2ND QUARTER 2018 ECONOMICS

TABLE OF CONTENTS LEBANON ECONOMIC REPORT

Executive Summary 1 A LACKLUSTER REAL SECTOR ACTIVITY YET COUPLED WITH PERSISTENTLY SOUND FINANCIAL AND MONETARY CONDITIONS

Introduction 2 • Slowing down economic conditions in the first half-year While Lebanon has witnessed an active first half-year, underlined by the early adoption of a 2018 budget Economic Conditions 3 regularizing the State’s accounts, a number of successful international support conferences and free and orderly parliamentary elections, the country’s economy remains subdued, with the main growth drivers still sluggish on the overall. In fact, while private consumption has benefitted this year from the Real Sector 3 recent ratification of the public sector wage scale and its corollary impact on consumption spending of public servants, Lebanon’s investment framework continues to be adversely impacted by a mood of External Sector 5 cautiousness and uncertainty among investors. Within this environment, BDL has recently forecasted growth at 2% for 2018, against 2.5% last year.

Public Sector 6 • A contracting trade deficit within the context of surging exports and declining imports Within the context of a 5% decline in trade deficit along with a 7% rise in financial inflows to Lebanon over the first five months of 2018 relative to the same period last year reducing the 2017 first half US$ Financial Sector 7 1.1 billion balance of payments deficit to a deficit of US$ 0.2 billion in the first half of 2018, a relative improvement in the external position was recorded over the period. The decline in the trade deficit comes within the context of a 9.9% growth in exports year-on year and a 3.0% retreat in imports over Concluding Remarks 11 the same period.

• Monetary conditions persistently sound despite overall macroeconomic challenges Lebanon’s monetary conditions remained strong during the first half of 2018, despite overall macro- CONTACTS economic challenges, with the country’s defense lines at one of their most solid levels. The Central Bank of Lebanon’s foreign assets reached a new record high level in June, helped by BDL’s swap operations and continuous FC-to-LP conversions. They grew by US$ 2.2 billion during the first half of 2018 to reach US$ 44.2 billion at end-June. The Central Bank’s foreign assets-to-LP money supply coverage ratio rose Research from 80.0% at end-2017 to 81.8% of LP money supply at end-June 2018, which is two times the average Marwan S. Barakat of reserve adequacy in similarly rated countries (an average of 41%), outlining the Central Bank’s strong (961-1) 977409 capacity to defend the currency peg. [email protected] • Sound bank deposit growth yet coupled with lending contraction Jamil H. Naayem Lebanon’s banking sector witnessed healthy activity and earning growth in this year’s first half amid (961-1) 977406 sound deposit inflows on the back of increased capitalization, but lending activity remains slightly [email protected] contractionary year-to-date. Customer deposits, the traditional activity driver in the sector accounting for close to three quarters of banks’ balance sheets, progressed by US$ 4.7 billion in the first half of 2018, Salma Saad Baba in line with average first half growth of the previous five years, and reached US$ 173.3 billion at end- (961-1) 977346 June 2018. This has been favored by a pick-up in deposit collection as banks offered enticing returns [email protected] on deposits in local currency and amid higher interest rates cross-currencies in general following the further tightening of the US Federal Reserve’s monetary policy. Fadi A. Kanso (961-1) 977470 Capital markets under adverse price pressures during the first half-year [email protected] • Activity in Lebanon’s capital markets was tilted to the downside during the first half of 2018. The equity market, which suffers from a lack of liquidity and efficiency, registered price falls, increased Gerard H. Arabian price volatility and declines in total turnover amid lingering uncertainties over the cabinet formation. (961-1) 964047 [email protected] In parallel, the fixed income market saw downward price movements amid extended international offer that was accompanied by a low domestic bid, with Lebanon’s five-year CDS spreads seeing significant expansions over the first half of the year. This is actually well reflected in the 7.9% plunge Farah N. Nahlawi (961-1) 959747 in the stock price index year-to-date and the 202 basis points expansion in Lebanon’s five-year CDS [email protected] spreads, a measure of market perception of sovereign risk, to reach 723 basis points at end-June, before contracting back to 607 basis points at end-July 2018.

2nd Quarter 2018 1 Bank Audi sal - Group Research Department - Bank Audi Plaza - Bab Idriss - PO Box 11-2560 - Lebanon - Tel: 961 1 994 000 - email: [email protected] 2ND QUARTER 2018 ECONOMICS LEBANON

While Lebanon has witnessed an active first half-year, underlined by the early adoption of a 2018 budget regularizing the State’s accounts, a number of successful international support conferences and free and orderly parliamentary elections, the country’s economy remains subdued, with the main growth drivers still sluggish on the overall, as witnessed by the lackluster performance of a number of real sector indicators.

Out of 11 real sector indicators, 4 are up and 7 are down in the first six months of 2018 relative to last year’s corresponding period. Among indicators with positive growth, we mention total exports with an increase of 9.9%, the number of passengers at the Airport with an expansion of 9.3%, , electricity production with a rise of 5.3% and the number of tourists with a growth of 3.3%. Among indicators with negative growth, we mention construction permits with a fall of 17.8%, value of property sales with a contraction of 14.0%, merchandise at the Port with a fall of 7.9%, new car sales with a decline of 5.4%, cement deliveries with a decrease of 4.1%, imports with a drop of 3.0%, and cleared checks with a downtick of 2.5%.

Consequently the coincident indicator of the Central Bank of Lebanon, a mirror image of real sector activity in the country, reported 314.5 over the first five months of 2018, i.e a growth of 2.5% year-on-year. Such a growth is below the one reported over last year’s same period (4.6%) and over the same period of the past three years (3.3%). It seems the real economy is slowing down this year, yet without falling into a recessionary trap. BDL has recently forecasted growth at 2% for 2018, against 2.5% last year.

