International ratings agency Standard & Poor's revised Lebanon’s outlook to negative from stable late Friday night. In a report released on its website, the agency “affirmed our 'B-/B' long- and short-term foreign and local currency sovereign credit ratings on Lebanon”.
Lebanon's ﬁscal deﬁcits are high and its already-large debt stock and debt servicing costs are rising. The formation of a government should improve investor conﬁdence, which will support government ﬁnancing needs in 2019. We are revising the outlook on Lebanon to negative from stable and afﬁrming the long- and short-term sovereign credit ratings at 'B-/B'. The negative outlook reﬂects the risk that a lack of material reforms to reduce the budget deﬁcit will see investor conﬁdence wane. As a result, nonresident deposit ﬂows may decelerate and foreign exchange reserves could continue to decline, eroding Lebanon's ability to service foreign currency debt.
On March 1, 2019, S&P Global Ratings revised the outlook on Lebanon to negative from stable. At the same time, we affirmed our 'B-/B' long- and short-term foreign and local currency sovereign credit ratings on Lebanon.
OUTLOOK We could lower our ratings on Lebanon within the next 12 months if political stasis causes fiscal deficits to rise while banking system deposit inflows--the government's key funding source--slow further. A resulting persistent drawdown of international reserves at the central bank to meet the government's foreign currency financing needs could test the country's ability to maintain the currency peg, in our view.
Alternatively, we could lower the ratings if the government signaled its intention to restructure its existing debt, implying that investors will receive less value than the promise of the original securities.
We could revise the outlook to stable if the Lebanese government is able to advance substantial economic and fiscal reforms that would boost economic growth and reduce government debt levels over the medium term, including addressing the gaps and inefficiencies in the electricity sector and reducing interest costs.
RATIONALE Our ratings on Lebanon reflect its sizable fiscal and external deficits and very high and rising public debt levels. These partly stem from weak institutions and sectarian tensions. Lebanon's net general government debt, projected at 133% of GDP in 2019, is the third-highest among all the sovereigns we rate, after Venezuela and Greece.
The Lebanese government's debt-servicing capacity depends largely on the domestic financial sector's willingness and ability to add to its holdings of government debt. In turn, this relies on bank deposit inflows, particularly from nonresidents, and on financing from the central bank, BdL.
Forming a government after the 2018 parliamentary elections took nine months. The prolonged uncertainty partly caused customer deposit inflows into the banking sector to slow, bond yields to soar, and dollarization rates to rise. At the same time, higher government spending, combined with a weak macroeconomic environment, exacerbated Lebanon's weak public finances. Against this background, the finance minister's statements on potential debt restructuring, which he later retracted, have added to rising concerns regarding the sustainability of government debt.
We have affirmed the ratings on Lebanon because we expect deposit inflows to the financial system to rebound following the recent formation of a new government. In addition, we anticipate that donor support from Qatar and potentially Saudi Arabia, alongside BdL's servicing of the government's foreign currency debt, will remain sufficient to support the government's borrowing requirements and fund the country's external deficit over the next 12 months.
Our base-case scenario assumes that the government will not restructure or reschedule existing commercial debt; doing so could be considered a default under our criteria.
Institutional and Economic Profile: Deep sectarian divisions in the political system and high regional security risks will continue After parliamentary elections in May 2018, the formation of a new government was delayed by nine months, mainly due to wrangling over cabinet portfolios among the different political factions. On Jan. 31, a new national unity government was agreed, at a time of heightened investor fears regarding Lebanon's debt sustainability and the possibility of debt restructuring. Lebanon saw a significant sell-off of its internationally traded debt, soaring bond yields, and rising deposit dollarization in January. Fortunately, Qatar provided some immediate relief by pledging $500 million to buy Lebanese debt.
We see long-term constraints on Lebanon's institutional and economic profile, largely stemming from a divided political environment organized along confessional lines. The surprise, temporary resignation of Prime Minister Saad Hariri while he was in Saudi Arabia in November 2017 was, in our view, evidence of the fragile political landscape and the ability of foreign governments to influence Lebanese politics. Despite the new government, we expect that sectarian divisions and regional interference will continue to obstruct policymaking.
