Spiralling risk in Lebanon

The extent of fiscal disruption in Lebanon in recent months is unclear and recovery dependent on the political environment, pace of economic improvement, and extent of international financial support, writes Elizabeth Stephens.

The assassination of Pierre Gemayel, the Lebanese industry minister, on November 22, reinforced concerns about fiscal stability and risk premia in the Lebanese Republic. The killing exacerbated the political crisis that has assailed Lebanon since the assassination of former Prime Minister Rafik Hariri in February 2005 and was compounded by the 34-day conflict with Israel in July and August 2006.

Despite the devastation of the country’s infrastructure caused by the aerial and ground assault, the Lebanese economy and public finances have proved notably robust and have withstood the immediate threat.

Saudi prop

Throughout the crisis, the stability of the Lebanese economy has been highly dependent on continued liquidity and inflows of foreign capital. The July 26 pledge of US$1.5bn by Saudi Arabia’s King Abdullah to Lebanon contributed to the country’s short-term economic and political stability.

The kingdom’s deposit of an additional US$1bn with the Banque du Liban, the central bank, shows that it is acting as a quasi-lender of last resort. The inflow of funds from Saudi Arabia firmly demonstrates the kingdom’s solidarity with Lebanon and has bolstered confidence in the Lebanese banking system and relieved pressure on the Lebanese pound.

Before the latest round of hostilities, the central bank had accumulated reserves of US$12.9bn, enabling the government to honour all its financial obligations as depositors converted Lebanese pound deposits into US dollars and US$2bn of funds were withdrawn from the country. September FX reserves registered US$11.17bn, up 15% on the January figure.

Despite inflows of foreign capital and international support for the Lebanese government, the maintenance of depositor confidence in Lebanon’s banking system is vital for the sustainability of Lebanon’s substantial debt burden, which totalled 180% of GDP in late 2005. In conjunction with other economic damage, the war may increase the total debt burden beyond US$40bn – double the level of GDP.

By early December, the yield on the US$ Global 09 has edged up to 8.632% – approaching the area hit after the assassination of former Prime Minister Rafik Hariri last year – from the 7.8% level reached in November.

Further sell-off is likely in response to street demonstrates throughout the capital, Beirut. As a natural corollary, the spread over the five-year US Treasury note is widening, pushing above the 400bp mark, and potentially stretching the differential back to the 500bp support level touched back in August.

Tourism bombed

Nowhere is the correlation between economic performance and violence more closely related than in the tourism sector, where tourist numbers have dropped by over two thirds. Hotels are empty and the beauty of Beirut’s only beach is partially concealed by an oil slick, an enduring legacy of the Israeli bombardment.

In the longer term, the greatest challenge to economic growth may originate from an ‘impending’s brain drain. Half of Lebanon’s population claim they would like to immigrate and many among the educated youth are planning their exit strategy. Already, three times the number of Lebanese live abroad than in the country – 10mn-12mn compared to 4mn.

Lebanon boasted one of the most advanced economies in the Middle East until the civil war of 1975 ripped the countries, economic, social and political fabric apart. Since this time, Lebanon has been the victim of the power struggle between Israel and Syria, its two more powerful neighbours.

Syria’s direct influence in the country was undermined by massive protests and international pressure, triggered by the February 2005 assassination of former Lebanese Prime Minister Rafik Hariri. An anti-Syrian and pro-US alliance asserted the country’s independence from Syria for the first time since the end of the country’s civil war in 1989, forcing a withdrawal of Syrian troops in April 2005.

Hezbollah support grows

However, while a confluence of US and French interests initially buoyed a new government that was elected in the wake of Syria’s withdrawal, the month-long conflict between Israel and the Shia militant group Hezbollah has undermined public confidence in its ability to govern.

At the same time, Hezbollah has gained in popularity and demonstrated its ability to deliver effective services to its own constituency. As a result, the balance of power within government has once again shifted and the anti-Syrian and pro-Syrian forces are closely matched.

The current political stand-off is centred on the cabinet’s approval of French-backed UN Resolution 1595 which provides for an investigation into Hariri’s death. As the inquiry has directly implicated Syrian officials in the assassination, an allegation Damascus strongly denies, Hezbollah is working on its patrons behalf, to derail the process.

In an effort to prevent the cabinet approving the investigating, Hezbollah demanded more cabinet seats for itself and its allies. The majority group in parliament refused Hezbollah’s demands that would have given it the power of veto. In retaliation, five Shia ministers and one Christian ally resigned from the government in November.

