International Labor Organization (2015), Towards Decent Work in Lebanon: Issues and Challenges in Light of the Syrian Refugee Crisis, Beirut, Lebanon. The Fundamentals | 9 THE WORLD BANK Fiscal Aggregates (% of GDP) B. The Shrinking Fiscal 5 3 0 Space 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 -3 -5 -8 Percent (%) -10 12. Lebanon’s public finances in the post- -13 war period have been structurally weak, with -15 -18 high overall fiscal deficits the norm. This has been -20 driven by below potential growth, an inability to -23 rein in waste and corruption and an exorbitant and -25 Overall Fiscal Balance Primary Balance -28 inefficient power generation sector. The decade prior to the Syrian conflict, the overall fiscal deficit FIGURE 7. A large fiscal deficit is the norm for Lebanon … ranged from 17.8 percent of GDP in 2001 to 7.5 Sources: Lebanese authorities and WB staff calculations. percent in 2010, averaging 11.7 percent of GDP over that period (Figure 7). As a result of these Gross Public Debt high and sustained deficits, Lebanon’s public 90 200 180 debt peaked at nearly 180 percent of GDP in 80 160 70 2006 (Figure 8). Between 2006 and 2010, above 60 140 Percent (%) US$ Billion 120 potential GDP growth significantly improved 50 100 40 Lebanon’s fiscal balances and pushed debt-to- 30 80 60 GDP down by about 40 percentage points (pp) 20 40 10 20 of GDP. The Syrian crisis, however, reversed this 0 0 progress pushing the public debt to 148.5 percent of GDP by end-2017. External public debt (US$ bln) Domestic public debt (US$ bln) Gross public debt (US$ bln) Gross public debt as a percentage of GDP (rhs, %) 13. Lebanon’s expenditures are characterized by large budget rigidities which FIGURE 8. … leading to one of the highest debt-to-GDP ratios in the world limit fiscal space and flexibility to react to Sources: Lebanese authorities and WB staff calculations. shocks. These expenditures are concentrated on wages, pensions, debt servicing and transfers to Electricité du Liban (EdL), the combination of 14. Low public capital expenditures have which accounted for an average of 76 percent of reduced potential growth. The absence of fiscal total spending over the past decade. The wage bill space combined with a lack of official budgets (as a share of GDP) for public sector employees between 2005-2016 have resulted in a sharp fall in Lebanon is not excessive when compared to in public spending on capital projects—these have a group of comparator countries (Le Borgne and averaged around 1.6 percent of GDP over the past Jacobs, 2016).5 Pensions, however, stand out as decade, which is significantly below comparator particularly costly, heterogeneous and highly countries. As a result, the country’s infrastructure insufficient, covering a very small minority; network and quality have deteriorated, particularly retirement and end of services compensation have transportation, water supply and electricity— averaged 2.6 percent of GDP over the past decade, services important for the population’s well-being. while hardly 2 percent of the entire population Further, low public investment in these sectors has receives a pension (including survivorship, caused capacity to lag behind demand, leading to invalidity and old-age pensions). a reduction in potential economic growth and an overall deterioration in living conditions. 5 Le Borgne, Eric and Thomas J. Jacobs (2016) Lebanon: Promoting Poverty Reduction and Shared Prosperity, Systematic Country Diagnostic, World Bank Group, Washington DC. 10 | The Fundamentals LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Exports & Imports of Goods & Services (% of GDP) C. The Need to be 100 80 $-Attractive 60 40 Percent (%) 20 0 -20 15. While structurally in a sizable deficit -40 -60 since the end of the civil war, Lebanon’s trade -80 balance further deteriorated with the eruption -100 -120 of regional turmoil. Lebanon’s exports (of goods 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 and services) have been severely afflicted by the Exports of G&S Imports of G&S Trade Balance regional turmoil, although a decline in their share of GDP has been in effect since 2008, when they FIGURE 9. The regional crisis led to an overall worsening of the trade balance reached a high of 78.1 percent of GDP (Figure 9).6 Sources: BdL and WB staff calculations. By 2017, exports regressed to a low of 36 percent of GDP, registering a bottom since 2002, with Current Account both merchandize goods and services sharing this dynamic. Exports of merchandize goods 15 have been specifically damaged by the closure 5 of the last remaining Syrian route in May 2015, % of GDP -5 through which exporters were able to access the -15 GCC and Iraqi markets. Exports of services have equally regressed since 2010, dragged by travel -25 and financial services, with the former reflecting a -35 2002-2010 2011-2017 contraction in the tourism sector and the latter a regression in banks’ strategy of regional expansion. Goods Services Income Current Transfers Current Account Imports of goods and services underwent a similar dramatic shift, falling from a high of 102 percent FIGURE 10. Exports of services has historically helped offset the large trade deficit of GDP in 2008 to a low of 60 percent in 2017. Sources: BdL and WB staff calculations. While exports and imports have imposed offsetting effects on the trade balance, the regional turmoil’s overall impact is a clear worsening of this balance; partially offset the massive trade-in-goods deficit. the trade deficit in the crisis period (2011-2017) Thus, the deterioration in the current account averaged 24.3 percent of GDP, compared to a pre- balance from pre-crisis to crisis periods can be crisis (2002-2010) average of 20 percent. attributed to a decline in the average net exports of travel services from 9.9 percent of GDP to 4.8 16. As with the trade balance, the regional percent of GDP, respectively. turmoil helped exacerbate an already sizable current account deficit from a pre-crisis (2002- 17. The economy is structurally and heavily 2010) average of 16.3 percent of GDP to an dependent on capital and financial inflows average of 20.1 percent of GDP over the 2011- to finance its current account deficit. This 2017 crisis period (Figure 10). Nonetheless, the dependence has become more acute as the current account retained its fundamental structure current account deficit expanded in recent years. over the two periods; a surplus in net exports of In addition, there have been structural shifts in services, driven by travel services, has historically the capital and financial accounts since the period prior to the regional crisis, reflecting a diminished 6 While the drop in the GDP share of exports from 2008 range of resources available for Lebanon. In the to 2010 can be attributed to a denominator-led effect of pre-crisis period (2002-2010), the main inflows exceptionally high GDP growth rates, the proceeding years were sourced from net foreign direct investments experienced a decline in the absolute value of exports. The Fundamentals | 11 THE WORLD BANK Capital and Financial Accounts Cumulative Change in Net Foreign Assets’ Position (% of GDP) 25 25 20 15 % of GDP 15 5 % of GDP 10 -5 5 -15 2002-2010 2011-2017 0 Liabilities Direct Investment -5 Portfolio Investment Assets Capital Accont Reserve Assets -10 Errors and Omissions Capital, financial plus errors FIGURE 11. The range of resources available to meet FIGURE 12. Lebanon’s NFA position has been under the balance of payments narrowed stress since 2011 Sources: BdL and WB staff calculations. Sources: BdL and WB staff calculations. (FDI) and net other investments (loans, currency operations (see section III.B). This successfully and deposits), averaging 9.8 percent of GDP and increased NFA in 2016 by US$ 1.2 billion. In 17 percent of GDP respectively, that partially 2017, however, and despite continued financial offset an accumulation in reserves asset at an engineering operations by BdL, there was again a annual average of 9.3 percent of GDP. The crisis decline in the NFA position, albeit by only US$ period (2011-2017) witnessed a sharp decline in 156 million. The decline has continued into 2018, net FDI and other investments, averaging instead falling in H1 by US$ 190 million. 3.4 percent of GDP and 13.8 percent of GDP, respectively.7 These, however, were mitigated by a slower accumulation of reserves assets, which fell to 4 percent of GDP. 18. Lebanon’s net foreign asset (NFA) position has been in a general decline since 2011. Within the context of a fixed exchange rate regime and long-term internal and external deficits, Lebanon necessitates a surplus accumulation in its NFA position on an annual basis. This was generally achieved in the pre-2011 period, with some exceptions (Figure 12). Nevertheless, a rise in the current account deficit, along with a sharp fall in FDI and other sources of inflows have resulted in a negative change in the NFA position of the economy for every year from 2011 to 2015. In order to safeguard its stock of foreign exchange reserves, and boost the NFA position, the Central Bank, Banque du Liban (BdL), initiated the first in a series of large financial engineering/SWAP 7 Interestingly, an important resource in managing this transition has been a better identification of the balance of payments, as errors and omissions fell from an average outflow of 4.5 percent of GDP in the pre-crisis period to an inflow of 0.1 percent in the crisis period. 12 | The Fundamentals LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON III. A MACRO-FINANCIAL ECONOMY 19. Throughout Lebanon’s modern history, 21. Lebanese banks attract depositors, and increasingly so since the end of civil war in primarily the large and wealthy Lebanese 1990, the banking system has been a primary diaspora, who appreciate BdL’s tight regulatory lure for capital inflows, and its sole conduit into environment that ensured a focus on traditional the economy. It led the financing of the post-civil commercial banking and minimum exposure war reconstruction efforts in the nineties and has to toxic assets. For example, a BdL-imposed been funding persistent and sizable internal and prohibition on investments in mortgage-backed external deficits ever since. Moreover, in light of securities, which were at the heart of the global regressed tourism and FDIs into the country since financial crisis in 2007-08, helped identify Lebanon 2011, banks have become the main vehicle for as a safe haven for regional capital that was fleeing capital inflows. Overseeing the banks has been an western financial institutions during the crisis. active and strong central bank, whose interventions Similarly, the stability of the system during the have been at times controversial. To understand banking crisis in neighboring Cyprus was salutary. the mechanics behind Lebanon’s macro-financial Additionally, Lebanon’s strict bank secrecy is a system, we first begin by considering the structural significant factor for some depositors (Le Borgne set up, and then proceed to elucidate more on and Jacobs, 2016, pg. 25). recent dynamics. 