Nonetheless, the new government has shown some willingness to act. It drafted a policy statement specifying several structural reform measures within a weekof appointment. We expect the government to finalize the 2019 budget in the coming two months, and to include some of the reforms agreed at the CEDRE conference in 2018. That said, implementation of the reforms remains uncertain.
We estimate that real economic growth slowed to 0.5% in 2018, following the release of official economic data that showed significantly weaker growth of 0.6% during 2017, compared to our prior estimate of 1.4%. We expect that investment and consumption were subdued by political uncertainty, the reduction in BdL's subsidized mortgage lending through banks, and new tax measures in 2018, despite the boost to consumption stemming from higher public sector wages. We also expect Lebanon's traditional growth drivers-tourism, real estate, and construction--to remain weak.
We forecast that growth will recover only gradually, to 2.5% by 2022, far below average real GDP growth of 9.2% seen in 2007-2010. Our growth forecasts assume some increases in exports and public and private investment following the partial implementation of the government's new Capital Investment Program, which was developed in conjunction with the World Bank.
The government attracted international donor funding for infrastructure and other investment of around $11 billion (mostly in concessional debt) during the CEDRE conference in April 2018. Because this funding is contingent on structural reforms, including improving public finances, we expect disbursements to be gradual and far lower than the pledged amounts. Saudi Arabia has announced that it would release $1 billion in pledged funds to the new government to support the implementation of several infrastructure projects. However, the timing of this disbursement remains uncertain.
The government expects to start the second round of licensing for offshore blocks in 2019, following the signing of oil and gas exploration and production agreements for two blocks in 2018. But we have not incorporated the effects of any potential discoveries into our economic forecasts at this time.
Although we project that real headline GDP will continue to increase, we estimate that real GDP per capita (which we proxy by using 10-year weighted-average growth) will continue to shrink by around 0.4% over 2013-2022. This is below average GDP per capita for peers at similar levels of development. In part, we attribute this to the heavy burden imposed on Lebanon by the influx of refugees from the Syrian civil war, estimated at around 1.5 million, or close to 25% of Lebanon's population.
We also expect external security risks to remain high. The Syrian conflict has abated, but has yet to be resolved, and Lebanon's political, security, and economic trajectories will remain entwined with those of its larger neighbor. There is also increasing risk of escalating tensions between Hezbollah/Lebanon and Israel. Moreover, Lebanese banks risk being affected if the U.S. imposes additional sanctions against Hezbollah. Nevertheless, our base-case scenario does not incorporate a destabilization of the country's banking industry or a return to civil war.
We see substantial shortcomings and material gaps in the dissemination of macroeconomic data and reporting delays. The availability and quality of official external data are also limited, in our opinion.
Flexibility and Performance Profile: Very high debt burden, with debt-servicing capacity dependent on steady growth in deposit inflows
Lebanon's fiscal flexibility remains constrained by high spending pressures from public sector wages and interest costs. In addition, transfers to the electricity company, Electricite du Liban, increased because of the higher oil prices in 2018. We estimate that Lebanon's fiscal deficit rose to almost 11% of GDP in 2018, from 7% in 2017. Interest payments accounted for about 50% of government revenues in 2018. Already the highest ratio among our rated sovereigns, we expect it to keep rising through 2022. The government increased public sector wages in 2017 and hired additional staff before the elections in May 2018. As a result, spending on wages rose by 30%.
We estimate that total revenues marginally declined, despite broad tax increases in 2018, intended to pay for the public sector wage increases. The tax increases included higher value-added tax, and a rise in corporation, property, and capital gains taxes. Revenues declined, in part, because of weak economic activity, but also because they were artificially high in 2017. 2017 saw a one-time increase in government revenues of $775 million, paid by domestic banks on revenues they accrued from BdL's 2016 financial engineering operations. The ratio of tax revenues to GDP remains low, at less than 15%, and tax evasion is widespread.
We expect Lebanon to face fiscal deficits averaging about 10% of GDP over 2019-2022. The new government has stated its intention of reducing fiscal deficits by one percentage point a year over the next five years, by reforming the electricity sector and freezing hiring in the civil service. At the time of the CEDRE conference, this was understood to be one of the conditions that would unlock pledged funds. However, given the significant widening of the fiscal deficit in 2018, donors may require more substantial fiscal consolidation.
