Economic Liberalization in Lebanon: Simulating the Impact of Government Reforms

EXECUTIVE SUMMARY

The relationship between economic liberalization and growth has received much attention from researchers and media alike. In fact, free markets have been expanding based on strong evidence and conviction that the higher the level of economic freedom, the higher the level of income per capita and vice versa.

In 2006 the Lebanese economy did not fare as well as previously expected. The growth rate stood at 0 percent, with some sources suggesting that the economy even shrank by 5 percent; inflation recorded 7.5 percent; and public debt rose to 180 percent of Gross Domestic Product (GDP).

As for economic liberalization, Lebanon ranked 77th among 150 countries in 2007 according to the Heritage Foundation’s Index of Economic Freedom (IOEF). The IOEF ranks countries according to a measure of 10 categories of freedom, ranging from property rights to business freedom, on a scale from 0 to 100, with 100 indicating the presence of an environment that is most conducive to economic freedom. Lebanon’s rank is mainly due to low scores in investment freedom, corruption, and property rights.

This report evaluates recent reforms undertaken by the government as laid out in the donors’ Paris III Conference for the period of 2007-2011 and their impact on liberalization ranking of Lebanon in terms of IOEF using a simulation financial model.

“Lebanon has one of the poorest scores worldwide in investment freedom, corruption and property rights”

Fiscal Reforms

These include expenditure and revenues reforms. In total, fiscal adjustment is estimated to amount to 14 percent of GDP by 2011.

Total government expenditures are forecasted to decrease by more than 10 percent of GDP. Most of this adjustment will be cuts in primary expenditure, as savings from lower interest payments have been exhausted. If this level is attained, freedom from government, one of the 10 freedoms of the IOEF, would improve.

“Fiscal adjustment estimated to amount to 14 percent of GDP by 2011”

Total government revenues (tax and non-tax) are expected to increase by around 4 percent of GDP during the same period. Global comparison reveals that taxes on income and taxes on goods and services in Lebanon are, respectively, 4 times and 2 times lower than world averages.

Among tax revenues, the Value Added Tax (VAT) remains the largest revenue source. VAT exemptions, however, are still broad and rates need to be raised in order to compensate for the tariff reductions required to comply with trade agreements. Also, the VAT, which at present is actually a single stage sales tax, needs to progress to proper multi stage VAT to prevent double taxation. Furthermore, tax evasion in Lebanon has proven to be endemic and difficult to be resolved in the government’s reform time frame. For instance, the rate of unpaid taxes on business and financial profits, particularly for high income groups, was over 50 percent in 2006, Ministry of Finance data. This worsens tax and corruption scores of the IOEF as evasion impedes competitiveness and distorts resource allocation.

Non-tax revenues constitute a high ratio of about a third of the total. These revenues are realized through over pricing and over taxing public sector services. This again reduces private sector competitiveness and imposes a higher burden on lower income groups.

Direct taxes are likely to become higher, thus worsening fiscal freedom, another measure of the IOEF. For instance, the telecommunications sector yields non-tax revenue of around 5 percent of GDP. When this sector is privatized, the government will be deprived of this revenue and would have to shift revenue generation to income tax. Tariff receipts, however, would become lower resulting in further trade liberalization – a positive impact on the IOEF. It is important to note that the impact of privatization and tariff reductions associated with trade agreements on revenues has not been estimated in the context of Paris III.

The total foreseen fiscal adjustment of 14 percent of GDP is an ambitious target and is not consistent with the growth objectives of 2007-2011: a good share of expenditure cuts is borne by reducing capital spending. Furthermore, the cost of reforms is not estimated or accounted for. For instance, implementing the Global Income Tax (GIT) requires income aggregation and tax filing at a high initial cost that has not been accounted for. Therefore, the question remains as to whether these savings can actually be realized.

Debt Reforms

– The main features defining the current public debt are as follows:

· Debt has been on an increasing trend reaching 180 percent of GDP in 2006.

· The share of debt held by the Central bank has increased to almost 20 percent of the total.

· Maturity, however, has improved and interest cost lowered: Long term debt – that has a maturity of over one year – comprises more than 70 percent of total debt.

· External debt remains low at 15 percent of GDP: a very low exposure to external risk relative to cases that experienced financial crises triggered by a shift in external sentiment.

Paris III will provide USD 5.1 billion in financing, mostly in project financing. Combined with normal debt increases, the public debt is estimated to increase by USD 8.4 billion. Three key indicators serve to improve the public debt outlook: growth rates, primary surplus, and real interest rates, but mainly the first two as control over interest rates is limited with a pegged exchange rate.

Risk exposure concerns remain high due to rollover risk and low net reserves. This risk is likely to maintain high interest rates, discourage investment, and decrease potential economic growth.

“No “quick fix” for high public debt, but rather a gradual approach”

There is no “quick fix” for addressing the current high public debt, but rather a gradual approach based on improved primary surpluses and growth rates. Even then, debt sustainability would remain elusive.

The debt reform proposal consists of creating a Higher Council for Debt Management and a debt management office. The functions of both, however, have not been defined and their impact remains unclear.