22. Lebanon’s banking sector enjoys a comfortable capital cushion. Banks are well capitalized and resilient owing to prudent investments and conservative regulation by BdL A. Staggered Incentives and the Banking Control Commission. The Capital Adequacy Ratio (as per Basel III requirements) was 20. The Lebanese financial system is at 16.5 percent by end-2016 (BankData, 2017)10, dominated by commercial banks, with the while commercial banks’ consolidated capital non-bank financial sector marginal and account11 has held steadily between 7 to 9 percent relatively inconsequential.8 In fact, banks’ of the total balance sheet since 2011. assets constituted 97 percent of financial system assets in Lebanon at end-2015 (WB-IMF, 2017).9 23. The main monetary policy objective for By June 2018, the balance sheet of the banking BdL has been sustaining the fixed exchange rate sector reached US$ 234 billion, equivalent to over regime at US$ 1 to LBP 1507.5, and a primary 4 times GDP, of which private sector deposits monetary tool used to achieve this objective made up US$ 173 billion. Moreover, Lebanese has been a staggered structure of interest rates. firms depend significantly on the banking sector This interest rate structure primarily involves for their financing, as 53 percent of all firms—50 three staggered clusters of rates, namely, and in percent of small firms and 63 percent of medium- increasing order of magnitude: (i) global rates— size firms—reported having received a bank loan proxied by the LIBOR; (ii) the rate paid on dollar (Le Borgne and Jacobs, 2016, pg. 43). deposits in Lebanon; and (iii) the interest rate paid on LBP deposits in Lebanon (Figure 13). 8 By end-2016, there were 67 operating banks in Lebanon, Since 2011, the margin paid on dollar deposits 50 of which were commercial and the rest investment banks (Association of Banks in Lebanon, Annual Report 2016). 10 BankData (2017), BilanBanques 2017. 9 WB-IMF (2017), Financial System Stability Analysis, January 2017. 11 The capital account is the sum of Tier 1 and Tier 2 capital. A Macro-Financial Economy | 13 THE WORLD BANK Deposit Average Interest Rate 60 Deposits at Commercial Banks (nsa, yoy %) 90 25 50 80 Deposit Average Interest Rate on US$ 70 20 40 Deposit Average Interest Rate on LBP 60 Percent (%) Percent (%) LIBOR rate (US$ 3m) 30 50 Percent (%) 15 20 40 10 30 10 0 20 -10 10 5 -20 0 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 0 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Resident deposits Non-resident deposits Total private deposits Deposit dollarization rate FIGURE 13. A staggered interest rate structure is the FIGURE 14. … that has helped attract inflows in the form primary monetary policy tool … of deposits into the economy Sources: BdL and WB staff calculations. Sources: BdL and WB staff calculations. in Lebanon vis-à-vis the LIBOR has averaged above 60 percent since the beginning of the 256 basis points (bps), while that paid on LBP millennium, registering 68.4 percent by June deposits vis-à-vis dollar deposits in Lebanon 2018. averaged 244 bps. The former margin helps attract dollars to the economy, while the latter 25. The interest rate structure and other bolsters demand and utility of the local currency. incentives have increasingly bound banks to This staggered structure is underpinned by term the public sector and ensured the inability deposits (TDs) and certificate of deposits (CDs) of other business models to compete. To offered by BdL in both LBP and US$, and bought operate profitably, banks’ chief business model by commercial banks. increasingly depended on attracting deposits to fund onward lending to the sovereign using various 24. The significance of this monetary conventional and non-conventional instruments, policy is amplified by the fact that deposits with key intermediation by BdL. High interest rates, are by far the main funding resource for a sovereign guarantee on public debt—along with banks, themselves being the sole financing a government record of never having defaulted on channel for the economy. In fact, by June 2018, public debt—and the simple business of lending the deposit-to-total liabilities ratio12 stood at 76 to the sovereign, all helped render the state the percent. A priority for the banking sector has been dominant client for banks. In fact, over half of to attract private non-resident deposits, which commercial banks’ assets have consistently been constituted 21 percent of total private deposits sovereign assets (Figure 15), primarily consisting by June 2018. Predictably, private non-resident of Treasury Bonds (TBs) in LBP, Eurobonds in US$ deposits have also been the most volatile, fleeing and various BdL instruments (Figure 16). Indeed, during times of upheaval (i.e. 2002 fiscal crisis, interest income amounted to 66 percent of total Hariri Assassination in 2005, 2006 Lebanon- consolidated banks’ income in 2015 (BankData, Israel war), and flowing in briskly during periods 2017).13 Over the years, BdL instruments have of optimism, reconstruction (post 2006 war) and increasingly become the main investment of in search of a safe haven in the 2008-09 global choice for commercial banks. As a result, large financial crisis (Figure 14). Moreover, Lebanon’s international retail banks, even ones with a economy is highly dollarized, with the deposit historical presence in Lebanon, have all together dollarization rate having remained comfortably 12 This is the ratio of total private and public-sector deposits at 13 Banks’ income figures for 2016 have been highly distorted commercial banks to commercial banks’ balance sheet. by profits reaped from the large financial engineering operation. 14 | A Macro-Financial Economy LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Commercial Banks Assets (% of total assets) 60 Bank's Assets (% of total assets) 400 120 50 350 45 50 100 40 300 35 40 250 LBP Trillions Percent (%) 80 Percent (%) Percent (%) 30 30 200 60 25 20 150 40 20 15 100 20 10 10 5 50 0 0 0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 H1 2018 Jul-10 Jan-16 Jun-11 Apr-13 Sep-08 Feb-15 Oct-07 Aug-09 Dec-05 Dec-16 Mar-14 Nov-06 Nov-17 May-12 Other Banks LBP lending to residents Banks FX lending to residents Banks soveriegn exposure TBs in LL Eurobonds Banks’ deposits in BIS banks (rhs) Deposits with BdL Balance sheet (rhs) FIGURE 15. Banks’ main investment has been in FIGURE 16. … with BdL instruments increasingly sovereign assets … dominating their portfolio Sources: BdL and WB staff calculations. Sources: BdL and WB staff calculations. abandoned the Lebanese market.14 The last such bank, HSBC, sold off its assets in Lebanon to B. Facing Post 2011 BLOM bank in August 2016. 27. Since 2011, there has been a discernable 26. In light of crowding out effects to the slowdown in deposit growth, the bulwark for private sector from the high interest rates, BdL financing internal and external imbalances. advanced incentive schemes to entice banks World Bank staff estimate that new private sector to lend to specific sectors. The 2007-2009 deposits at commercial banks since 1994 have period witnessed a surge in banks’ investments averaged around 12 percent of GDP annually, in high-yielding BdL certificates of deposits and of which new non-resident private deposits Treasury papers leading to insufficient lending averaged 3.3 percent of GDP. This, however, in Lebanese Pounds to the private sector (IMF, conceals a decidedly decelerating trend. In fact, 2012).15 In response, BdL allowed for larger between 2003 and 2010 new total (resident plus reductions in the effective reserve requirements non-resident) private deposits (D) averaged 19.2 of commercial banks, conditioned on extension percent of GDP, while new non-resident private of loans to specific sectors.16 The success of deposits (NRD) averaged 4.3 percent.17 These these incentive schemes led BdL to increase the ratios have declined sharply since, due primarily deduction ceiling on reserve requirements to 90 to the regional turmoil, and secondarily to the percent in January 2011. unsustainability of such high levels. During the crisis period of 2011-2017, D and NRD shares of GDP fell to 7.5 percent and 3.2 percent, respectively (Figure 17).18 28. In light of slowing deposit growth, reflecting decelerating capital inflows, BdL has 14 Risk management practices for international banks place substantial limits on investments in Lebanese sovereign assets, embarked on successive financial engineering precluding them from offering high enough interest rates to operations in order to reinforce the economy’s capture a sufficient depositor base. net foreign assets (NFA) position. From 2011, 15 International Monetary Fund (2012), Lebanon: Selected the economy suffered 5 consecutive years Issues, IMF Country Report No. 12/40, Washington DC. of hemorrhaging of its NFA position (Figure 16 The IMF (2012) notes that “Additional reserve requirement exemptions introduced in 2009 allowed banks to deduct 60-100 percent of a qualifying loan in LL (depending on the type of loan) 17 World Bank staff estimates. from required reserves on customer deposits, up to a ceiling of 75 percent of the reserve requirement for all qualifying loans.” 18 World Bank staff estimates. A Macro-Financial Economy | 15 THE WORLD BANK New Deposits (% of GDP) Change in Net Foreign Assets’ Position (NFAP) 25 10,000 8,000 20 6,000 4,000 US$ mln 15 % of GDP 2,000 10 0 -2,000 5 -4,000 -6,000 0 1994-2002 2003-2010 2011-2017 Change in banks' foreign assets Change in economy's NFA Total new deposits New non-resident deposits Change in BdL's foreign assets FIGURE 17. Decelerating new deposits ... FIGURE 18. … induce pressure on the NFA position Sources: BdL and WB staff calculations. Sources: BdL and WB staff calculations. 