As a result of Lebanon's large financing needs, we expect gross general government debt to increase to 162% of GDP by 2022, from an estimated 143% in 2018. In our calculation of gross general government debt, we net out government debt held by public entities, such as the National Social Security Fund and the National Institute for the Guarantee of Deposits, as per our sovereign criteria. Although the proportion of foreign currency-denominated debt to total government debt is high, at around 40%, nonresident holdings of government commercial debt are relatively low, at less than 15%. This suggests that although foreign-investor sentiment is important, it isn't crucial to meeting the Lebanese government's foreign exchange (FX) financing needs.
Domestic banks support government debt-servicing in two ways:
We understand that banks have preferred to buy BdL CDs instead of T-bills, because the CDs offer higher interest rates and the Banking Control Commission of Lebanon assigns a higher risk weight to the sovereign than to BdL. In December 2018, the Ministry of Finance (MoF) and BdL agreed that the government would increase the interest rate on its 10- and 15-year T-bills to closer to market rates (10.0%-10.5%), from around 7.5%-8.0%. This will shift more of the cost of financing the government back to the MoF.
BdL has conducted financial engineering operations since 2016, including swapping the U.S. dollar equivalent of government local currency T-bills it held on its account with newly issued MoF Eurobonds of $1.75 billion in November 2017 and $5.5 billion in May 2018. We understand that these transactions were an accounting procedure.
BdL has since sold $3 billion of the Eurobonds to domestic banks, and holds the residual unsold amount of $4.9 billion in its FX reserves. In our view, the residual amount is not readily available for FX operations, including the repayment of the government's external debt, until it is issued to investors. We therefore deduct this amount from our calculation of FX reserves. In our view, these unusual transactions underscore the challenges of meeting Lebanon's high funding requirements.
We expect that the current account deficit will decline slightly through 2022, helped by gradual growth in exports following the opening of the Nassib border between Jordan and Syria in late 2018. Nonetheless, we expect the deficit to remain very large, averaging about 22% of GDP over 2018-2022, reflecting the large current account payments.
Although growth in nonresident and total deposits has provided a reliable source of funding for the current account and fiscal deficits, respectively, inflows are sensitive to swings in confidence. During 2018, growth in customer deposits slowed to 2.8% (inflows of $4.8 billion), from 3.6% in 2017 ($5.9 billion) and an average of 7.2% over 2011-2016 ($9.2 billion). In 2018, inflows of deposits were lower than the fiscal deficit, which suggests that the government's funding sources are becoming constrained. The deposit dollarization rate also increased to more than 70%, weighing on official foreign reserves. We note that during past episodes of volatility--such as after the November 2017 resignation of Prime Minister Saad Hariri, 2005 assassination of Prime Minister Rafic Hariri, and the 2006 war with Israel--actual deposit withdrawals lasted for only a short period and were more than compensated for by returning inflows.
We expect that deposit growth will rebound to some extent in 2019, given the improved political situation and promised support from Qatar and Saudi Arabia. If some of the crucial reforms described in the new government's policy statement are implemented, it could also boost confidence among depositors. That said, downside pressures could recur if the deterioration in the public finances is not reversed, if rising U.S. Federal Reserve interest rates and increasing volatility in emerging markets reduce the attractiveness of returns on Lebanon's U.S. dollar and Lebanese pound-denominated deposits and securities, or if there are elevated political or geopolitical risks.
BdL plays a material role in steering macroeconomic and financial policy and assists in financing the budget deficit. It encouraged foreign inflows back to the economy and increased central bank FX reserves through financial engineering operations conducted since 2016. However, BdL's gross FX reserves (after netting out the amount associated with the MoF-BdL debt swap transaction) declined by $5.7 billion in 2018.
Our estimates of usable reserves (after deducting the monetary base and reserve requirements for resident FX deposits) stood at a comfortable nine months of current account payments as of end 2018. We expect that reserves will decline further, in the absence of a significant increase in nonresident deposit inflows or further financial engineering operations.
Moreover, the quality of the reserves has been somewhat diminished, in our view, by offsetting liabilities in the form of FX deposits placed by domestic commercial banks in BdL. Given the high and rising level of short-term external debt, we expect Lebanon will face rising pressure to maintain sufficient levels of FX reserves if it is to preserve confidence in the currency peg.