S&P: Lebanon 'B-/B' ratings affirmed; outlook remains negative

On March 4, 2016, Standard & Poor's Ratings Services affirmed its 'B-/B' long- and short-term foreign and local currency sovereign credit ratings on the Republic of Lebanon. The outlook remains negative.

The affirmation incorporates our assumption that Lebanese bank deposits will grow by at least four% in 2016, or about 12% of GDP. Approximately two-thirds of Lebanese bank deposits are in foreign currency and nearly one-fourth is externally sourced. These flows of funds are critical sources of funding for the government's 2016 gross borrowing requirement of about 26% of GDP and for the country's 2016 gross external financing requirement of 88% of GDP (or 147%of current account receipts [CARs]).

In our analysis, the Lebanese government's debt servicing capacity depends on the domestic financial sector's willingness and ability to add to its holdings of government debt, which in turn relies on bank deposit inflows. Domestic banks support the government debt market in two ways. First, they buy Lebanese government debt directly. Banking system claims on the public sector account for about 20% of total banking system assets. This means bank creditors hold about one-half of total government debt. Second, Lebanese banks buy certificates of deposit issued by the Banque du Liban (BdL, the central bank), which in turn buys government debt. As of year-end 2015, BdL held 37% of the government's outstanding treasury bills, which amounted to 23% of total government debt. Although we view the concentration of government financing from these sources as a structural weakness, at the current rating level these flows are an essential support.

Similarly, the financial system is key in meeting the country's external financing requirement. Bank deposit inflows are largely sourced by remittances from the Lebanese diaspora. The banks induce the inflows by paying on average about 6% on Lebanese pound deposits and three% on U.S. dollar deposits. Last year, the inflows covered net government debt issuance two times. We note as a consequence that banks' external positions have deteriorated. We expect banks' net external debtor positions will almost double in 2016 to $13 billion (41% of CARs), compared with $7 billion in 2013 and a net creditor position in 2010. Nonresident retail deposits constitute the bulk of banks' external liabilities (about 83% as of year-end 2015), the rest being cross-border interbank deposits. To meet the 2016 gross external financing requirement, we expect banks and corporations will add to their external borrowings, and the government will return to the eurobond market. We also note that drawdowns on the BdL's external reserves (nearly US$32 billion at end-February, net of our estimate of bank reserve requirements on foreign currency deposits) could finance part of Lebanon's 2016 $46 billion gross external financing requirement.

That said, there are risks to these inflows. Bank deposit growth slowed to about 5.2% annually at year-end 2015 from 11.5% at year-end 2010 since the start of Syria's civil war and, to a lesser extent, with the economic slowdown in the Gulf Cooperation Council (GCC; Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates). Inflows are sensitive to swings in confidence. In February 2016, the government of Saudi Arabia announced its curtailment of its US$4 billion grants for military procurement for Lebanon and the GCC states placed restrictions on their citizens' travel to Lebanon. Still, these measures will likely have a softer impact on depositor confidence than the 2005 assassination of Prime Minister Rafic Hariri (prompting nearly US$2 billion in withdrawals from the banking system) or the 2006 war with Israel (triggering about $3 billion in withdrawals). The withdrawals from these earlier, more perilous periods lasted a few weeks at most, were in the low-single-digit percentages of total bank deposits, and were more than compensated for by returning inflows.

We also see longer term constraints on Lebanon's deposit and economic growth, largely stemming from the tough political landscape. We consider that policymaking in Lebanon is hampered by a divisive political environment organized along confessional lines. The presidency has been vacant since President Michel Sleiman's term ended in May 2014. On March 2, 2016, the Lebanese parliament failed for the 36th consecutive time to elect a president.The parliament itself is led by a national unity government comprising both the March 14 and March 8 political alliances. These alliances back opposing sides in the Syrian civil war. Absent a president, the parliament, whose term was due to end in June 2013, voted to extend its term for a second time in November 2014. The split political environment can thwart policymaking even onsmall matters, such as garbage collection. We note, though, that parliament passed some key laws at the end of 2015, such as legislation permitting the government to borrow in foreign currency in 2016.

We believe that Lebanese economic growth will remain weak as long as the domestic political standstill persists and the Syrian civil war does not conclude. The Syrian crisis is about to enter into its sixth year--without a resolution in sight--and we expect that Lebanon's political, security, and economic trajectories will remain entwined with its larger neighbor. We therefore anticipate that Lebanon's traditional growth drivers--tourism, real estate, and construction--will remain subdued, despite the current oil price. We project economic growth over 2015-2018 at 1.6% on average, down from the 2.6% estimated previously. We estimate per-capita GDP at US$10,000 in 2016.

We expect that the current account will remain large but narrow to average about 18% of GDP in 2016-2019, due to a smaller import bill stemming from lower oil prices and weaker domestic economic activity. The strengthening U.S.dollar will also reduce the cost of imports from the eurozone, which accounts for about one-third of Lebanon's imports. On the other hand, exports, tourism, and net remittances will remain constrained because of the Syrian crisis. However, we note that sizable positive net errors and omissions suggest that the current account deficit could be overstated by as much as a factor of two.

We estimate Lebanon's public and financial sector external assets will exceed the country’s external debt by an average 54% of CARs between 2016 and 2019, albeit on a declining trend. We estimate that gross external financing needs will average 117% of CARs plus usable reserves over the same period.

We expect general government deficit will widen to about 8.7% of GDP in 2016, compared with 6% in 2014. We note that government revenues in 2014 benefited from a onetime receipt of about 2% of GDP due to exceptionally higher telecom transfers. The deficit includes transfers to the electricity company Electricité du Liban (EdL), estimated at about 2% of GDP in 2015 compared with four% of GDP in 2014, with EdL requiring less government support due to lower oilprices. The Syrian civil war and the flow of refugees to Lebanon continue to impose a heavy burden on Lebanon's infrastructure. Registered refugees reached 1.1 million according to the UN High Commissioner for Refugees, but estimates range up to about 2 million, compared with an estimated population living in Lebanon of about 5.9 million according to the government. In our view, public finances and fiscal flexibility will remain constrained by structural expenditure pressures, including transfers to EdL, as well as by high interest payments, which account for more than two-fifths of general government revenues. Still, without a fully functioning government, current expenditures were contained at about 23% of GDP in 2015, while capital expenditures were cut to one% of GDP in the same year, notwithstanding Lebanon's significant infrastructure needs. We expect that the already very high net general government debt will increase in the coming years, to 129% of GDP by 2019.

Lastly, in our view, there are substantial shortcomings and material gaps in the dissemination of macroeconomic data and reporting delays. Official national accounts data for 2013 are the latest available, and were published in December 2014. The availability and quality of official external data are also limited, in our opinion.

The negative outlook reflects our view that the protracted political deadlock and increasing regional tensions could further impair the functioning of the Lebanese government and result in a further slowdown in banking sector deposit growth over the next 12 months.

We could lower our ratings on Lebanon if, over the next 12 months, deposit inflows significantly slowed or foreign-exchange reserves declined much further than we currently expect. If the domestic political gridlock escalated to something more destabilizing, we could also lower the ratings.

We could revise the outlook to stable if Lebanon's policymaking framework became more predictable, supporting foreign capital inflows and the sustainability of the public finances.