18), a unique condition and an appreciable been reinforced at the expense of banks’ foreign vulnerability for the post-war economy in currency-denominated buffers.20 Lebanon. In response, BdL initiated its first large financial engineering operation in 2016 in the 29. To offset the sharp slowdown in form of a SWAP, with the intention of attracting economic activity that ensued post 2011, inflows into the country and boosting its own BdL introduced successive and sizeable stock of foreign exchange reserves as well as stimulus packages, in the form of subsidized banks’ capital base.19 This was followed by other loans. These were in effect from 2014 to 2017. SWAPs with differentiated terms but similar According to BdL (2015),21 the principal goal objectives of reinforcing the economy’s NFA from launching the stimulus packages was “to position, and more specifically, increasing BdL’s create new job opportunities for the Lebanese stock of foreign exchange reserves. Common youth and stimulate the Lebanese economy to all operations is a type of premium offered through ensuring the necessary financing for by BdL to incentivize banks to engage in these small and medium enterprises”. The funds from SWAP operations. These operations have so far the stimulus packages were provided as soft achieved the primary objective of boosting the loans to commercial banks who on-lend the NFA position, or at the very least mitigating its funds at a subsidized rate of interest (World decline. However, this has been achieved at high Bank, 2016).22 According to BdL, as of August and increasing costs carried on BdL’s balance 2018, BdL extended a total of LBP 9,141 billion sheet, and higher exposure to macro-financial (US$ 6.1 billion), based on this scheme, to risks for the economy. Moreover, in light of banks, which subsequently lent out LBP 12,162 slowing deposit growth, a main funding source billion (US$ 8.1 billion) to the private sector. for banks to engage in these activities has been Around 59 percent of these loans were directed their holdings in foreign banks, as illustrated by toward the housing sector. Preliminary evidence a declining trend in banks’ deposits with BIS also suggests that economic activity would have banks (Figure 15). Essentially, the sovereign’s been more sluggish in the absence of BdL’s foreign currency-denominated buffers have 20 This likely also involved an improvement in the risk profile as BdL assets are invested in instruments rated BBB and above. 21 Banque du Liban, (2015), Banque du Liban Stimulus Package, 19 For more in-depth discussion of BdL’s 2016 financial Beirut, Lebanon. engineering operations, refer to: World Bank (2016), The Big Swap: Dollars for Trust, the Lebanon Economic Monitor, Fall 22 World Bank (2016), The Big Swap: Dollars for Trust, the 2016 Issue. Lebanon Economic Monitor, Fall 2016 issue. 16 | A Macro-Financial Economy LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON subsidized lending, considering the political risk (in the private or public sector)24 and (ii) paralysis, the volatile security environment and global market integration. Hence, contagion is spillovers from the Syrian conflict that Lebanon not so much a result of direct economic linkages was exposed to over this period (World Bank, between affected countries. In the case of 2016). Lebanon, while direct economic linkages between Lebanon and Turkey are not insignificant (see Box 30. BdL subsidized lending to the real 1), Turkey might only act as a regional gateway for economy via the banking sector ensured strong a wider more classical emerging market reaction flow of credit to the private sector, especially since to rising global interest rates. 2012. By June 2018, the stock of outstanding credit to the resident private sector reached 99 percent of 33. Large internal and external foreign GDP (and that to resident and non-resident private exchange financing needs subject Lebanon to sector reached 130 percent of GDP), which is by acute refinancing risk. As illustrated earlier, the no means low. The real estate sector has been the Lebanese economy is strongly a deficit economy primary beneficiaries of these loans. that depends on short-term capital inflows to finance long-term, sizable (twin) deficits. Gross public debt reached around 148 percent of GDP by end-2017, registering one of the highest ratios in the world. Over 40 percent of gross public debt is denominated C. Emerging Lebanon? in foreign currency. As a result, debt service for the government amounts to approximately 10 percent 31. Current emerging market volatility of GDP annually, consuming about half of domestic have centered around economies which revenues and driving a large overall fiscal deficit that have traditionally been dependent on capital has averaged close to 8 percent of GDP over the inflows to finance external deficits, exposing past decade. Externally, a large trade deficit leads to them to sudden stop scenarios. This dynamic is a sizable structural current account deficit, which especially relevant during times of monetary policy has averaged close to 20 percent of GDP since transition for the US FED from expansionary to 2011. In 2016, gross financing needs for the public contractionary policy, as is the case now. Indeed, sector were 30 percent of GDP, while that for the a group of emerging economies, which includes external sector (gross external financing needs) Turkey, South Africa, Argentina and Brazil, were 171 percent of GDP (IMF, 2017). This is all benefited from the search for yield in periods of under the context of a fixed exchange rate regime low global interest rates. These same economies that has been in effect for a couple of decades and are now facing refinancing pressures as global which has become a main pillar of the Lebanese interest rates pick up and international investors macroeconomic policy. deleverage risk. The depreciation of the Turkish Lira (TRY), and indeed other emerging market 34. While the above has been a long- assets, are manifestations of such conditions.23 term structural vulnerability for Lebanon, a principal buffer has traditionally been the 32. For an economy to be exposed to the economy’s relative segmentation from global above dynamic, it needs to be subject to two financial markets. This is due to the dominion main criteria: (i) foreign exchange refinancing of domestic investors—domestic commercial banks, central bank and public institutions—in the Lebanese foreign debt market. While statistics 23 The Turkish currency, which has been gradually softening against major currencies for a few years now, depreciated by over 24 Experience, such as the 2008 Great Financial Crisis, suggests 60 percent vis-à-vis the US dollar since the beginning of 2018 (as that the public sector can be forced to assume private sector of August 27, 2018, the exchange rate is 6.2 TRY to the US$). liabilities in order to prevent from systemic financial collapse. A Macro-Financial Economy | 17 THE WORLD BANK on foreign holders of Lebanese Eurobonds—the 37. If this confidence shock should only sovereign debt instrument readily accessible materialize into systemic malfunctions, the to foreign investors—are not available, we can stabilizing tools available to Lebanon are deduce relevant information residually from limited. Lebanon’s fixed exchange rate regime other data. In March 2016, domestic commercial is a central pillar for its macro-financial structure banks held US$ 18.5 billion worth of Lebanese and cannot be abandoned without a significant sovereign Eurobonds, equivalent to 73.9 percent risk of systemic financial failures. Moreover, due of Lebanon’s outstanding stock of Eurobonds.25 to Lebanon’s relatively less diversified export base The rest was split between the central bank and (small merchandise exports, non-WTO member, foreign investors. As a result, returns on Lebanese weak trade agreements), say compared to Turkey, Eurobonds were relatively uncorrelated with those it lacks the routes to an export-led adjustment. for other emerging markets’ debt instruments; the correlation coefficient between Lebanon’s EMBIG 38. Nonetheless, domestic investors and a more general emerging market composite remain an important, albeit weakened, buffer EMBIG26 using monthly observations for the period for Lebanese debt instruments, requiring a January 2012 to December 2015 was a low 0.078. reasonably high threshold intensity for the confidence shock to threaten the macro-financial 35. Increased dependence on foreign structure. Even if foreign investors of Lebanese portfolio investors to raise foreign exchange Eurobonds hold up to 45 percent of the outstanding over the past couple of years, has rendered sovereign Eurobond portfolio, this would constitute the financial sector more exposed to global less that 20 percent of Lebanon’s gross public debt. financial markets. By June 2018, domestic commercial banks still held US$ 16.1 billion 39. Other mitigating factors include a in Lebanese Eurobonds, with the proportion of captive/ home-biased depositor base, credibility the total outstanding declining sharply to 48.9 of the central bank and potential monetary percent.27 While the central bank also holds a policy discretionary space. In comparison with stock, anecdotal evidence suggests that a principal emerging market risk/return profile, Lebanon’s driver of this decline is a significant rise in the risk premium has been consistently higher, proportion held by foreign investors. Furthermore, but interest rates more around the average. As the Lebanon EMBIG-composite EMBIG correlation illustrated in Figure 19, risk premium paid on coefficient rises to 0.28 over the period January Lebanon’s Eurobonds has been significantly 2016 to August 2018. higher than that paid on emerging market debt. However, this has not been compensated for 36. As a result, global market conditions by correspondingly high interest rates (Figure have become a more important determinant 20). A number of factors work in Lebanon’s of Lebanese Eurobonds’ risk/return profile. favor. To begin with, the depositor base is Consequently, the recent normalization of global relatively captured as both resident and non- interest rates has had an impact on Lebanese resident depositors28 exhibit strong resiliency Eurobonds as indicated by a sharp rise in Lebanon’s toward political and security shocks in Lebanon. Credit-default Swap (CDS) spread (Figure 20). In addition, there is extraordinary confidence by depositors in the central bank, which has become renowned for its crisis management 25 Association of Banks in Lebanon (2016), The Economic Letter (2016), March 2016. successes (2005 Hariri assassination, 2006 war etc.). More recently, the financial engineering 26 The J.P.Morgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for traded external debt operations have helped reinforce the net foreign instruments in the emerging markets. For Lebanon, this would primarily be sovereign Eurobonds. 27 Association of Banks in Lebanon (2018), The Economic 28 Lebanese expatriates are the main constituency for non- Letter, May 2018. resident depositors. 