Wracked by political deadlock and a refugee crisis from neighboring Syria, Lebanon’s economy has sputtered along for the better part of the last decade. GDP growth has averaged a paltry 1.7% since 2011 as the country has racked up a series of bumper budget deficits. Despite slogging onward, the country’s economic outlook is looking more and more precarious. Ratings agencies and financial institutions are increasingly stressing that if Lebanon does not take immediate action, a financial crisis is a matter of ‘when’ rather than ‘if’.

Moody’s delivered the most recent forewarning, downgrading Lebanon’s outlook on 13 December from ‘stable’ to ‘negative’ whilst affirming its B3 rating, some six notches below investment grade.

“In the absence of fiscal consolidation measures that would allow the release of some international loans and partly reverse the widening in risk premia observed in recent months, Lebanon’s fiscal metrics that have already been among the weakest of all sovereigns rated by Moody’s would weaken further, contributing to yet higher liquidity and financial stability risks,” the agency says. S&P and Fitch are equally nervous about Lebanon’s prospects (MEES, 7 September).

By ‘international loans’ Moody’s is referring to the $11.5bn pledged by the international community earlier this year in Paris as part of the CEDRE donor conference (MEES, 13 April).

The loans and grants would undoubtedly make a huge splash in Lebanon’s $57bn economy and provide a much-needed influx of infrastructure spending (capex accounted for only 7% of 2017 government spending; see table), but disbursement hinges on a host of fiscal reforms. A government has yet to be formed despite seven months of political horse-trading following May elections, thus delaying the reforms needed to unlock the investment.

Even if a government is formed – and murmurings suggest one could be before year’s end – it will nonetheless contain the same cast of characters that failed to manage the country’s economy in the first place. Investors and citizens alike will be less than enthused.

Lebanon’s financial woes are deeply rooted. Its 150% debt-to-GDP ratio – the world’s third highest – puts immense pressure on the country’s already ineffectual public sector. Interest payments on the national debt alone eat up a third of all government spending (see chart). Transfers to the inefficient state electricity company Electricité du Liban (EDL) account for another 10-20% of spending depending on oil prices, meaning nearly half of government spending is essentially poured down the drain (MEES, 6 July).

After the bloated public sector wage bill (another third of total spending) is paid out, little money is left over to invest in actually growing the economy. The influx of 1.5 million refugees from Syria has only made matters worse.

The IMF expects 1% growth in 2018 and 1.4% in 2019; it doesn’t foresee even 3% growth through 2023. Not exactly a vote of confidence. And to add insult to injury, Lebanon is currently on pace for its largest deficit in history this year: 1H 2018 figures show the deficit at $3bn. 2017’s full-year deficit only totaled $3.8bn.

Table LEBANON PUBLIC FINANCES ($BN)…

vs 1H17 1H17 2014 2015 2016 2017
1H18 $bn %
Revenues 5.94 -0.12 -2% 6.06 10.88 9.58 9.92 11.62
Tax Revenues 4.57 -0.15 -3% 4.72 6.89 6.85 7.03 8.21
Non-tax Revenues 0.86 -0.18 -17% 1.04 2.89 2.19 2.25 2.56
Treasury Receipts 0.51 +0.21 69% 0.30 1.10 0.53 0.64 0.85
Spending 8.98 +2.01 29% 6.97 13.95 13.53 14.87 15.38
Current 7.59 +1.41 23% 6.18 12.29 11.68 12.36 13.41
o/w interest payments on debt 2.88 +0.34 14% 2.54 4.38 4.68 4.96 5.18
o/w EDL transfers 0.74 +0.18 33% 0.56 2.09 1.13 0.93 1.33
Capital 0.51 +0.12 32% 0.39 0.59 0.59 0.72 0.79
Other 0.88 +0.47 117% 0.40 1.08 1.26 1.79 1.18
BALANCE (Deficit) -3.04 -2.13 235% -0.91 -3.07 -3.95 -4.94 -3.76

Table …& KEY ECONOMIC INDICATORS

2010 2011 2012 2013 2014 2015 2016 2017 2018*
GDP ($bn) 38.4 40.1 44.0 46.5 48.5 49.9 51.5 54.2 56.7
GDP Growth % 8.0% 0.9% 2.8% 2.7% 2.0% 0.2% 1.7% 1.5% 1.0%
Govt Debt ($bn) 52.6 53.7 57.7 63.5 66.6 70.3 74.9 79.5 85.1
Debt to GDP % 137% 134% 131% 137% 137% 141% 145% 147% 150%
Current Account ($bn) -7.7 -6.1 -10.4 -12.1 -12.6 -9.1 -11.2 -12.4 -14.5
% of GDP -20.2% -15.2% -23.6% -26.1% -26.0% -18.3% -21.7% -22.8% -25.6
Remittances ($bn) 6.9 6.9 6.7 7.6 7.2 7.5 7.6 8.0 7.8
% of GDP 18.0% 17.2% 15.1% 16.3% 14.8% 15.0% 14.8% 14.7% 13.7%
*FORECASTS.
SOURCE: MOF, IMF, WORLD BANK, MEES.

DANGEROUS IMBALANCE

Government finances are only the tip of the iceberg. Lebanon’s weak performance in the industrial and agricultural sectors see the country run the world’s largest current account deficit (by GDP). According to IMF numbers this topped $12.4bn in 2017 (23% of GDP) and will likely exceed $14.5bn this year (26% of GDP). For context, Tunisia is projected to have the region’s next highest deficit at 9.6% of GDP followed by Algeria with 9%.

