Lebanon’s optimistically named ‘government of national unity’ finally agreed a statement of its policies in early August, after weeks of tense discussions. This cautious agreement, which offers a broad overview of principles rather than detailed plans, marks a watershed for the country, ending an impasse of nearly two years.

Political stability is central to any plans for economic growth. Not only will it allow for the ratification of at least some of the much-delayed programme of reform laws, but it also has positive implications for Lebanon’s sovereign credit rating.

Improved ratings

On 6 August, international ratings agency Capital Intelligence revised the outlook for Lebanon’s long-term foreign and local currency rating, which is designated B-, from negative to stable. The long-term foreign currency ratings of six Lebanese banks were also changed to stable.

Capital Intelligence says the change is a response to the improvement in the domestic political climate following the formation of a multi-party government. Given the size of the country’s public debt, any improvement in the credit rating could result in significant savings for the government because of the reduced cost of borrowing.

Ghazi Kraytem, chairman of the Beirut Chamber of Commerce, says if the government borrows at lower rates, general interest rates will also decrease. This could, in turn, provide the private sector with cheaper credit and stimulate a more attractive platform for business and investment.

The nature of politics in Lebanon means that governments do not tend to last long - on average, administrations have a lifespan of just one year and four months. This has meant that previous economic plans have quickly come and gone.

There is some optimism that the new government will be able to continue where the previous one left off. In the policy statement published in early August, the government commits itself to follow the earlier promises of economic reform made by Lebanon to the Paris III international donor conference in January 2007. It also says it will push for sustainable economic growth and more foreign investment to improve the state of public finances and reduce the ratio of public debt to gross domestic product (GDP).

Analysts at investment bank Merrill Lynch say there are unlikely to be any significant changes to the economic programme given the background of incoming Finance Minister Mohamad Chatah. His career includes a stint
as vice-governor of Bank du Liban, the central bank, in addition to a period at the International Monetary Fund (IMF), and he is thought to support the economic reform programme.

However, the level of commitment to the reforms from some segments of the cabinet is unclear. Former opposition parties have enough seats to be able to veto decisions, and the cabinet could divide over the contentious issue of privatisation, which is so critical to reducing the debt burden.

With parliamentary elections due by mid-2009, the amount that can be achieved is limited, says Alain Balian, a vice-governor of Bank du Liban. “Even if they address the issues in the cabinet, how long will they have to implement anything? Nine months?” he asks.

Despite the limited scope for fresh action, revenues in the first six months of 2008 have risen by 15.7 per cent compared with the same period in 2007. The IMF attributes this to the rise in value added tax (VAT) receipts, which are up by 24.1 per cent because of the expanding retail and services sectors. Another positive sign is the forecast by the Finance Ministry of 4 per cent growth in real GDP in 2008.

On the other hand, spending increased by 3.8 per cent in the first half of 2008, compared with the same period last year. The increase could rise to as much as 20 per cent for the full year, according to some analysts, as the Treasury continues to support the failing state-owned Electricite du Liban. If this trend continues, the fiscal deficit could widen to $3.3bn by the end of 2008.

Political priorities

While economic reforms are badly needed, they are likely to have to take a back seat to constitutional and security issues, which will dominate the political agenda at least until next year’s elections.

Politics has long-hampered Lebanon’s economy and there have been several episodes of political shocks, triggering economic downturns. However, the country has largely managed to weather these storms without suffering the debt crisis that many economists expected. According to Edward Gardner, an economist at the IMF, the economy appears to benefit from “a perceived implicit guarantee” from international donors that they will not let Lebanon fall into a financial crisis.

The country needs such support in the face of its steadily increasing debt level. By the end of the first quarter of 2008, public debt had reached £Leb65.1 trillion ($43.2bn), according to the Finance Ministry, an increase of 2.7 per cent on the level at the end of 2007.

Local-currency debt accounts for half of this, up 3.7 per cent from the end of last year to £Leb32.5 trillion. Foreign currency debt now stands at £Leb32.6 trillion, an increase of 1.8 per cent over the same period.

Supporting government

With more than $3bn in Eurobonds (international bonds not priced in the local currency) due to mature before the end of 2009, a key determinant of the sustainability of the public finances remains the willingness and capacity of domestic commercial banks to support the government with finance. These banks currently hold $11.2bn in public debt, or 26 per cent of the total.

Given the extent of their exposure, they have little incentive to liquidate their positions abruptly, even during the most severe crisis, as this would be self-defeating. The banks, say Gardner, can also use the healthy levels of deposits from their clients to provide the necessary financing.

“At about 300 per cent, Lebanon has one of the highest ratios of bank deposits to GDP in the world, surely a sign of investors’ confidence in the Lebanese banking sector,” says Alain Balian, another vice-governor of Banque du Liban.

Of course, further political shocks could yet hit confidence. When former Prime Minister Rafiq Hariri was assassinated in 2005, Lebanon suffered an outflow of deposits worth $2.2bn. The Israeli invasion in 2006 resulted in $3.1bn being withdrawn.

But the deposits returned swiftly after both events and the sector has enjoyed an increase in deposits of about $12bn since the end of the 2006 war between Israel and Hezbollah. Three decades of experience along a political fault line have taught investors to react quickly to events.

Bank du Liban has faced many severe political shocks and so far has managed to keep the currency stable. It has also kept the dollar peg, which is critical in maintaining confidence.

“The peg to the dollar is a cornerstone in the central bank’s efforts to support the currency and helps its ability to finance the deficit of the government,” says Nassib Ghobril, head of economic research and analysis at the local Byblos Bank. “There were many calls, mostly politically motivated, during the 1990s for the Lebanese pound to depeg from the dollar. We cannot afford to depeg until we see a substantial reduction in public debt and the fiscal deficit.”

Despite its best efforts, the government has not been able to reduce the size of its debt, but it has managed to contain its growth. Given the difficulties Lebanon has faced in recent years, this is a notable achievement in itself, but does little to solve the country’s economic difficulties. Only a rigorous privatisation drive will lead to any significant drop in the size of the debt, and this has been delayed by political feuding over the past eight years.

Although the debt burden continues to hang over them, Lebanon’s government and monetary authorities have managed to buy some time. With signs that the right political climate for reform is emerging, Lebanon could have the chance to address the problem directly.