18 | A Macro-Financial Economy LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Emerging Markets CDS: Top3, Bottom 3, and Average 14 Emerging Markets Deposit Rate 8.0 12 7.0 10 6.0 8 5.0 4.0 6 3.0 4 2.0 2 1.0 0 0.0 JAN 13 MAR 13 MAY 13 JUL 13 SEP 13 NOV 13 JAN 14 MAR 14 MAY 14 JUL 14 SEP 14 NOV 14 JAN 15 MAR 15 MAY 15 JUL 15 SEP 15 NOV 15 JAN 16 MAR 16 MAY 16 JUL 16 SEP 16 NOV 16 JAN 17 MAR 17 MAY 17 JUL 17 SEP 17 NOV 17 JAN 18 MAR 18 MAY 18 MAR 16 MAY 16 JUL 16 SEP 16 NOV 16 JAN 17 MAR 17 MAY 17 JUL 17 SEP 17 NOV 17 JAN 18 MAR 18 MAY 18 MAR 13 MAY 13 JUL 13 SEP 13 NOV 13 JAN 14 MAR 14 MAY 14 JUL 14 SEP 14 NOV 14 JAN 15 MAR 15 MAY 15 JUL 15 SEP 15 NOV 15 JAN 16 JAN 13 Sample Average Top 3 List Average (excl. Lebanon) Top 3 Bottom 3 LBN avg deposit rate (LBP) Bottom 3 Lebanon LBN avg. deposit rate in (US$) FIGURE 19. Risk premium is highest for Lebanon … FIGURE 20. … but interest rates along the average Sources: JP Morgan and WB staff calculations. Sources: Lebanese authorities, IFS and WB staff calculations. The sample group of emerging markets is sourced from Bloomberg’s The sample group of emerging markets is sourced from Bloomberg’s 2018 list of “These Are 2018’s Most (And Least) Attractive Emerging 2018 list of “These Are 2018’s Most (And Least) Attractive Emerging Markets”, and includes (listed from most to least attractive): Mexico, Markets”, and includes (listed from most to least attractive): Mexico, Turkey, Czech Republic, Poland, Malaysia, Republic of Korea, Turkey, Czech Republic, Poland, Malaysia, Republic of Korea, Hungary, Colombia, Peru, UAE, Chile, Taiwan, South Africa, Brazil, Hungary, Colombia, Peru, UAE, Chile, Taiwan, South Africa, Brazil, Russia, Thailand, Philippines, Indonesia, China and India. Russia, Thailand, Philippines, Indonesia, China and India. Plotting Lebanon’s CDS spread against (i) the sample group’s average; Plotting Lebanon’s average deposit rates in LBP and US$ against (i) (ii) the countries with the 3 highest spreads — Turkey, Russia and the sample group’s average deposit rate; (ii) the countries with the 3 Brazil; and (iii) the countries with the 3 lowest spreads — Czech highest rates — Turkey, Brazil, and India; and (iii) the countries with Republic, Republic of Korea, and Poland. the 3 lowest rates — United Arab Emirates, Hungary, and Thailand. asset position of the economy, without the has since fallen by 30 bps to reach 68.42 percent necessity of raising interest rates at a time when by June 2018. Reflecting the rush to dollarization, the risk premium was surging higher (Figure 19) private sector deposits (resident and non-resident) in and global interest rates rising. This leaves some LBP decreased by US$ 2.9 billion in the crisis month discretionary space in the form of interest rate of November 2017. increases. In fact, this seems to be the latest mitigating measures adopted by BdL, especially 41. BdL stepped in very rapidly with counter since November 2017. measures that proved critical in preventing outright outflows. In the face of the surge in demand for dollars, BdL adopted the following measures: (i) it prohibited withdrawal of fixed-term deposits prior to maturity, when prior to the crisis D. Recent BdL such withdrawals could be done anytime at a cost of foregoing an interest rate margin; (ii) it closed Responses off the discount window such that commercial banks could no longer exchange Treasury bonds 40. The Saudi-based temporary resignation they held for LBP liquidity; and (iii) it made it of PM Hariri on November 4, 2017, constituted compulsory to spot deliver LBP when exchanging a significant negative shock on confidence for into dollars, when previously, trans-actors were Lebanon’s financial markets, leading to substantial given 24 hours to meet the LBP cost. This led to exchange market pressures. A spike in dollarization an LBP liquidity crunch which sent the overnight of deposits ensued in the first few days of the crisis; interbank rate souring temporarily, reaching 150 people’s rush for dollarizing their accounts saw percent, before settling back to more normal the deposit dollarization rate increase by 145 basis single digit rates. Anecdotal evidence suggests points (bps) in November and December 2017, but that this liquidity crunch was a deliberate policy A Macro-Financial Economy | 19 THE WORLD BANK intended to deny speculators the resources with of bank runs, compared to conditions just prior which they can attack the Lebanese Pound. to November 2017, when term deposits could be withdrawn at any point prior to maturity without 42. The central bank also encouraged significant penalty. Additionally, tighter liquidity banks to offer enticing rates for longer in LBP, as mentioned earlier, limits speculation maturity deposits. Worried depositors who power against the exchange rate. inquired with banks about their holdings, or who went to banks with intentions of dollarization 44. Another achievement has been a rise or even withdrawal, were offered very enticing in the maturity profile of commercial banks’ interest rates for longer maturity, LBP- and holdings of BdL assets. In May 2018, BdL, along US$-term deposits.29 In fact, weighted average with Ministry of Finance, conducted a SWAP deposit rates in LBP and US$ rose by 85 bps operation that led to a rise in the maturity profile and 17 bps, respectively, from October 2017 to of BdL’s debt held by commercial banks. BdL’s December 2017, the largest increases since the latest financial engineering operation can be Hariri assassination in February 2005. In total, summarized as follows: from the onset of the crisis, the weighted average i. MoF swapped $US 5.5 billion in newly issued deposit rate in LBP and US$ rose by 116 bps and Eurobonds for an equivalent amount in LBP- 37 bps, respectively, to register 6.72 percent denominated TBs held by BdL. The MoF issue and 4.09 percent, by June 2018. Looking at the was in 4 different tranches ranging from 10 relative margins within the staggered interest to 16-year maturity, paying 8 to 8.25 percent. rate structure can also be telling. The LBP-US$ ii. BdL also subscribed to LBP 8250 billion deposit rate margin rose by 79 bps over the period (~US$ 5.5 billion) in new TBs issued by MoF October 2017 to June 2018, whereas, that for at 1 percent coupon rate over 2 maturities: 3 US$ deposit-LIBOR declined by 59 bps (October years and 10 years. 2017 to May 2018). Hence, tightening global iii. BdL proceeded to swap $US 3 billion of the monetary conditions have led to a 98 bps rise in $US 5.5 billion with dollar-denominated BdL the LIBOR, more than offsetting the increases in debt held by commercial banks, which were the weighted average deposit rate in US$. This maturing in 2018 and 2019. In this step, can further expose Lebanon to emerging market BdL issued instruments with a 10 to 16-year stresses, possibly driving further increases on maturity and redeemed short term debt (3 interest rates on US$ deposits in Lebanon. month to 3 years). iv. To incentivize the banks to rollover $3 billion 43. Key achievements by BdL have been a at longer maturities, for each $100 new sharp rise in the maturity profile of deposits at subscription by banks, BdL loaned banks $125 commercial banks and tighter liquidity in LBP. equivalent in LBPs at 2 percent interest rate, on The combination of higher interest rates, especially the condition that this is once again investment on LBP deposits, and restrictions on withdrawal of in BdL debt instruments at long maturity. term deposits prior to maturity, led to a sharp rise in the maturity profile of deposits. Average maturity This helped increase average maturity of banks’ on deposits have risen to 5.7 months—4 months holdings of TDs and CDs from 14.5 years to 15.5 for LBP deposits and 7 months for US$ deposits— years. compared to 45 days just prior to the November 2017 crisis, and where it had been stable for some 45. BdL also put a halt to the majority of its 20 years.30 This significantly lowers the chances subsidized lending that have been administered via the banking sector.31 This allows for further 29 Anecdotal episodes circulated that rates of up to 15 percent annually were offered for long term-deposits. 31 BdL has indicated that a primary reason for cancellation of 30 Source: BdL. these loans is improper use of these loans by some banks. 20 | A Macro-Financial Economy LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON control over liquidity. As a result of all these measures, by June 2018, gross foreign exchange reserves at BdL constituted 81.5 percent of M2 measure of liquidity.32 In theory at least, the stock of Lebanese LBP in the market can be exchanged for dollars at the fixed exchange rate. 32 M2 is composed of currency in circulation, demand deposits in LBP and term deposits in LBP. A Macro-Financial Economy | 21 THE WORLD BANK IV. SUMMING UP 46. The resultant macro-financial system has 48. A key enabler of stability over the medium developed to be a potent but brittle structure, term is a boost to Lebanon’s growth potential and any failure in any of its components can be through structural reforms and effective capital a systemic threat. Hence, no single commercial spending targeting key infrastructural projects. bank, no matter the size, can be allowed to fail and The Paris investor conference in early April 2018 default on its depositors; neither can the public presents a unique opportunity for Lebanon to sector be allowed to default on its debt, nor the effect a sustained boost to the economy, attract fixed exchange rate regime broken. Confidence by much needed capital inflows and catalyze job depositors is key to the sustainability of the whole creation. An essential component of this process structure. is the adoption and implementation of a structural reform program, including a debt management 47. BdL has successfully navigated strategy that aims to lower the public debt-to- serious challenges using conventional and GDP ratio toward a more sustainable trajectory. nonconventional tools, but risks have also risen, and the global environment is much less supportive. Beefing up its stock of foreign exchange reserves in anticipation of needed interventions in response to shocks is an important buffer. Also, controlling liquidity and lengthening the maturity of deposits is an effective inhibitor to speculation against the currency in a high-risk environment. Additionally, some room remains for interest rate increases when compared to other emerging market economies. On the other hand, the depleting utility of some tools after years of application (i.e. SWAPs, subsidized loans), along with the convergence of a number of negative factors are raising the risk profile for Lebanon. These factors include rising political and geopolitical disputes that elevate the chances of negative confidence shocks, such as the November 2017 crisis. Furthermore, global monetary conditions along with increased, albeit limited, integration into the global markets subjects Lebanon to emerging market pressures it has traditionally avoided. It is also important to note that tighter monetary conditions are likely to lead to increased deterioration in economic activity and the subsequent worsening of both private and public balance sheets, with implications on the financial sector. 