Monetary Reforms

– The government’s monetary policy prime objectives are to:

· Maintain price stability

· Preserve the currency peg to the US Dollar

· Finance the public debt

· Ensure an adequate reserve cushion

“Unrealistic low prices over the past 5 years”

Reported inflation over the past five years has been understated due to several factors, mainly: high growth in money supply, the Lebanese Pound depreciation, the application of the VAT in 2002, and increases in petroleum prices.

Recently, banks’ credit has been concentrated on the public sector, comprising around 35 percent of total claims. As a result, credit to the private sector has been declining in real terms. In spite of this, no specific reforms were proposed, only the target of strengthening liquidity management due to the high financial risk associated with the high debt. In 2006 the rate of non-performing loans stood at a high 23 percent.

It is worth noting that preserving the peg and maintaining high reserves carries a high cost for the Central Bank. This makes its operations less centered on monetary and liquidity management.

Financial Markets Reforms

– Lebanon’s financial markets are one of the smallest in the Middle East. The Beirut Stock Exchange (BSE) lists 16 companies, whose total value is approximately USD 10 billion, 45 percent of GDP. Daily trading ranges between 2 and 3 USD billion. Lebanon continues to face limited sources of long term financing at internationally comparable costs.

“The BSE remains one of the smallest in the Middle East”

Proposed reforms in this sector include:

· Passing a capital markets law, insider trading law, securities lending law, and dematerialization of securities law.

· Setting up a capital markets commission

· Developing secondary market liquidity

· Establishing delivery versus payments system

· Developing a stock market index

These reforms would slightly improve the capital market outlook, however, their impact is expected to be limited due to the unfavorable investment environment, the IOEF Investment Freedom score is only 30.

Public Sector and Privatization Reforms

– The main public sectors of concern are power and telecommunications, which both have been providing over priced services (one of the highest in the world) to cut losses or generate exceptional revenues.

First, the power sector has been plagued with poor quality and high operating costs. Power supply shortages are extensive making households and industry rely on supplementary power. Industry in particular has complete dependence on its own power generation. The production problems facing electricity can be resolved without high investment commitment by contracting power supply internationally (For example, Build-Operate-Transfer). Due to its high losses, power privatization should be given top priority in the reform program.

“Prices in Power and Mobile sectors 5 times higher than in the region”

Mobile telecommunications has a low penetration rate of 27 percent, one of the lowest in the Middle Eastern countries, and much lower than countries with similar income levels. The government’s reform plan is to financially and operationally reform the power sector and to privatize the telecommunications sector. A preferred method to privatize would be to transferring ownership to the public by corporatizing the sector (offering shares in the BSE) rather than selling to a strategic buyer.

“Top priority for privatization: Power Sector; Mobile sector should be sold off to the public”

According to government sources, licensing the two mobile operators in Lebanon could bring in USD 2.5 billion per license. Such high license proceeds can only be realized with high service rates. Actually the government calculated these proceeds on the basis of discounted revenues from the telecommunications sector over a 20 year period using 13 percent discount rate and the existing tariff pricing structure. The current mobile price rates are 5 times higher than the regional norm leading to an operational rate of return of 80 percent according to the government’s updated scenario for 2007-2008. Instead, discounted revenues should be calculated on the basis of an internationally competitive price. This will bring in lower receipts, but insures lower tariff rates and maintains profitability in the industry.

Privatization should be guided by providing a competitive price for users rather than receiving the highest amount for the licenses. Furthermore, the current privatization approach continues to maintain a closed market (duopoly), and will result in a limited improvement in the competitive environment.

Governance Reforms

– The government has introduced several new laws and regulations. These include:

· A new draft law to audit public finances and public enterprises,

· A regulatory body to upgrade public procurement,

· Internal control units in ministries (finance and public works at first), and

· Proper procedures for public recruitment

The important issue, however, is that the government did not provide a time table and a scale of effectiveness for each of these measures. Therefore, we cannot determine whether this would improve or worsen governance.

“FOR GOVERNANCE & TRADE: Government did not provide a time table for each of these measures”

Business Environment Reforms

– The government has proposed a few reforms to improve the business environment and attract investment. These include:

— Lowering the minimum capital requirement for establishing businesses

— Reducing the time needed to obtain licenses

— Reducing the cost of terminating business

— Improving access to government subsidized credit

— Reducing government borrowing from banks through reforms in the fiscal and capital markets

— Strengthening loan guarantees (KAFALAT, IDAL)

— Simplifying tax procedures

As with governance reforms, no time table was set for these reforms, which means that the significance of these reforms on the economy cannot be assessed.

Trade Agreements Reforms

– Lebanon has concluded a number of trade agreements with key trading partners in the last decade. These are:

· The Greater Arab Free Trade Agreement (GAFTA)- Concluded in 1998

· The European Union-Mediterranean Agreement - Concluded in 2003.

· The European Free Trade Association (EFTA) - concluded in 2004.

