Part II of Crisis in Lebanon: Buildup of Interrelated Challenges
What led Lebanon into this financial crisis, the biggest challenge the nation has faced since its 1975-1990 civil war? The underlying economic problems are complex and interrelated. In this blogpost of the Lebanon series , we provide an overview of the causes, focusing on five areas: 1) the large current account deficit , 2) the unsustainable fiscal deficit , 3) the fragile financial sector, 4) the Bank of Lebanon’s “financial engineering,” and 5) slow growth, political deadlock, and the impact of the Syrian crisis.
#1: The large current account deficit
For years, Lebanon has run a large current account deficit, equivalent to roughly 25 percent of annual gross domestic product (GDP). The vast majority of imports are composed of fuel and food; Lebanon depends on imports to meet 80 percent of its daily needs of these items (Figure 1).
As introduced in Part I , Lebanon has committed itself to a fixed exchange rate, pegging the Lebanese Pound (LBP) at 1,507.5 to the US dollar since 1997. The fixed exchange rate, which stabilized Lebanon’s inflation over a decade, eventually led to the overvaluation of the Lebanese pound (LBP); IMF (2019) suggests that the LBP is overvalued by more than 50 percent. As a result, under the fixed exchange rate regime, Lebanon enjoyed access to imports but its export sector suffered from the lack of competitiveness. Corruption and insufficient business foundation also hinder the development of the export sector (IMF, 2019).
Lebanon depends on imports for petroleum products and fuel; unlike the neighboring Gulf States, Lebanon does not enjoy oil money and its recent attempt to exploit offshore hydrocarbon reserves exploration has been failing. Most of the energy used in Lebanon is derived from oil.
The majority of exports is led by services, namely the tourism industry. The total contribution of the sector was estimated to be $10.4 billion or 19.1 percent of GDP in 2018. However, the outbreak of protests, travel restrictions imposed by COVID-19, and the recent explosion in Beirut cast a dark shadow on the outlook for the leading industry. Compared to the previous year, the total visitor arrivals to Lebanon plunged by 98 percent in May 2020 (Figure 2).
#2: The unsustainable fiscal deficit
The weak tax regime, large and inefficient public sector, and unsustainable debt issuance in foreign currency has led to low government revenue (17,402 billion LBP, or 20.5 percent of its GDP in 2018) and high expenditure (26,754 billion LBP, or 31.5 percent of its GDP). Consequently, Lebanon has been suffering from large fiscal deficits, -11.3 percent of GDP in 2019 (Figure 3). The total public debt increased from 131 percent of GDP in 2012 to an estimated 160 percent of GDP at end-2019.
The low tax revenue is the result of slow economic growth and a tax regime riddled with loopholes. In the past, the IMF has encouraged the government to raise and broaden the base for corporate income taxes, property taxes, value-added-taxes (VAT), and fuel taxes; remove tax exemptions; and strengthen compliance by cracking down on tax evasion. For instance, currently, foreign-registered yachts, diesel used for electricity generation, and road vehicles are exempted from VAT. Furthermore, the conflict in neighboring Syria since 2011 has caused a large influx of refugees into Lebanon (see #5). One study suggests the Syrian conflict has led to a negative fiscal impact of $2.6 billion in 2012–14 (about 6 percent of 2013 GDP).
Lebanon is suffering from expenditures that far exceed government revenue. The largest costs include a subsidy to the main state-owned electricity company, personnel costs in the public sector, and interest payments. According to the IMF (2019), personnel costs were 9.7 trillion LBP, the subsidy to the electricity company was 2.6 trillion LBP, and the debt service was 8.2 trillion LBP.
First, the subsidy to Electricité du Liban (EdL), a state-owned electricity company, is sizable at 4 percent of GDP. The EdL is notorious for failing to supply electricity to its citizens. In 2019, the IMF reported that “(i) installed capacity is well below consumers’ demand; (ii) losses (technical, non-technical and non-collection) represent 43 percent of production—i.e. only 57 percent of electricity produced is actually transmitted, billed, and collected; and (iii) electricity tariffs are subsidized, which imposes a heavy burden on the government budget.” According to a World Bank estimate in 2018, the sector’s overall costs are $2.6 billion, while revenues are only $884 million (Figure 4). Arabnews reported that losses are due to fuel oil subsidies; low consumer tariffs, which have been based on an oil price of $20 per barrel since 1994; and theft. According to the same news source, oil and fuel products are often smuggled to neighboring Syria, contributing to the losses for EdL. Currently, the daytime power cut lasts more than 20 hours.
Second, government personnel costs account for 11.4 percent of GDP. This is due to hiring in state owned enterprises. The Lebanese government owns and often enjoys a monopoly in important sectors such as utilities (telecom landlines, mobile companies, electricity, and water supply), casino, tobacco, and the national airline. In 2017, then-President Michel Aoun raised salaries in the public sector close to parliamentary elections. This new salary scale was more expensive than anticipated, increasing the fiscal burden by spiking expenses related to pension payments and early retirements. Furthermore, IMF (2019) reports that the ongoing new hiring in the public sector despite a hiring freeze has further raised spending on personnel.
Third, debt service accounts for nearly half of government revenues, further aggravating the fiscal balance. Figure 5 compares Lebanon’s interest payments to peer countries. The recent currency devaluation will further raise the debt-to-GDP ratio, as more than one-third of the government debt is denominated in foreign currency (Figure 6). This is partially due to the country’s history; during the post-civil war era, government had to borrow at high double-digit rates, or issue bonds in US dollars to attract foreign investors (Figure 6). According to an article by Reuters, Lebanon’s government does not necessarily know the identity of many of the holders of Eurobonds. This would further challenge the debt-restructuring process.