22 | Summing Up LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON BOX 1. The Impact of a Currency Crisis in Turkey on Lebanon The Turkish currency has been gradually softening against major currencies for a few years now, depreciating by over 60 percent32 vis-à-vis the US dollar since the beginning of 2018 (Figure 21). Several factors are exerting pressures on the Turkish Lira (TRY), including political and geo-political factors, especially the tense relationship between President Recep Tayyip Erdogan and Western powers.33 However, global economic conditions have also been a critical determinant. Contagion effects to other economies, including Lebanon, can occur via economic linkages, which primarily include: trade of goods and services, as well as via the impact on confidence. Depending on the potency of these channels, the impact on the Lebanese economy can be (i) pseudo-simultaneous exchange market pressures, with lagged real economy effects; (ii) lagged real economy effects and balance of payments pressures; or (iii) minor ripples. We examine these effects on Lebanon. FIGURE 21. Nominal exchange rate: TRY per US$ FIGURE 22. Real exchange rate: TRY per LBP 8 0.0025 7 0.0020 6 5 0.0015 4 3 0.0010 2 1 0.0005 0 15-Aug-13 15-Oct-13 15-Dec-13 15-Feb-14 15-Apr-14 15-Jun-14 15-Aug-14 15-Oct-14 15-Dec-14 15-Feb-15 15-Apr-15 15-Jun-15 15-Aug-15 15-Oct-15 15-Dec-15 15-Feb-16 15-Apr-16 15-Jun-16 15-Aug-16 15-Oct-16 15-Dec-16 15-Feb-17 15-Apr-17 15-Jun-17 15-Aug-17 15-Oct-17 15-Dec-17 15-Feb-18 15-Apr-18 15-Jun-18 15-Aug-18 0.0000 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Sources: Factiva and WB staff calculations. Sources: Lebanese authorities and WB staff calculations. I. THE TRADE CHANNEL Trade in Goods The sharp depreciation in the TRY more than offsets higher Turkish inflation, leading to the worsening of Lebanon’s terms of trade, both directly and indirectly. As illustrated by (Figure 22), the TRY—Lebanese pound (LPB) real exchange rate (RER) has been on a rising trajectory34, boosting the competitiveness of Turkish products vis-à-vis Lebanese products. This will likely lead to a rise of Turkish imports to Lebanon at the expense of Lebanese exports to Turkey. More indirectly, and to the extent that Lebanese products compete with Turkish products in third countries, Lebanon’s exports of goods can lose global market share. The agricultural sector and agri-businesses are 33 34 35 33 This is as of September 12, 2018, where the Turkish currency approached 6.4 TRY to the US$. 34 It is interesting to note that the TRY lost about 30 percent in value against the US dollar since July 10—the date Erdogan took office for elections won in June, under new and expanded constitutional powers for the presidency. 35 When the TRY-LBP RER rises, there is an appreciation in the real purchasing power of the LBP vis-à-vis the TRY. Summing Up | 23 THE WORLD BANK FIGURE 23. Top 5 export destinations for FIGURE 24. Top 5 sources of imports for Lebanon + Turkey (% of Total Exports) Lebanon + Turkey (% of Total Imports) 14% South Africa 12% 12% 11.4% China KSA 10.6% 9.9% UAE Syria 10% USA 10% 9.2% 8.9% 8.8% Italy 8% 7.8% 8% Iraq 6.8% Germany 6.0% France 6% 6% 5.5% Turkey Turkey 3.7% 4% 3.9% 4% 2% 2% 0% 0% 2013-2017 2013-2017 Sources: Lebanese Customs and WB staff calculations. Sources: Lebanese authorities and WB staff calculations. likely to be of the most affected due to relative substitutability between Turkish and Lebanese products in these sectors, as suggested by the close culinary cultures and related raw materials. As an indicator of the importance of these sectors, agricultural, animal and food products constituted an average of 22.6 percent of Lebanon’s total annual merchandise exports and 16.8 percent of its imports over the period 2013-2017. Turkey is a moderately significant trading partner for Lebanon’s merchandise. In fact, Lebanese exports of goods to Turkey averaged around US$ 120 million annually over the 2013-2017 period, constituting 3.7 percent of Lebanon’s total merchandise exports (Figure 23), and making Turkey the 6th destination for Lebanon. Main products exported to Turkey are agricultural and food products, as well as non-capital goods equipment. On the other hand, and over the same period, Turkey ranks as the 8th main source for Lebanon’s merchandise imports, exporting to Lebanon an average of US$ 787 annually, which constitute 3.9 percent of Lebanon’s total imports of goods (Figure 24). Lebanon’s top imports from Turkey are agricultural and food products, textiles, non-metallic products and capital goods. FIGURE 25. Average annual tourist arrivals For both Lebanon and Turkey, energy imports in Lebanon (2013-2017) compose a sizable portion of the trade deficit. That vulnerability is currently deteriorating more Iraq (197,133) sharply for Turkey, where the float induces France (136,634) depreciation against dollar-denominated USA (135,662) Canada (89,875) energy prices, accelerating price increases. Jordan (81,314) While Lebanon does not have the exchange rate 2013-2017 Germany (77,642) Egypt (74,780) exposure to energy prices given the dollar peg, Australia (60,257) it will feel pressures via other conduits, such as UK (56,257) KSA (47.848) higher import volumes (since the price adjusts Turkey (23.260) by less) and currency overvaluation due to the 0 50,000 100,000 150,000 200,000 250,000 lack of exchange rate flexibility. Sources: Ministry of Tourism and WB staff calculations. Despite the above, Lebanon’s balance of payments position is likely to be impacted only marginally and with some lag. With the 24 | Summing Up LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON trade in goods deficit amounting to over US$ 14 billion (2017), equivalent to almost 27 percent of GDP, a deterioration by an extra percentage point (pp) or two is only a marginal worsening. Trade in Services: Tourism Tourism is not an effective channel of economic contagion from the TRY crisis to Lebanon as the country is not a main destination for Turkish tourists. Turkish visitors to Lebanon constituted an average of only around 0.5 percent of total visitors over the period 2013-2017. This compares to Iraqis who comprised 12.8 percent of all tourists visiting Lebanon, followed by French (8.9 percent) and Americans (8.8 percent) (Figure 25). Trade in Services: Financial Services The Lebanese financial sector is exposed to the Turkish economy via the presence of two large Lebanese banks: Audi Bank and Bank Med. The former is a majority shareholder (76 percent of shares) for Odea Bank, while Bank Med owns 50 percent of Turkland Bank. Odeo bank comprised about 16 percent and 13 percent of Bank Audi’s assets (by June 2018) and net profits (over H1- 2018), respectively. By end-2017, almost 8 percent of BankMed’s assets were in Turkland Bank, with the latter reporting a net operating loss in 2017. Audi and BankMed are both systemic banks and any significant erosion of their capital base will likely require interventions by the Lebanese Central Bank. Audi is in fact Lebanon’s largest bank in terms of assets, raising the likelihood of recapitalization in case of significant damage to its capital. This will add to BdL’s already intensive and costly interventions (financial engineering operations). II. CONFIDENCE CHANNEL Turkey has traditionally been dependent on inflows to finance external deficits, exposing its economy to sudden stop scenarios, especially during times of monetary policy transition for the US FED from expansionary to contractionary policy. Indeed, Turkey was part of a group of emerging economies, which also included South Africa, Argentina and Brazil, that benefited from the search for yield in periods of low global interest rates. The downside is that these are main characteristics of economies which would face refinancing pressures as global interest rates pick up and international investors deleverage risk. This is a main dynamic behind the current depreciation of the TRY, and indeed other emerging market assets. More global integration for Lebanon’s debt market means higher correlation with emerging market assets. The recent normalization of global interest rates has had an impact on Lebanese Eurobonds as indicated by a sharp rise in Lebanon’s Credit-default Swap (CDS) spread (Figure 26) and a higher correlation with Turkish debt instruments (Figure 27). If a confidence shock should materialize into systemic failures, the stabilizing tools available to Lebanon are limited compared to those available to Turkey. The floating TRY acts as a shock absorber, compared to Lebanon’s fixed exchange rate regime that is a principal pillar for its macro- Summing Up | 25 THE WORLD BANK FIGURE 26. Lebanon’s & Turkey’s CDS FIGURE 27. Turkey + Lebanon EMBIG 8 800 Lebanon CDS Turkey CDS EMBIG Turkey EMBIG Lebanon 7 700 EMBIG Composite 6 600 5 500 4 400 3 300 2 200 1 100 0 0 May-14 May-16 May-17 May-18 Nov-13 Nov-14 Nov-16 Dec-13 Mar-15 Dec-15 Mar-16 Dec-17 Mar-18 Aug-13 Aug-14 Aug-16 Aug-18 Oct-14 Sep-13 Sep-15 Oct-15 Oct-17 Feb-14 Apr-14 Apr-15 Feb-16 Sep-16 Feb-17 Apr-17 Sep-17 Jun-15 Jun-16 Jun-18 Jan-15 Jan-17 Jan-18 Jul-14 Jul-15 Jul-17 May-17 May-17 May-18 May-18 Nov-17 Nov-17 Mar-17 Dec-17 Dec-17 Mar-18 Mar-18 Aug-17 Aug-17 Aug-18 Aug-18 Oct-17 Oct-17 Sep-17 Sep-17 Sep-17 Apr-17 Apr-17 Feb-18 Feb-18 Apr-18 Apr-18 Apr-18 Jun-17 Jun-17 Jun-17 Jun-18 Jun-18 Jan-18 Jan-18 Jan-18 Jul-17 Jul-17 Jul-18 Jul-18 Jul-18 Sources: JP Morgan and WB staff calculations. Sources: JP Morgan and WB staff calculations. financial structure. Moreover, due to Lebanon’s much less diversified export base compared to Turkey (small merchandise exports, non-WTO member, weak trade agreements), it lacks the routes to an export-led adjustment that Turkey clearly has (large industrial base, WTO membership, customs union with EU, growing integration with Caucasus/ Central Asia). 26 | Summing Up LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON V. RECENT ECONOMIC DEVELOPMENTS 49. Following the Hariri resignation crisis in low 6.6 percent of GDP in 2017 to a projected November 2017, BdL abruptly siphoned off its 8.3 percent in 2018. Moreover, subdued GDP subsidized lending that was being channeled growth and high interest payments mean that via the banks to the real estate sector, providing the debt-to-GDP ratio is expected to persist in an a rare source of growth impetus since 2012. As unsustainable path toward close to 155 percent such, WB projection for 2018 real GDP growth is by end-2018. revised downwards to 1 percent, from a previous forecast of 2 percent. 