· The Trade and Investment Framework Agreement (TIFA) with the United States– concluded November 2006

The objective of these agreements is to widen Lebanon’s free trade zones through gradual tariff reduction. This would certainly improve Lebanon’s trade, however, tariffs have been replaced by imposing VAT on imports. In fact, taxes on international trade constituted 37 percent of total government revenues in 2001. After VAT introduction in 2002, VAT revenues reached 23 percent of total revenues in 2006, while taxes on international trade decreased to 14 percent. As most VAT revenues are collected on imports, one can clearly see that revenues from taxes on goods and services (from both domestic and imports) have almost remained at the same level as in 2001. The Lebanese government also continues to maintain extensive trade controls, mainly restrictive license rules and quotas.

“Net effect of VAT and tariffs in 2006 same as net effect of tariffs in 2001”

Macroeconomic Impact – Feasible?

According to the reviewed reforms, the government expects to improve macroeconomic indicators as follows:

· Increase Gross Capital Formation to 20.8 percent of GDP (around 8 percent increase)

· Increase Gross Savings to 15.1 percent of GDP (around 10 percent increase)

· Reduce the Saving/Investment gap to -5.7 percent of GDP (around 1 percent increase)

· Increase growth rates to 5 percent of GDP (around 5 percent increase)

· Decrease inflation rates to 2 percent (around 5 percent decrease)

· Decrease debt to GDP to 135 percent of GDP (around 50 percent decrease)

Of these targets, the forecasted gross capital formation increase and the debt reduction appear to be over optimistic.

Liberalization Impact – Feasible?

Lebanon’s scores (over 100) for the 10 freedoms that the Index of Economic Freedom (IOEF) measures for 2007 are as follows:

Business Freedom 56.2

Trade Freedom 67.4

Fiscal Freedom 95.9

Freedom from Govt. 64.3

Monetary Freedom 83.5

Investment Freedom 30.0

Financial Freedom 70.0

Property Rights 30.0

Fdm from Corruption 31.0

Labor Freedom 74.4

There is very little that bears concretely on improving the IOEF score from Paris III, particularly in the areas with the lowest scores, which are investment freedom, corruption, and property rights. Corruption is widespread, especially in government contracts as regulations are vague and allow discretionary interpretation. While tax rates are generally not high, a variety of fees and indirect taxes are collected and tax evasion is still high. This environment creates barriers to fair competition.

The impact of Paris III on fiscal and debt reforms: simulation scenarios

The following scenarios primarily take into account the impact of donors’ support and downward adjustment in privatization receipts of the two mobile operators. Even at USD 4.5 billion, these expected proceeds remain very generous. As a result, the expenditure and debt outlook are less favorable than the government projections in spite of maintaining unrealistic cuts in expenditures foreseen by the government. For instance, wages and salaries will bear the brunt of adjustment further declining considerably in real terms, jeopardizing civil service effectiveness and morale.

Without Privatization - Scenario I

Projecting revenues and expenditures for the case without privatization, our simulation for 2007-2011, as shown in the table below, yields the following results:

· Total revenues reaching 25 percent of GDP is reasonable over the 5 year time frame

· Total expenditures will reach 30 percent of GDP after the full disbursement of the pledged amounts by donors

· The primary surplus is projected to be lower than government expectations, due to increased spending associated with external assistance

· The overall public debt will decline to 170 percent of GDP in 2011, far from the over-optimistic estimate of the government.

With Privatization - Scenario II

To attain the same level of revenues in this case, the government has to compensate for the 5 percent loss in non-tax entrepreneurial revenue. Shifting the mobile sector from a non-tax revenue to a tax revenue source could partially make up for the difference, as the government’s share of earnings now drops to 20 percent (the corporate tax rate). Even at the current overpriced tariff rate for the mobile sector, only 1 percent of GDP could be compensated for. This motivates the government to maintain a high price structure, which is possible under a duopoly market, primarily to keep a viable long term source of income.

On the expenditures side, total spending after privatization could be lowered by only 1 percent of GDP compared to the previous scenario, resulting from a lower interest payment on a lower public debt level. The primary balance with privatization would also be lower by 1 percent only. Public debt will decline to 150 percent of GDP by 2011, also far from the over projected level of 135 percent of GDP estimated by the government.

Concluding Remarks

The Lebanese government ought to be prudent in taking advantage of the current reform momentum by seeking a sound choice and implementation of the intended reforms. Public engagement and consensus are crucial to any comprehensive reform, without which success could be very limited. This consensus has not been fully sought and this may risk the ability of current and future governments to successfully undertake the needed reforms.

Further economic liberalization is anticipated to allow Lebanon to exploit its growth potential, specially at times when the external environment is less favorable. Currently, the regional boom had tremendously boosted Lebanon’s economy through remittances and strong performance of exports of goods and services. In the absence of this positive environment, Lebanon could pay a high cost in terms of unemployment and low economic growth. High emphasis should be placed on the weak liberalization scores of the Lebanese economy, in particular reducing corruption, enhancing property rights, and investment freedom.

Copyright © 2008 Lebanese Economic Association