Lebanon used to counter this imbalance by ‘importing’ dollars from abroad through tourism, foreign direct investment (FDI) and remittances. But the war in Syria (and associated ‘spillover’) saw tourists (especially rich ones from the Gulf) take their money elsewhere. Citing Iranian influence, Saudi Arabia has tightened the noose by implementing a travel ban and encouraging its allies in the Gulf to do so too. Tourist arrivals fell from 2.2mn in 2010 to a low of 1.3mn in 2013 and are still stuck under 2mn.

Investment has also dried up. FDI peaked at $4.8bn in 2009 when the economy was growing at 10%, but has averaged just $2.8bn since. Even Lebanese abroad are opting to invest outside Lebanon – a reality that the government has sought to address through sentimental PR campaigns targeting the wealthy diaspora.

Remittances are now the only thing keeping the economy afloat, providing a $7.5-8bn (c.15% of GDP) cash injection each year from Lebanese professionals working abroad (see chart, MEES, 21 December and MEES, 1 June). But much less talked about is the fact that manual laborers (mostly Syrians and Egyptians) and domestic workers from Africa and Asia send around $4bn back out of the country each year. So net remittance gains are far more modest.

Foreign capital inflows don’t just provide locals with pocket money and prop up Lebanon’s haughty and lavish lifestyles; they are also crucial support to Beirut’s all-important banking industry. With some $200bn in assets, the banks essentially bankroll government borrowing – thus intertwining sky-high debt and a massive current accounts deficit.

Some 60% of the public debt is held by local banks, which has interesting implications. One, it means interest payments on the debt enrich stakeholders in the banking sector – many of whom belong to the political elite. Cynically, one might conclude this is partly why deficit spending is not taken seriously. It also means a government default would trigger a banking crisis and throw the entire country into ruin.

MONETARY GAMES

Like foreign inflows, Lebanon’s other major source of stability – the Lebanese pound (LBP) – appears to be hitting new lows.

As an emergency measure the Banque du Liban (BDL), the country’s central bank, pegged the pound in the 1990s to stave off hyperinflation accrued during and after the 1975-1990 civil war. The pound was pegged to the US dollar at 1507.5LBP to $1 to help correct the economy, but like many ‘emergency measures’ in Lebanon, once in place it stayed in place.

The artificially strong currency gives the Lebanese workforce abnormally high purchasing power compared with their productivity, but it also makes exports less competitive, hinders industrial growth and contributes to high unemployment – a key factor why one of the region’s most educated and multi-lingual populations loses so much talent to emigration.

Despite these drawbacks, Beirut’s financial and political elite are desperate to keep the currency peg in place, and not without reason. If the currency floated, most Lebanese (who are paid in pounds) would see much of their savings and incomes vanish overnight.

Nobody is keener to maintain the dollar peg at all costs than long-time BDL governor Riad Salameh. Mr Salameh often appears on Bloomberg or CNBC assuring the world that all is well in Lebanon. The BDL boasts $45bn in foreign assets, he says, so everyone can rest easy knowing no monetary meltdown is imminent.

But when one rolls back the curtains, the actual process of bolstering the pound is quite grotesque. Even the IMF has condemned Lebanon’s ‘financial engineering’ practices, which they say provide a cosmetic solution to a terribly imbalanced economy (MEES, 25 May).

The ‘engineering’ efforts have taken different forms, but essentially, they involve a series of swaps between commercial banks, the finance ministry and the central bank that bolster the latter’s foreign assets by extracting either dollar denominated bonds or foreign currency whilst replacing it with Lebanese pounds. BDL incentivizes commercial banks to take on more local currency by offering outrageously high interest rates.

Currently a personal savings account denominated in Lebanese pounds yields as high as 16% interest rate for a five-year deposit, with 9% being the standard on deposits. In other words, the financial sector is forced to provide massive incentives for depositors to keep their money in pounds versus dollars.

Many Lebanese economists praise Mr Salameh’s work, arguing that he is solely responsible for keeping the economy afloat. But even his most ardent supporters will also admit his methods are highly unorthodox. Mr Salameh himself told the FT last year “My only wish is that when you analyze Lebanon, you analyze it in this environment and these realities and not as if we were a normal, peaceful country.”

Chart Beirut's Spending Outlay (% Of Total): State Wage Bill At Record Levels, Over 1/3 Of Spending Goes On Servicing Debt

Chart Lebanon Revenue Inflows: Syria War Halted Boom In FDI And Tourism ($Bn)

Source: World Bank, WTTC, MEES.

OUTLOOK UNCERTAIN

One thing is clear: unless a political consensus emerges and the CEDRE pledges are disbursed and spent in an efficient (and non-clientelist) manner, Lebanon’s economy is headed in a dangerous direction. And even Mr Salameh’s magic has its limits – especially as the debt burden grows by the minute. The fear is that laissez-faire inertia will continue and the government goes on believing Lebanese ingenuity will right the ship.

Unlike the region’s more state-controlled economies, Lebanon has always opted for relatively free market policies. Belgian economist Paul Van Zeeland was commissioned to study the economy in the early 1950s and famously reported back to the government “I don’t know what makes this economy work, but it’s doing very well and I wouldn’t advise you to touch it.” Little has changed since, except the ‘working’ part.

Both Lebanese and foreign onlookers tend to stress the geopolitical risks to Lebanon’s future – be it another war with Israel, its hapless role in the Saudi-Iran regional showdown, or everybody’s favorite issue, ‘sectarianism’. In reality, economic factors pose as big of a threat as they ever have. Is the economy set to collapse? Nobody really knows, and that’s precisely the problem.