52. CDS and EMBIG spreads, indicators of risk premium, are at elevated levels, surpassing 50. Indeed, high frequency indicators— those registered in November 2017 (Figure mostly based on H1 2018—point to a deceleration 19). This is being driven by foreign deleveraging in economic activity thus far in 2018 across all from Lebanese assets due to political (lack of but the external sector, where a 7.3 percent year- government), geopolitical (Iran, Syria tensions) on-year (yoy) rise in merchandize exports over and emerging market pressures. In response, BdL H1 2018 neutralized higher imports to leave the financial engineering continues, with the latest trade deficit minimally varied in absolute value being a SWAP of TBs held by BdL with newly (and lower as percentage of GDP). Meanwhile, MoF-issued Eurobonds in the amount of US$ tourist arrivals rose by 3.3 (yoy) in H1 2018, while 5.5 billion, around US$ 3 billion of which were marking a sharp deceleration compared to 14.2 subsequently sold (along with enticements) to percent growth in H1 2017. Hence, whereas banks. The main objective of this operation was private consumption has traditionally led real to raise BdL’s foreign exchange (Forex) reserves, GDP growth, net exports are expected to be the which reached around US$ 44 bln by end-June, main driver in 2018 for the second year running.36 equivalent to about 15 months of imports of goods On the other hand, real estate indicators also and services, compared to US$ 42 bln at end-2017. point to a contraction in the sector, with cement Nonetheless, this primarily is driven by BdL’s deliveries down by 3.4 percent (yoy) in H1 2018 cache of government Eurobonds, which it began (Figure 28). Structurally, the economy remains counting as part of its forex stock since November heavily based on services (especially real estate, 2017. That is, while the stock of foreign currencies retail and financial services) and oriented towards 9 the region, rendering it vulnerable to volatility in 8 7 growth and sizable macroeconomic imbalances. 6 5 4 3 51. In 2018, the lack of an exceptional tax Percent (%) 2 1 windfall (generated in 2017 from large banking 0 -1 sector profits reaped from financial engineering -2 -3 operations in 2016), are expected to be offset by -4 -5 the full impact of additional revenue measures -6 -7 introduced by the salary scale reforms. The -8 2013 2014 2015 2016 2017 e 2018 f latter will nonetheless increase current spending Private consumption Government consumption Net exports Statistical discepancy Gross fixed capital formation GDP driving up the fiscal deficit from an exceptionally FIGURE 28. Net exports assumes driver role of economy after years of being a drag 36 The recent re-opening of Syria-Jordan Nassib border crossing Sources: CAS and WB staff calculations. will positively impact Lebanese exporters. Recent Economic Developments | 27 THE WORLD BANK at BdL decreased by US$ 2.7 bln over H1 2018, its stock of foreign-denominated securities increased by US$ 4.8 bln. 53. Inflationary pressures are persisting in 2018. The 12-month headline inflation rate averaged a 6.2 percent (yoy) over 7M-2018, in good part due to the salary scale increases in 2017, a strong rebound in commodity prices, especially fuel products and a low-threshold effects after 2 deflationary years. Meanwhile, the halt in BdL subsidized loans has had a palpable impact on lending activity; commercial banks’ total credit to private sector increased by only 1.9 percent (yoy) in June 2018, compared to a growth of 8.4 percent (yoy) in June 2017. 28 | Recent Economic Developments LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON VI. OUTLOOK 54. The regional turmoil, especially the war 58. The Lebanon Economic Monitor has in Syria, continues to impose a security risk continuously urged the implementation of a premium for Lebanon, despite diminution structural reform program, identifying essential of the prospect of violence. A key assumption short-term and medium-term reform measures.37 underlying projections for the Lebanese economy We have also indicated that interventions by the regards the Syrian conflict and its spillovers. central bank, even when successful, offer only World Bank staff projections assume that current temporary reprieve, and are not without additional conditions hold, i.e., spillovers continue to be macro-financial risks. This has been corroborated contained without precluding the occurrence of by the heightened macro-financial risks over the occasional serious security events. Moreover, in past year, and the increased susceptibility to future light of robust inflation and heightened macro- shocks. The government’s commitments in Paris financial risks, we assume continued monetary to a number of important reforms is an important tightening. first step, but ultimately effective implementation is key. Building on that, the commitment to and 55. Lack of obvious sources for an economic implementation of a more comprehensive and boost suggests Lebanon’s medium-term integrated medium-term reform roadmap would economic prospects remain sluggish remaining be an essential boost to confidence, which is also below 2 percent annually. much needed in the short term. 56. World Bank fiscal projections do not assume implementation of Lebanon’s commitment in Paris to an annual 1 pp decline in the fiscal deficit ratio over the next 5 years, and as such, Lebanon’s public finances are projected to remain structurally weak. Debt servicing is expected to continue rising due to pass through from higher global interest rates, while rising oil prices will reflect on transfers to EdL. Meanwhile, government revenues are unlikely to improve significantly. As a result, and despite the return of positive inflation, the trend for the debt-to-GDP ratio based on current policies and real GDP growth rates remains unsustainable and is expected to notably worsen as global interest rates continue rising. 57. Externally, the current account deficit is expected to moderate somewhat due mainly to suppressed imports, as slow economic growth is weighed down by monetary tightening. 37 World Bank (2017), ‫ﻟﻜﻢ‬ ‫ﻧﺪاؤﻧﺎ‬, the Lebanon Economic Monitor, Spring 2017 issue. Outlook | 29 THE WORLD BANK VII. A WAY FORWARD 59. A critical first step is the formation of a new government, upon which, the risk premium A. For a Fiscal Strategy for Lebanon would likely improve quickly. This can relieve some of the burden placed on 62. The Government of the Lebanon (GoL) the central bank. Ultimately, structural solutions committed during CEDRE to an ambitious are the prerogative of the political authority as fiscal consolidation program. The government enshrined in the executive branch of government. presented at the conference a Vision for Stabilization, Growth and Employment in which 60. A new government is essential to take it pledged “a fiscal consolidation of 5 percentage advantage of the unique opportunity offered points of GDP over the next five years (i.e. one by the CEDRE conference, which can help percentage point a year). This will be achieved effect a sustained boost to the economy, attract through revenue measures, including improved much needed capital inflows and catalyze job collection and a reduction of loopholes, as well as creation. The World Bank Group (WBG) has a reduction in spending where possible, including favorably assessed Lebanon’s capital investment through a reduction in the government’s transfers plan that was presented in the Paris conference. to EdL which exceeded 4 percent points of GDP in The WBG Assessment generally finds that the recent years, as part of a broader effort to improve choice of sectors is appropriate for a Capital cost recovery in infrastructure services.” Investment Plan (CIP) for Lebanon, and that many of the listed projects are relevant, indeed, 63. To realize this necessary commitment, some are critical, to help alleviate infrastructural the following strategy is suggested: bottlenecks. Nonetheless, the Assessment also notes that implementation of projects, which has a. GoL should embark on a comprehensive traditionally been a challenge in Lebanon, is key. reforms, investment and capacity building To enable the CIP, the WBG Assessment proposed program for the electricity sector, with the a set of horizontal and vertical reforms, to which objective of bringing EdL to cost recovery in the government’s CEDRE commitments converge. the medium term (See Section VIIB). 61. Fiscal reforms and re-structuring b. To increase the likelihood of success, of the power generation sector have been transparency and confidence in the continuously highlighted as critical short- government’s fiscal reform program can be term initiatives. Low credibility in government solidified early on via a formal adoption of is such that an announced commitment alone is a fiscal rule with the following suggested insufficient. Implementation is needed. contours: i. Any increase in power supply from new power generation output would be matched by a commensurate rise in the average tariff; ii. All savings generated from electricity reforms would be directed at the budget deficit; iii. New current primary spending would replace existing non-EdL related current 30 | A Way Forward LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON primary spending, so as to be deficit through borrowing, rendering the electricity sector a neutral and not require new resources. principal determinant of Lebanon’s debt burden. This achieves the following objectives: (a) to prevent a widening of the fiscal 66. Underlying the fiscal burden of the power deficit, and (b) to increase efficiency of sector in Lebanon is a high cost structure for current expenditures by incentivizing power production combined with shortcomings the elimination of less effective transfer on the revenue side. In a comparison of 14 programs; and countries in the MENA region, Lebanon ranked iv. Capital expenditures to be financed from last in terms of the power sector’s quasi-fiscal soft loans, an opportunity presented by deficit (QFD), with a QFD of 8.9 percent, worse CEDRE. than Sub-Saharan African countries. This is driven by both cost and revenue factors. On the cost c. GoL to identify and cut wasteful and inefficient side, more expensive and polluting diesel fuel is spending; used at existing dual-fired combined-cycle gas- fired (CCGT) power plants. On the revenue side, d. GoL to streamline tax administration based on technical and non-technical losses in distribution a progressive revenue generating mechanism. and transmission can reach 40 percent. Moreover, electricity is significantly underpriced, with tariffs e. GoL to articulate a debt-management strategy largely unchanged over the last 20 years. that is consistent with the above. 