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Middle EastOctober 4 2009

Lebanon's tradition of economic liberalism continues

Political risk consultant Exclusive Analysis provides a comprehensive overview of the opportunities and the risks of investing in Lebanon.
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Despite deep political divisions between the sectarian parties that dominate public life, there is a remarkable degree of convergence over economic policy in Lebanon. A liberal tradition has characterised the economy since independence, with political elites such as the Hariri family, the Jumblatt family, Hizbollah and the powerful Maronite Christian groups invested in the country's lucrative financial services, tourism and construction sectors. No significant politician or party has articulated a platform that opposes the fundamental openness of the Lebanese economy or denies the importance of foreign investment to the country's economic prosperity.

Nationalisation of assets is highly unlikely; the proposed privatisation of state institutions such as power and utilities company Électricité du Liban and Lebanon's mobile telephone operators enjoys wide support in principle, with influence groups far more likely to delay the process over competition for revenues and businesses than opposition to privatisation. The nationalisation of private businesses, foreign or domestic, has no important advocates in Parliament or government. Further, much of the substantial international economic aid that Lebanon receives to help service its large public debt burden is conditional on progress in privatisation and economic openness.

With the exception of Hizbollah, Lebanon's political parties are basically dominated by a zaim, or leader, whose power depends largely on the ability to distribute patronage to fellow sect members. Economic ideology plays a secondary role, if at all, in leaders' policy making, and the voting public, heavily dependent on foreign remittances and Lebanon's reputation as an attractive tourist spot and reliable banking centre, are unlikely to advocate a major transformation of its economic structures, including its emphasis on preserving economic liberalism and attracting foreign investment. In any case, Lebanon's divided democratic system fragments political power and prevents any one party or sect from dominating policy making. The ascension of a powerful, economically protectionist party would likely be met with an opposing coalition of powerful politicians eager to preserve their stake in the liberal economy.

Monetary assistance

The likelihood of a financial crisis in Lebanon within the next three years depends on the government's ability to retain donors and use the financial assistance pledged in the Paris III conference in January 2007 to renegotiate sovereign debt. Following general elections in June this year, in which the March 14 coalition - which enjoys US support - retained a parliamentary majority, the backing of international donors is likely to be forthcoming. Indeed, the financial support of the West is among the coalition's strongest assets against the Hizbollah-led opposition. However, the assistance pledged at Paris III will not be sufficient to ease Lebanon's debt, which stands at about $44bn. It is merely a rescheduling, which will buy time through an extension of soft loans for another three to five years.

Political infighting makes the cabinet unlikely to implement the economic reforms proposed at Paris III, intended to stimulate the private sector and improve the regulatory environment. These reforms include privatisations in the telecoms sector, the loss-making Électricité du Liban, Middle East Airlines, management of Rafiq Hariri International Airport, Tripoli and Beirut ports, and the water and sewage systems. Other reforms include the extension of working hours for civil servants to 36 hours a week and a gradual increase of value-added tax to 15% by 2010.

The government is likely to remain unable to gather the political consensus required for these reforms, particularly as an essential precursor to cross-party consensus is progress in ongoing national reconciliation talks, currently stuck on the question of Hizbollah's disarmament. Important drivers of the Lebanese economy, such as financial services, real estate and tourism, rely too heavily on elusive political stability and an improved regulatory environment currently marred by corruption to contribute significantly to reducing Lebanon's budget deficit (predicted to exceed $3.2bn, or 37% of spending, in 2009). Consequently, although donor support is likely to keep the Lebanese economy from sliding into financial crisis by maintaining its debt-to-gross domestic product (GDP) ratio at about 160% to 180%, it is unlikely that it will be reduced over the next three years.

Diplomatic network

Relations with the US and Saudi Arabia are likely to be strong under the March 14 coalition government. The majority coalition is committed to privatisation in the telecoms sector, but progress will likely be stalled by political infighting. The election victory of the March 14 coalition implies that diplomatic and economic ties between the Lebanese government and the Gulf states, particularly Saudi Arabia, will be strong, especially as Saad Hariri has been named prime minister. Mr Hariri receives generous funding from the Saudi government and closely co-ordinates his policies with the Saudis; both are Sunni Muslim, implying that their politics in Lebanon will very often align. Relations between most parties in the March 14 coalition and the US and France are also close and Western governments will remain committed to the $7.9bn economic aid package formulated at Paris III. The significant US commitment to arming and training Lebanese security forces is also unlikely to be revised and US support may well increase in light of March 14's electoral victory.

