Economic Research Forum (ERF)

Lebanon’s challenge of fiscal sustainability

1215
New legislation by the Lebanese government, which provides a big boost to the salaries of public sector employees, puts considerable pressure on the country’s public finances. This column outlines the potential impact on inflation, interest rates, the balance of payments and the exchange rate – and the kind of austerity measures that are needed to restore fiscal sustainability without too much damage to potential economic growth.

In a nutshell

A significant rise in public employees’ salaries in Lebanon should have been avoided given the country’s deteriorating macroeconomic fundamentals.

The country’s fiscal and monetary indicators suggest that tapping new international sources of financing will becoming increasingly difficult, which renders financing of the external debt unsustainable.

The government may be compelled to abandon its fixed exchange rate peg, and may have to introduce painful fiscal adjustment measures.

The Lebanese government has recently approved a 120% increase in the salary scale of public employees, thus paving the way for an estimated additional budget burden of $1.5 billion. The public salary adjustment, which came as a result of tremendous economic and political pressure, has been granted without securing adequate revenues to finance it. The legislation has already started to impinge negatively on inflation and the deteriorating macroeconomic fundamentals of Lebanon’s economy (Neaime, 2015b).

While the salary increase is expected to worsen existing budget and current account deficits, it is already putting further pressure on the exchange rate regime (which is pegged to the dollar) and on the balance of payments – and it might negatively affect the declining trend in inflows of portfolio and foreign direct investments (Neaime, 2000, 2008). After a surplus of about $8 billion in 2010, the balance of payments has been on a declining trend, reaching a deficit of $1.1 billion during the first quarter of 2017.

To date, Lebanon’s permanent current account deficits have largely been offset by remittances, averaging $7 billion per year, and by surpluses in the capital account due mainly to direct and indirect foreign investments. But if these capital inflows decline, as a result of the newly introduced salary scale adjustment, the central bank will once again have to tap its foreign exchange reserves.

During Lebanon’s recent political turmoil, and just before the election of a new president, the central bank lost the equivalent of $1 billion trying to maintain its peg to the dollar. But recent estimates of the foreign exchange reserves held by the Banque du Liban put them at a new historical high of $43 billion, following its financial engineering operations.

Despite a robust level of foreign exchange rate reserves, if adequate financing is not secured to account for the salary scale increase, the government will face further budget deficits. In addition, there is the risk of a downgrade in its sovereign credit ratings to a rating below B, which, coupled with a treasury bill downgrade to junk bond status, will subsequently be considered too risky to be offered on international financial markets (Mora et al, 2013).

The adoption of the new salary scale may then lead to devastating consequences for domestic interest rates – and for the servicing of the huge public debt, estimated at $77 billion or more than 160% of GDP. Despite the generally good financial position of local commercial banks, a decline in Lebanon’s credit ratings may also affect the credit ratings of those with a significant exposure to the government’s public debt.

Expected higher public wages will worsen inflationary pressures due to a rise in local demand. The plausible response to this increase in demand is either through an increase in the demand for imports or through an overall increase in the domestic price of goods and services.

The added inflation will further affect monetary stability as the equivalent of 25% of the budget will be injected into the economy and hence, affect negatively the exchange rate peg to the dollar. The expansion of imports to meet the increase in domestic demand resulting from the increase in public sector salaries and the huge influx of about one and a half million Syrian refugees will worsen a deteriorating current account deficit.

Such a significant adjustment in public employees’ salary scale should have been avoided at this stage, especially given the deteriorating macroeconomic fundamentals of Lebanon’s economy, following the financial and debt crises (see Neaime, 2012, 2016; and Mansoorian and Neaime, 2003), as well as the military and political turmoil in several Arab countries since 2011.

Instead, austerity measures should have been introduced (see Neaime, 2015a, 2015b; and Neaime and Gaysset, 2017). But such measures should not target aggregate demand in the short run to avoid worsening the prevailing recession. Lebanon’s austerity measures should target the supply side of the economy.

The proposed increase in the value added tax from 10% to 11% is expected to renew inflationary pressures and lead to further appreciation of the real exchange rate. Instead, the government should consider, for example:

  • Lowering fiscal spending.
  • Improving the tax collection system.
  • Increasing the dividend/corporate tax rates.
  • Reorganising the social security system.
  • And tackling Electricité du Liban’s chronic deficits with yearly registered losses of $1.5 billion.

Any potential austerity measures should be carefully designed so that any increase in taxes should target financial capital rather than labour, with a subsequent lower impact on aggregate demand and GDP growth rates. The potential tax increase should target neither productive sectors nor sectors prone to international competition such as the real estate sector. Thus, austerity measures should be carefully designed so as to minimise their negative macroeconomic impact (Neaime, 2015a, 2015b).