67. These challenges were further exacerbated by a huge influx of refugees resulting from the ongoing conflict in Syria. The number of displaced Syrians in Lebanon is B. Electricity Sector: estimated at 1.5 million, representing more than 30 percent increase in the country’s population Reforms, Investment in a relatively short period. The United Nation’s Development Program (UNDP) estimates that and Capacity Building government transfers to EdL to cover the costs of electricity provided to the displaced totaled 64. Deficiencies in the power sector have approximately US$ 1 billion during the 2012-2016 long had an economy wide bearing, with direct period. UNDP further estimates that increased implications on Lebanon’s growth potential, the electricity demand from Syrian refugees amounted economy’s competitiveness and productivity, to 486 MW, which absorbed much of the new household and firm welfare, the country’s generation capacity added to EdL’s system over balance of payments and its precarious the past decade. fiscal position. 68. The power sector also represents a 65. Electricité du Liban (EdL), the national major handicap for Lebanon’s productive utility company, imparts a staggering burden on sector. Despite extensive subsidies, EdL is unable Lebanon’s public finances. Government transfers to to provide a reliable 24/7 supply of electricity EdL averaged 3.8 percent of GDP from 2008 to 2017, services, resorting to rolling blackouts of 3-18 amounting to about half of Lebanon’s fiscal deficit. hours per day. Recent World Bank surveys also At their peak in 2012 and 2013, the government indicated that availability of reliable electricity in transferred around US$ 2 billion per year to EdL. Lebanon is the second biggest obstacle to private As the overall fiscal balance has been in deficit sector growth, after political instability. Almost since 1992, EdL transfers have been effectively paid all firms run private generators at considerable additional expense. A Way Forward | 31 THE WORLD BANK 69. Any subsidy reform process in Lebanon b. Power generation cost structure to be reduced will require a coordinated and very carefully by: sequenced action in three areas. First, while i. Construction of LNG infrastructure under tariffs clearly need to move on an upward PPP arrangements as part of the strategy trajectory, the magnitude of the current disparity to adopt a less costly source of energy for between prices and costs cannot be eliminated power generation, which would reduce overnight. Second, there is a need to adopt electricity generation costs; aggressive cost-reduction measures to reduce ii. Transportation infrastructure will be gross inefficiencies in generation as well as restructured for the optimal transportation transmission and distribution, to bring the cost of gas and fuel to the power plants. recovery benchmark down to a more reasonable iii. The transmission network infrastructure level. Third, raising tariffs in a context where will be improved to secure vital quality of electricity service is so inadequate risks requirements for the efficient and a strongly adverse social reaction. Measures successful operation of the distribution to improve the quality and reliability of supply service providers. will need to be an integral element of subsidy reform so that willingness to pay for EdL service c. Electricity tariffs will be adjusted with a increases over time. view to reduce EdL’s financial losses. In the short term, the increase will be limited to 70. Sequencing is of utmost importance. the equivalent of the reduction in the cost Electricity tariffs cannot be increased until of private generation that results from the residents, who are already heavily burdened by additional EdL supply. a high electricity bill (private and public), first experience an improvement in the public utility’s d. Establishing a regulatory authority to regulate power supply that can allow them to lessen their the sector with a view to update Law 462 dependence on private generation. Moreover, (2002); reductions in technical and non-technical losses are a major prerequisite for the tariff increases. e. Modernizing EdL’s operations and internal systems to make it a well-established 71. Given the significant impact the power company with an assigned Board. The sector has on Lebanon’s economy, the GoL Board must overview EdL’s functions based committed during CEDRE to undertaking on commercial foundations and create the important reforms in the sector. In the necessary framework for activities related to government’s Vision for Stabilization, Growth generation, transmission and distribution; and Employment, power sector reforms and modernization initiatives are central. These reforms f. The status of the contracted employees within include the following package of measures: EdL will be settled in order to secure EdL’s operation and sustainability. a. Power generation to be enhanced by: i. The construction of new power plants in partnership with the private sector under an independent power producer (IPP) arrangements enabled by the PPP law; ii. Construction of photovoltaic and wind power facilities under PPP arrangements as part of the objective to diversify to clean energy; 32 | A Way Forward LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON 72. Implementing the Government’s Vision in the electricity sector over the next 4 years is vitally important to materially shift the sector’s current cost trajectory. In the short-term (1-2 years), reducing EdL’s fuel costs and its technical and non-technical losses on the distribution network are key priorities. In the medium-term (3-4 years), increasing EdL’s electricity supply, through expansion of both thermal and renewable energy generation capacity, are important. In the long-term (>4 years), EdL modernization is key to ensuring the utility’s health and stability to operate the sector in the future. 73. It is important to note, however, that the timeframes needed to implement these priorities require that they be commenced now to address the burdens on the country’s broader economic and fiscal performance within a reasonable time. These priorities also need to be pursued in parallel, rather than in sequence. Procuring, financing and installing marine LNG infrastructure for example, typically requires at least 2 years to complete; thermal power plants require 3-4 years to complete; and EdL modernization is likely to require at least 5-6 years. A Way Forward | 33 THE WORLD BANK TABLE 1. Lebanon Selected Economic Indicators, 2013-2020 2013 2014 2015 2016 2017 2018 2019 2020 Est. Est. Est. Est. Proj. Real sector (annual percentage change, unless otherwise specified) Real GDP 2.7 2.0 0.2 1.7 1.5 1.0 1.3 1.5 Real GDP per Capita /1 -4.3 -4.0 -4.0 -0.9 0.3 -1.6 -1.3 -1.1 Agriculture (share of GDP) 3.7 4.2 3.6 3.8 4.2 4.2 4.2 4.2 Industry (share of GDP) 14.5 13.7 12.9 12.7 13.0 13.7 14.0 14.1 Services (share of GDP) 71.8 72.2 73.1 72.6 74.8 74.1 73.8 73.7 Net indirect taxes (share of GDP) 10.0 9.9 10.4 11.0 8.0 8.0 8.0 8.0 Money and prices CPI Inflation (p.a) 2.7 1.2 -3.7 -0.8 4.5 5.0 1.0 1.0 Money (M3, including non-resident deposits) 9.0 6.0 5.1 7.3 4.2 8.5 8.0 8.0 Investment & saving (percent of GDP, unless otherwise specified) Gross Capital Formation 27.5 23.9 21.2 20.8 20.0 18.5 19.0 19.9 o/w private 25.7 22.3 19.8 19.4 18.6 17.1 17.5 18.4 Gross National Savings 1.7 -2.1 4.1 0.5 -3.2 -2.9 -1.0 0.7 o/w private -0.2 -4.0 -0.4 -4.1 0.8 4.0 6.3 8.4 Central Government Finance (percent of GDP, unless otherwise specified) Revenue (including grants) 20.3 22.4 19.2 19.3 21.7 21.5 21.5 21.5 o/w. tax revenues 14.4 14.2 13.7 13.7 15.3 15.1 15.1 15.1 Total expenditure and net lending 29.3 28.6 26.9 28.5 28.3 29.8 30.4 30.7 Current 27.5 27.1 25.5 27.1 27.0 28.4 28.8 29.2 o/w Interest Payment 8.2 8.6 8.9 9.3 9.3 9.7 10.0 10.3 Capital & Net Lending (excluding foreign financed) 1.8 1.5 1.4 1.4 1.4 1.4 1.5 1.5 Overall balance (deficit (-)) -9.1 -6.2 -7.7 -9.2 -6.6 -8.3 -8.9 -9.2 Primary Balance (deficit (-)) -0.9 2.4 1.2 0.0 2.7 1.4 1.1 1.1 External sector (percent of GDP, unless otherwise specified) Current Account Balance -25.8 -26.0 -17.0 -20.4 -23.2 -21.4 -20.0 -19.3 Trade Balance -28.7 -29.7 -22.9 -23.5 -24.5 -23.2 -22.6 -22.5 o/w Export (GNFS) 45.0 39.7 39.7 37.1 35.8 36.6 36.8 36.9 Exports of Goods 11.2 9.4 8.0 7.7 7.5 8.2 8.4 8.5 Exports of Services 33.8 30.3 31.7 29.4 28.2 28.4 28.3 28.4 o/w Import (GNFS) 73.7 69.4 62.6 60.6 60.2 59.8 59.4 59.4 Imports of Goods 45.7 42.1 35.2 34.8 34.4 34.2 34.0 34.0 Imports of Services 28.0 27.2 27.4 25.8 25.8 25.6 25.4 25.4 Net private current transfers: 3.4 4.9 6.8 4.8 2.3 2.9 3.6 4.2 Remittances 5.0 5.8 7.2 6.6 5.1 4.6 4.7 4.9 Net Income reciepts -0.6 -1.2 -0.9 -1.6 -1.0 -1.2 -1.0 -1.0 Capital Accounts 0 0 0 0 0 0 0 0 Gross Reserves (months of imports GNFS) /2 /3 11.7 13.1 13.8 15.2 15.6 17.0 16.9 15.6 Total Public Debt Total Debt Stock (in million US$) 63,490 66,564 70,325 74,900 79,539 84,025 88,918 94,144 Debt-to-GDP ratio (percent) 136.6 137.2 140.9 145.5 148.5 154.6 161.1 165.7 Memorandum Items: Nominal GDP (in billion LBP) 70,056 73,151 75,240 77,612 80,767 81,918 83,205 85,650 Exchange Rate, Average (LBP/US$) 1,507.5 1,507.5 1,507.5 1,507.5 1,507.5 1,507.5 1,507.5 1,507.5 GDP (in million US$) 46,471 48,525 49,910 51,484 53,577 54,341 55,194 56,816 Source: Government data, and World Bank staff estimates and projections. /1 Population figures, which include Syrian refugees registered with the UNHCR, are taken from the United Nations Population Division /2 Gross Reserves (months of imports GNFS) = (Imports of Goods & Services / Gross Res. excl. Gold)*12 /3 Total Imports using the BOP data from the Quarterly Bulletin of BDL 34 | A Way Forward LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON SELECTED SPECIAL FOCUS FROM RECENT LEBANON ECONOMIC MONITORS engines for job growth. To ensure adequate SME SPRING 2017 LEM: access to finance and stimulate economic activity, the Banque du Liban (BdL) has established a A CALL FOR ACTION number of schemes. The Special Focus reviews SMEs’ role in Lebanon’s activities and outlines Priority Reforms for the Government of Lebanon the various BdL policy interventions in the real (Special Focus): The end to the long political economy. The preliminary findings suggest that stalemate offers Lebanon a unique window of