No significant legal or policy changes are expected in the financial sector under the next Lebanese government. Riad Salameh will likely retain his post as central bank governor, implying that conservative financial laws which limit Lebanese banks' ability to invest in real estate and securities abroad will remain in place. Monetary policy under Mr Salameh has contributed significantly to Lebanese financial institutions being relatively insulated from the global credit crisis and neither the majority nor the opposition has called for his replacement.

The next government will almost certainly seek to privatise several public institutions, including Lebanon's mobile telephone network providers, Alfa and MTC. Électricité du Liban and Beirut Port have also been targeted for privatisation by the March 14 coalition. However, the opposition is likely to use its parliamentary and cabinet positions to increase its members' shares of the privatisation 'proceeds', or, in the event of another opposition stand-off over major issues such as relations with Syria or Hizbollah's weapons, seek to block privatisation as a means of exerting pressure on the majority.

Financial strength

Lebanon's banking sector is a major source of lending for the state. Financial services, along with tourism and other commercial services, account for some 60% of GDP. Under the direction of Banque du Liban (BDL), the country's central bank and financial regulator, the sector has consistently withstood political and economic crises, including a war with Israel in 2006, a series of assassinations of public figures, a low-level jihadist insurgency, sectarian infighting, and government paralysis from 2005 to 2008. The country's banks grew their deposits in 2008 by 15% and this is expected to grow an additional 12% in 2009. Foreign reserves increased to $13bn in 2008/09 and BDL has not faced significant difficulty in maintaining a currency peg to the dollar, which along with the Lebanese pound is used as national currency.

Liquidity in the domestic banking sector has not been significantly affected by the global financial crisis, nor has demand for loans, which is expected to be strong in 2009/10. Capital inflows increased by 40% from April 2008 to April 2009, amounting to about $5bn. In a June 2009 survey of 86 banking systems, a prominent rating agency identified Lebanon as one of 30 with a "low level of potential vulnerability". Foreign banks are permitted to operate in Lebanon, but local banks have privileged lending access to the government and are dominated by the country's political elite, helping to ensure their dominance of the Lebanese banking sector.

Banking sector risks

Losses on mortgage-backed securities: Under BDL regulations , Lebanese banks are prohibited from investing in derivatives and mortgage-backed instruments. These investments, which have badly hurt banks' performances in other Arab countries including in the Gulf, have therefore not harmed banks in Lebanon, which have continued to lend at a high rate this year. Crucially, this differs from the banking practices in Gulf Arab countries, where exposure to a significantly weakened real estate sector has hurt banks' balance sheets and lending.

Lending to government and liquidity: Much of Lebanese banks' lending goes to the country's government. Given its ongoing need to secure international loans and attract investment, the government has yet to default on any debt obligations and is unlikely to do so. This is despite fiscal challenges in the form of debt servicing and large expenditures on utilities, especially Électricité du Liban. Remittances from Lebanese people abroad account for about $3bn annually - 20% of Lebanon's GDP. Although the income of Lebanese people in the Gulf is expected to decline in 2009, given the economic crisis affecting those countries, the weakness of the Gulf banking sector makes it increasingly likely that Lebanese people (and other Arabs) will send their savings to banks in Lebanon instead of Gulf-based banks.

Also, since the 9/11 terrorist attacks in New York, Arabs are finding their funds coming under increased scrutiny when deposited in banks in the US and Europe, owing to concerns about financing of militant groups. Therefore, Lebanese banks have emerged as a default choice for many wealthy Arabs looking to deposit their money in a secure banking environment. With few foreign banks operating in Lebanon, local banks will likely reap most of these benefits. Indeed, a balance of payments surplus in Q1 2009 indicates strong capital inflows in Lebanon.

A real estate collapse: Lebanese banks are increasingly offering mortgage services to meet the high demand for property. This demand is driven mostly by Lebanese people living abroad who want to own property in Lebanon, and by Gulf Arabs who regularly take vacations in Lebanon and who saw their countries' real estate markets seriously weakened in 2008/09. Expatriate deposits and Gulf Arab wealth make substantial capital available for construction projects and Lebanese banks, insulated from investment in financial derivatives, have no shortage of liquidity.

Lebanon's terrain is mostly mountainous and its urban areas are concentrated on a narrow coastal plain, limiting the availability of land for construction and helping to buoy real estate prices. This implies that the price collapse witnessed in Gulf Co-operation Council state economies is highly unlikely to affect the Lebanese property market unduly.

Faysal Itani is deputy head of Middle East and north Africa forecasting at Exclusive Analysis.

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