With other urgent matters to attend to, the government of Fouad Siniora could be excused for being distracted from economic reform. That the pro-Western administration has still attempted to push through a series of measures to revitalise the economy and relieve it of the effects of a debt burden exceeding£Leb 62 trillion confirms the enormity of the financial challenge facing the Beirut authorities.

Unfortunately, the absence of political consensus is undermining the government’s effort to privatise state assets and rationalise public expenditure. The wider regional political narrative is hardly supportive of economic activity. The summer-long standoff between Islamic militants and the Lebanese army has forced the risk factor up a notch. The authorities may have patched up the damage inflicted by Israeli munitions from the summer of 2006, and skilfully managed the financial and fiscal pressures from the July 2006 conflict fully recovering the deposit outflow seen in the aftermath of the conflict by the end of the year but investor sentiment is not exactly positive.

Reform programme

The government cannot afford to let the political drift disrupt its reform programme. Reforms are imperative if it is to address the country’s medium-term fiscal constraints. The fiscal deficit which rose to£Leb 2.3 trillion in August 2007, a deficit-to-expenditure ratio of 28 per cent is largely the result of massive debt-servicing costs associated with the public debt overhang, which itself has been fuelled by more than two years of political instability. Debt servicing costs of£Leb 3.2 trillion inflated overall spending by 13.2 per cent in the first eight months of 2007.

The public debt is split fairly evenly between foreign and domestic components, with debt servicing on foreign debt accounting for 55 per cent of the total in the first eight months of 2007, and domestic debt constituting the remaining 45 per cent. Efforts are being made to drive down the debt ratio. Like so much else, this needs political movement.

‘They need to pass laws that have been stuck in parliament for nearly one year,’ says Nassib Ghobril, head of research at Lebanon’s Byblos Bank. ‘This is a major obstacle and the overall situation has not been favourable for economic growth.’

The burgeoning debt burden has overshadowed more favourable news, such as a 19 per cent increase in state revenues to£Leb 5.9 trillion in the first eight months of 2007, largely from higher VAT and customs revenues. This is an indication that government efforts to make public administration more efficient are yielding rewards, at least on those components where parliamentary approval is not necessary.

Stronger-than-projected revenue collection has helped contain the primary budget deficit. A balance of payments surplus of£Leb 438 trillion in the eight months to August has also steadied nerves. ‘Some economic indicators have performed better than in the first half of 2006,’ says Joe Sarrouh, adviser to the chairman of Lebanon’s Fransabank. ‘Exports have increased, imports are down a little, and the real estate sector is doing well.’

Yet the political crisis shows few signs of dissipating, leading investment bank Merrill Lynch to maintain its recommendation on Lebanon’s external debt as ‘underweight’ in early October, citing continued deterioration in the political outlook and the government’s inability to deliver on a substantial portion of pledges from the Paris III conference. The Paris III plan agreed in January involves£Leb 11.5 trillion worth of donor financing being pledged to the government, a lifeline conditional on a series of commitments to economic reform. The strategy envisages the implementation of fiscal measures equivalent to about 10 per cent of GDP over five years. Combined with privatisation efforts and external donor support, Paris III is intended to bring government debt down to less than 130 per cent of GDP by 2012, from more than 180 per cent now.

Debt reduction

Progress is mixed. Funds pledged at the 2002 Paris II conference have not arrived. ‘Some of the Paris II funds have arrived and a major chunk of private sector commitments from Paris II have been signed, but with a debt-to-GDP ratio exceeding 180 per cent, we need to look at how to reduce the nominal amount of public debt and reduce the growth of the debt itself,’ says Ghobril.

One of the main objectives of Paris III was to reduce the growth of debt and spiralling debt-servicing costs through refinancing mechanisms, grants and soft loans. Finance Minister Jihad Azour plans to sign an additional£Leb 1.5 trillion in soft loans and grants before the end of 2007, with more than£Leb 1.2 trillion allocated to reforms and public debt reduction on top of the£Leb 5.2 trillion already signed off from Paris donors. This includes£Leb 1.1 trillion for private sector support,£Leb 1.6 trillion for project financing,£Leb 431,000 million for aid-in-kind, and£Leb 1.9 trillion in budgetary support.