the real estate sector was the largest recipient of opportunity to mitigate impending risks and tackle subsidized lending by BdL and that the proportion longstanding and, by now, pressing development of subsidized funds channeled to SMEs continues to challenges. The sense of urgency is reinforced be modest. Nonetheless, the preliminary evidence by rising macroeconomic risks and a palpable suggests that, with the existing political paralysis, deterioration in the quality of public services a volatile security environment and spillovers from and institutional performances. This has been the Syrian conflict, economic activity in Lebanon compounded by the Syrian war and the massive would have been more sluggish in the absence of influx of refugees, taking a toll on the economy BdL’s policy interventions. These interventions, and placing added strain on Lebanon’s education, however, come at a cost born by BdL, which are health, municipal and other sectors. This Special difficult to quantify but have possible implications Focus presents a menu of reforms that would enable on long-term monetary policy. the country to rapidly and significantly turn the page of inaction and decline and return the country to a prosperous and inclusive development path. SPRING 2016 LEM: To that end, reforms are prioritized over two time horizons—the short term, allowing for initiative A GEO-ECONOMY OF by the present government to establish a record of achievements and government credibility that RISKS AND REWARD is currently sorely absent, and the medium term for more comprehensive and systemic reforms, Industrial Parks and Special Economic Zones which can alter Lebanon’s fundamentals toward in Lebanon (Special Focus 1): Lebanon’s sustainable and inclusive development. industrial sector in Lebanon has lagged, both on a regional and global comparative basis. Lebanon’s macroeconomic structure, being FALL 2016 LEM: THE BIG heavily dependent on tourism and real estate at the expense of industry and agriculture, SWAP: DOLLARS FOR renders the economy vulnerable to political and economic shocks. In this context, Lebanon needs TRUST to focus on its industrial potential and provide solutions to the numerous constraints hindering Central Bank Intervention in the Lebanese its industrial establishments from functioning at Economy (Special Focus): Small and Medium their full capacity. One possibility to strengthen Enterprises (SMEs) occupy a central role in the the industrial sector is via spatial industrial Lebanese economic landscape and are primary policies, most notably, industrial parks and special A Way Forward | 35 THE WORLD BANK economic zones (SEZs), which support increased endures systemic failures. Institutionalized investment and competitiveness in the industrial confessionalism intended as protection for the sector. Special care should be allotted to fiscal mosaic of communities in a country that lacks incentives which evidence suggest are ineffective a demographic majority has developed into and might instead lead distortions such as the pervasive elite capture and patronage system. This relocation of existing businesses to the zones elite commands the main economic resources, rather than the establishment of new business. generating large rents and dividing the spoils of Under suitable conditions, industrial zones a dysfunctional state. In the process, the public have proven successful in various locations and sector has become increasingly governed by industries across the world which make them an bribery and nepotism practices, failing to deliver attractive tool in Lebanon. basic public services and incapable of resolving the most urgent needs. This has culminated in Tech Startup Ecosystem: The Case of Lebanon the comprehensive breakdown in the political (Special Focus 2): A new wave of entrepreneurship process, with the three branches of government driven by small digital businesses is sweeping both either vacant or effectively idle, and the only developed and emerging economies. Information national plebiscite abrogated. This has triggered a and Communications Technology (ICT) has series of protests and civil disobedience measures dramatically reduced the cost of innovation and targeting the ruling political class with emphasis on market access, allowing small tech entrepreneurs corruption and incompetence. Current conditions to compete with established businesses. Today, are unsustainable, and without significant political a startup can be created with just a laptop and and economic reforms, a widening and worsening Internet connection. This has led to the surge of socio-economic unrest is not unfathomable. of tech startup ecosystems worldwide, where communities of entrepreneurs interact. Lebanon Lebanon’s Health Sector: Modest Reforms despite in particular can benefit from this phenomenon, the Challenges (Special Focus 2): This special particularly for job creation. Tech startup founders focus provides an overview of the health sector are predominantly young and have a college in Lebanon and highlights both successes and degree, generating employment for educated challenges facing the system. Lebanon’s trends youth. The innovation that startups generate also in health outcomes, inputs and spending are helps make the tech sector more dynamic and analyzed over time and compared to a number of sustainable. Lebanon’s tech scene is becoming countries with similar levels of income and health increasingly attractive driven by the example of spending, as well as to the averages for the Middle successful startups that have tapped regional and East and North Africa (MENA) region. Global global markets and the innovative initiative by comparisons are presented for each of these the country’s central bank in facilitating venture measures based on the latest available year of data capital financing. The nation now needs to (generally 2011). Key challenges are highlighted; leverage these developments by finding solutions (i) low public spending on health which hinders to constraints hindering the blossoming of its tech the Ministry of Public Health’s (MoPH) ability startup ecosystem. to adequately respond to the health needs of low income groups; (ii) high household out-of- pocket spending on health subjecting low income FALL 2015 LEM: groups to financial hardship; (iii) disproportionate allocation of resources on expensive curative care; THE GREAT CAPTURE and (iv) emerging epidemiologic and population trends associated with unprecedented influx of Elite Capture and the Hollowing of the State: an refugees having significant implications on the Overarching Constraint to Lebanon’s Development delivery and financing of the health sector. Despite (Special Focus 1): Lebanon’s post-war governance the challenges and prolonged periods of instability, 36 | Selected Special Focus from Recent Lebanon Economic Monitors LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON the MoPH embarked on several successful reforms the fiscal deficit. Some of the measures needed to that contributed to the resilience of the system in improve EdL’s financial situation are well known, the face of the crisis. such as increased investment, tariff reforms and corporatization of EdL. Political and confessional obstacles, however, have so far hindered any SPRING 2015 LEM: progress. THE ECONOMY OF Water in Lebanon - Coupling Infrastructure with Institutional Reform (Special Focus 3): Despite NEW DRIVERS AND the relative availability of water resources, the Lebanese water sector has not achieved suitable OLD DRAGS levels of service provision and is not in line with the level of economic development reached by The Trade Impact of the Syrian conflict on Lebanon the country. The cost of inaction in the water (Special Focus 1): We explore the trade effect of sector is estimated at about 1.8 percent of GDP, the Syrian war on Lebanon up until the second or 2.8 percent of GDP if the cost of environmental half of 2014. A dissection of the data reveals that, degradation is included. Several factors have led so far, the war seems to have affected neither to this situation and require sustained attention. merchandise nor services exports at the aggregate These include: (i) low continuity of water supply level. At the same time the relative stability of due to small storage capacity, large amount of merchandise imports is likely a result of increased water lost to the sea, growing demand for water demand due to refugee inflow being offset by and deficiency of the existing water networks; higher transit costs through Syria as well as (ii) unfinished reform agenda that contributed depressed Syrian production. A gravity-type trade to institutional uncertainty and fragmentation model confirms these findings, suggesting also that of functions particularly relating to wastewater Lebanese trade seems to have been less negatively and irrigation; (iii) an irrigation sector that is affected by the Syrian war than other Syria’s characterized by inadequate water storage neighbors. An empirical analysis using micro level capacity, lack of proper maintenance and a exporter data substantiates this finding. While heavy reliance on subsidies; and (iv) regional Lebanese exporters to Syria have suffered from a water establishments (RWE) that severely lack drop in demand in the Syrian market (but less so management and financial autonomy and are than their Jordanian counterparts), other Lebanese impeded by limited inter-agency coordination exporters have started to export to Syria to fill the and weak central government oversight. Moving gap in Syrian production. Further econometric forward, the Government must urgently address analysis suggests that Syrian refugees in Lebanon priorities within the sector. provide important impetus to Lebanese services exports. Challenges in the Lebanese energy sector (Special Focus 2): The Lebanese electricity sector has been underperforming and in crisis for several decades, requiring urgent action to avoid further deterioration of the quality of electricity delivery. The macroeconomic impact has been massive; accruing debt on investments in and transfers to Electricité du Liban’s (EdL) amounts to 40 percent of Lebanon’s gross public debt and is escalating rapidly as transfers now account for over half of Selected Special Focus from Recent Lebanon Economic Monitors | 37 THE WORLD BANK SELECTED RECENT WORLD BANK PUBLICATIONS ON LEBANON (for an exhaustive list, please go to: http://documents.worldbank.org/curated/en/docadvancesearch/ docs?query=&cntry=82571&majorDocTY=906674,658101) 38 | Selected Recent World Bank Publications on Lebanon LEBANON ECONOMIC MONITOR | DE-RISKING  LEBANON Selected Recent World Bank Publications on Lebanon | 39