The resignations left Prime Minister Fuad Siniora with just 18 cabinet members, three more than the legally required number to govern under Lebanon’s complex political rules. The assassination of Gemayel reduced the margin to two, arousing suspicion that pro-Syrian forces carried out the attack. If enough ministers resign, or are assassinated, the government will lose the two-thirds majority required to ratify the UN tribunal. Lebanon’s pro-Syrian President Emile Lahoud reinforced the impact of the resignations by declaring the government unconstitutional.

Sheikh Hassan Nasrallah, Hezbollah’s leader, has now taken his protest to the streets. Mass street demonstrations have been staged in support of his demand for additional cabinet representation and to put pressure on the government to resign. Opposition to the demonstrations was strongest in Beirut where the business community has been rocked by the economic impact of the group’s actions and the knowledge of its ability to paralyse Lebanon’s economy.

The spate of assassinations of non-Shiite Lebanese leaders has served to intensify resistance, but this has led to an increase in visible support for Prime Minister Siniora, which is contributing to instability. In the Shia-dominated Beqaa valley, support for Hezbollah is palpable and the economy will be less susceptible to disruption from the protests.

Civil war unlikely

Despite perceptions that the assassination and street protests appear to bring the prospect of government collapse, a descent into sectarian violence and significant capital flight from the banking system a step closer, the country is unlikely to descend into civil conflict. At the very least, the prospect of a sectarian conflict should be reduced by the fact that the opposition alliance is comprised of Shias and Christians.

Both the pro and anti-Syrian alliances are part of a power-sharing arrangement and to that extent they continue to benefit from their stake in the current government. While the Shia militant group Hezbollah and Michel Aoun’s Free Patriotic Movement, which are both part of the pro-Syrian alliance, are seeking greater political representation, they are unlikely to precipitate a civil conflict because to do so would compromise their position and undermine their ability to influence government policy.

Hezbollah’s leverage is further curtailed by the fact that as it cannot form a new government if the current cabinet collapses, it will be forced to return to negotiations. Where this to happen, the current cabinet would remain as the caretaker government, leaving Hezbollah in the position where it started.

Irrespective of the outcome of the street protests, the tribunal investigating the Hariri assassination is likely to be stillborn. The speaker of Lebanon’s parliament – who the constitution stipulates must be Shiite – is pro-Syrian and refuses to table the issue. Russia has publicly announced that it will oppose a Security Council vote to make the tribune mandatory through a Chapter 7 resolution. Arab League officials are working to broker a resolution to the political stand-off

Of vital importance to medium-term political and economic stability is the Paris III Donor Conference. The conference, currently scheduled to begin on January 25, 2007 aims to secure billions of dollars in grants and loans to boost post-war reconstruction efforts. The Lebanese government on November 24 estimated the war’s direct costs at US$2.8bn, much of which should be covered by the Donor Conference.

Despite the increasing political turmoil in Lebanon, the French government, which is hosting the conference, has prepared invitations and remains supportive of the event, as do potential donors. The nations of the Gulf Cooperation Council have stated that their investment in Lebanon is guaranteed even if the country is politically unstable. This support is an essential investment, but western capital is also necessary as much to boost international confidence as for infrastructure reconstruction. The working days lost and businesses closed because of Pierre Gemayel’s assassination and the demonstrations are further undermining the already fragile economy in the run-up to the conference.

The extent of medium-term fiscal disruption is unclear and recovery is dependent on the political environment, the pace of economic improvement, and the extent of international financial support. If these factors work in Lebanon’s favour, the country could revert to a stable position with a promising financial outlook. If they do not, the outlook for Lebanon is uncertain.

Regional tensions and violent conflict are high, even by the turbulent standards of the Middle East. With impending civil war threatening Iraq and violence continuing to characterise Israel’s relations with the Palestinians, the majority of the Middle Eastern states and the west have a shared interest in preventing the descent of Lebanon into protracted civil conflict.

The signs are that Lebanon will not default. Apart from the strong banking sector, the July crisis proved that Lebanon has a loyal network of allies throughout the world. A list published by the central bank of the top 10 countries from which Lebanon received transfers in July show a range of countries from Saudi Arabia (US$10mn), to the US (US$5.7mn), to Gabon (US$2mn), to Germany (US$1.7mn).

During that turbulent month, cash transfers to Lebanon (US$56mn) were more than three times the amount transferred out of the country (US$17mn), thanks to the strong global network of Lebanon’s expatriates. If only Syria and Israel were as benevolent as the rest of the international community, a bright and prosperous future for the former ‘Paris of the Middle East’s could be assured.