The latest progress report, issued by the Finance Ministry in early October, reveals an increase in budgetary support sources, with the signing of a£Leb 378,000 million grant from the US, a debt replacement agreement for£Leb 756,000 million with Malaysia and a£Leb 151,000 million development policy loan agreement with the World Bank, reaching a cumulative£Leb 1.9 trillion worth of assistance for addressing debt issues. An IMF emergency post conflict assistance (EPCA) programme is also supporting the public finances.

Speeding progress

The quid pro quo for all this support is speedier progress on the reform programme. According to Azour, the government will have implemented 123 reforms out of 300 planned by the end of the year. The IMF’s staff report for the first half of 2007 shows all of its targets under the EPCA programme had been met, with the exception of net government borrowings from Banque du Liban (central bank), which were well below target owing to its sales of government paper on the secondary markets.

On the other hand, the level of disbursements from the Paris III conference are still disappointing, with many agreements taking longer than expected because of technical and administrative constraints a pointer to the bureaucratic logjams afflicting Beirut under political siege from opposition supporters.

‘Those parts of Paris III related to the reconstruction after the July 2006 war have largely come, but not the other parts tied to a basket of reforms,’ says Sarrouh. ‘The government has done many things in preparation for Paris III and there are a number of laws in parliament, but it needs to get them passed.’

The reality is that the substantive, strategic component of Paris III is inextricably linked to the forging of wider political consensus between the two political camps. Yet common ground is still elusive. The government’s economic programme has been rejected by the opposition, and the political stalemate in Beirut will make it difficult to implement.

Some of the reforms are politically sensitive. The Siniora reform programme includes unpopular measures such as an increase in VAT on goods and services from 10 per cent to 12 per cent from 2008, as well as fuel price hikes. These measures will hit the poorest mainly anti-government Shia Lebanese the hardest. It was no coincidence that some of the biggest protests against the government in early 2007 brought trade unionists and Hezbollah supporters together to fight tax reforms.

Proponents of reform argue that there would be material reward from persevering with measures like telecoms privatisation, which would have a decisive impact on improving debt levels. There is progress of sorts with the Higher Privatisation Council announcing the terms and conditions of the bidding for the two cellular companies, Alfa and MTC. The council has decided to list one-third of the mobile phone companies’ shares on the Beirut Stock Exchange, selling the remaining two-thirds to private companies. But so long as the political standoff rumbles on, such reforms will be stuck in legislative limbo.

Persistent systemic risk is a given in Lebanon. In October, negative sentiment swept through the eurobond market. Banque Audi reports that on a cumulative basis, the average spread on eurobonds has widened by 120 basis points since 2006, due to adverse local security conditions and the political bottleneck.

A more persistent concern is that the state will run out of cash in 2008, forcing it to resort to further borrowing. New loans due from the Paris III agreement should at least allow the government to finance the fiscal deficit in 2008, but much will depend on the attitudes of commercial banks, with more than£Leb 7.6 trillion in eurobonds due to mature this year. If the banks are willing and able to roll over the foreign debt, a serious fiscal crisis is likely to be averted. If not, there could be worse to come.

Some clever, Beirut-style financial engineering should help contain debt levels. A financial engineering measure between the central bank and the Finance Ministry covering the differential in the book and market values of gold is providing some relief. The central bank has to disburse 80 per cent of this differential to the ministry, which foregoes the accrued sum worth about£Leb 2.1 trillion in exchange for the bank writing off the equivalent amount of its holdings of domestic debt.

Volatile climate

Yet the overall outlook for economic growth hinges on sustained improvements in the political climate, which remains highly volatile. Economic growth is unlikely to exceed 2 per cent this year, and is more likely to slide to 1 per cent, say local observers. Sluggish growth also has a noxious impact on the debt situation.

‘For the debt ratio itself to be reduced to a sustainable level, you need stronger economic growth as well,’ says Ghobril. ‘If you have real GDP growth that is sustained, plus moves to reduce the actual size of the debt, then you will have a ratio that will decline over time.’

There is enough life left in the economy to keep Lebanon afloat for a while longer. The currency is still stable, and Lebanese expatriates continue to provide a bedrock of support, with about£Leb 7.6 trillion in annual remittances returning home every year.

The country is not out of the woods yet, but locals are taking each day as it comes. ‘I am conservatively confident that if we can get past the presidential election, some form of political consensus could trigger a lot of positive things,’ says Sarrouh.

Now it is up to the politicians.

Table: SELECTED ECONOMIC INDICATORS

f=forecast; na=not available. Source: IMF; Banque du Liban; MEED