Given Lebanon’s fiscal and monetary indicators, tapping new international sources of financing is becoming increasingly difficult, which renders financing of the external debt unsustainable (Neaime 2012, 2016). Therefore, the government may be compelled to abandon its fixed exchange rate peg, and may have to introduce painful fiscal adjustment measures to generate the necessary foreign exchange from its own internal resources to finance its external debt in the coming years.

In short, policy-makers need to move on several fronts to tackle Lebanon’s issues of fiscal unsustainability:

  • First they should try to stimulate national saving by reducing the budget deficit, reducing domestic interest rates and increasing the rate of private saving.
  • Second, they should introduce much-needed fiscal adjustment measures, enhance the tax collection system and actively fight corruption.
  • And finally, they should tackle the future implications that may emanate from an expected depreciation of the exchange rate.

Further reading

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, APF Press.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.

 

Most read

Economic roots of early marriage in Iran

Despite the documented harms of being married off before the age of 18, particularly for girls, early marriage remains common in parts of Iran. This column summarises research that sheds light on the economic factors that drive this practice, using unique provincial data to show that poverty, inflation and income inequality are key determinants –while religiosity is not. The findings suggest that economic policies can play a crucial role in reducing the prevalence of child marriage.

Natural disaster literacy in Iran: survey evidence from Tehran

The frequent floods, earthquakes, and heat waves in the Middle East and North Africa underscore the urgent need to assess the region's preparedness for natural disasters. This column summarizes the state of 'natural disaster literacy' in various parts of Tehran, the capital of Iran and one of the most populous metropolitan areas in MENA. Data from a survey conducted in the winter of 2020/21 enabled the development of a disaster literacy index, which helps to identify the city's most vulnerable districts.

Should Arab countries join the WTO’s agreement on government procurement?

Not all members of the World Trade Organization are signatories of the institution’s Agreement on Government Procurement – the GPA. Indeed, although many developing economies are now joining the agreement or at least acquiring observer status, it has long been thought that the costs outweigh the benefits. This column re-evaluates the pros and cons of GPA accession for Arab countries.

Financial development, corruption and informality in MENA

Reducing the extent of informality in the Middle East and North Africa would help to promote economic growth. This column reports evidence on how corruption and financial development influence the size of the informal economy in countries across the region. The efficiency of the financial sector in MENA economies reduces the corruption incentive for firms to seek to join and stay in the formal sector.

EU climate policy: potential effects on the exports of Arab countries

The carbon border adjustment mechanism aims to ensure that Europe’s green objectives are not undermined by the relocation of production to parts of the world with less ambitious climate policies – but it could impose substantial costs on developing countries that export to the European Union. This column examines the potential impact on exporters in the Arab world – and outlines possible policy responses that could mitigate the economic damage.

Climate change threats and how the Arab countries should respond

The Arab region is highly vulnerable to extreme events caused by climate change. This column outlines the threats and explores what can be done to ward off disaster, not least moving away from the extraction of fossil fuels and taking advantage of the opportunities in renewable energy generation. This would both mitigate the potential for further environmental damage and act as a catalyst for more and better jobs, higher incomes and improved social outcomes.

Exchange rate undervaluation: the impact on participation in world trade

Can currency undervaluation influence participation in world trade through global value chains (GVC)? This column reports new evidence on the positive impact of an undervalued real exchange rate on the involvement of a country’s firms in GVCs. Undervaluation acts as an economy-wide industrial policy, supporting the competitiveness of national exports in foreign markets vis-à-vis those of other countries.

Child stunting in Tunisia: an alarming rise

Child stunting in Tunisia seemed to have fallen significantly over the past two decades. But as this column reports, new analysis indicates that the positive trend has now gone dramatically into reverse. Indeed, the evidence is unequivocal: the nutritional health of the country’s youngest citizens is rapidly deteriorating and requires immediate and decisive action.

Green hydrogen production and exports: could MENA countries lead the way?

The Arab region stands at the threshold of a transformative opportunity to become a global leader in green hydrogen production and exports. But as this column explains, achieving this potential will require substantial investments, robust policy frameworks and a commitment to technological innovation.

Freedom: the missing piece in analysis of multidimensional wellbeing

Political philosophy has long emphasised the importance of freedom in shaping a meaningful life, yet it is consistently overlooked in assessments of human wellbeing across multiple dimensions. This column focuses on the freedom to express opinions, noting that it is shaped by both formal laws and informal social dynamics, fluctuating with the changing cultural context, particularly in the age of social media. Data on public opinion in Arab countries over the past decade are revealing about how this key freedom is perceived.




LinkedIn