In fact, while private consumption continues to be sound, private investment is adversely affected by the wait-and-see attitude among investors. Private consumption has benefitted this year from the recent ratification of the public sector wage scale and its corollary impact on consumption spending of public servants. On the other hand, Lebanon’s investment framework continues to be adversely impacted by a mood of cautiousness and uncertainty among investors as witnessed by the decline in bank loans to the private sector amid scarce lending opportunities.

At the external level, within the context of a 7% rise in financial inflows to Lebanon over the first five months of 2018 relative to the same period last year reducing the deficit in the balance of payments, a relative improvement in the external position was recorded over the period. Financial inflows, which had been lagging in recent years behind the trade deficit, almost offset it year-to-date. Financial inflows to Lebanon rose from US$ 6,647 million over the first five months of 2017 to US$ 7,090 million over the first five months of 2018. In parallel, a 5.2% decline in the trade deficit is witnessed amid a 9.9% growth in exports year-on-year, and a 3.0% retreat in imports over the same period.

Amid a slight increase in financial inflows, banking activity was sound, with satisfactory deposit growth but with negative lending growth. Deposit growth reported US$ 4.7 billion over the first 6 months of 2018, close to the same period last year, while the lending portfolio reported a net contraction of US$ 0.1 billion for the first time in recent years. Unlike last year when all deposit growth was driven by FX deposits, this year’s deposit growth was evenly broken down between LP and FX deposits, leading to a slight retreat in dollarization from 68.7% at end-December 2017 to 68.4% at end-June 2018.

The overall economic sluggishness over the first half-year was accompanied by adverse capital markets developments. At the equity market level, the BSE price index contracted by 7.9% over the first six months of 2018, amid a 47.3% decline in the trading volume year-on-year. At the fixed income level, the 5-year CDS spreads, a measure of the markets perception of sovereign risks, rose from 521 bps at end-December 2017 to 723 bps at end-June 2018, i.e a deterioration of 202 bps, before relatively improving in the month of July.

The developments in the real sector, external sector, public sector and financial sector for the first half of 2018 will be analyzed thereafter while the concluding remarks are left to an in-depth assessment of the requirement to fight fiscal evasion as a prerequisite for public finance softlanding.

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1. ECONOMIC CONDITIONS

1.1. REAL SECTOR

1.1.1. Agriculture and Industry

Mixed performances for Lebanon’s primary and secondary sectors

The country’s agricultural and industrial sectors witnessed rather mixed performances during the first five months of 2018. Internally, demand on agricultural imports grew, while demand on industrial imports came under pressure. On the external front, both agricultural and industrial exports significantly rose in the first five months of this year.

With regards to Lebanon’s industrial sector, exports continued performing well, overcoming the constraints of blocked land routes and the high costs for transportation. They expanded by 9.3% year-on year in the first five months of 2018, against a rise of 10.1% in the corresponding period of 2017. On the other hand, industrial imports contracted by 4.2% year-on-year during the first five months of 2018, compared to a rise of 1.9% in the previous year.

On the agricultural front, the sector witnessed solid performances at the level of exports and imports. As a matter of fact, agricultural exports witnessed a notable expansion of 18.5% during the first five months of 2018, compared to an increase of 62.0% during 5M 2017. Moreover, imports of the agricultural sector rose by 7.4% in 5M 2018, against an expansion of 11.2% in the same period of last year.

In parallel, the country’s bank financing for small and medium-sized enterprises through Kafalat loans continued losing pace, witnessing a further contraction in the first six months of 2018. The total value of Kafalat loans fell by 24.4% year-on-year to reach US$ 28.8 million in the aforementioned period of this year

The number of Kafalat loans also dropped by 28.1% year-on-year. In details, financing to the agricultural sector saw a decline of 35.7% year-on-year in the first six months of 2018, and financing to the industrial sector decreased by 20.8% year-on-year. With regards to Kafalat loans given out by caza, Mount Lebanon came on top, constituting 43.5% of the total. It was followed by the Bekaa and North Lebanon, which formed 17.0% and 10.8% respectively of total Kafalat loans.

Out of total Kafalat loans through June 2018, the industrial sector constituted the lion’s share at 37.7%, followed by the agricultural sector at 36.3% and the tourism sector at 21.5%. It is worth adding that the average value per loan was US$ 129,094 in the firsthalf of 2018, up by 5.1% year-on-year.

Finally, agricultural and industrial sectors are impacted by domestic and regional geopolitical dynamics that continue to pose security and stability challenges. A stable domestic political environment accompanied with structural reforms, alongside the efficient usage of financial support from the international community could attract investments into the country‘s industrial and agricultural sectors. Thus, authorities are called to take constructive action in the formation of a government, and take advantage from the support of the international community to incentivize Lebanon’s primary and secondary sectors.

1.1.2. Construction

Slowdown in realty markets amid contracting demand

A generally adverse mood took over the country’s property market on both the demand and supply sides in the first half of 2018, in an environment of contracting demand weighing the sector down. This was highlighted by a slowdown in most of the posted indicators.

A look at the performance of property markets during the first half of the year shows that they are slowing down, reversing the growth trend seen in 2017. The number of property sales operations declined by

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18.2% year-on-year to reach a total of 27,472 operations in the first half of 2018. This followed a yearly increase of 12.0% registered in the corresponding period of last year.

The drop in demand for property in Lebanon during the first half of this year was accompanied by a fall in the value of property sales transactions during the aforementioned period. The latter posted a decline of 14.0% year-on-year to register a total of US$ 3,872.8 million in the first half of 2018. Most of the regions recorded declines in the value of sales transactions, with the most significant movements coming as follows: North (-35.0%), Baabda (-25.0%) and Nabattiyeh (-19.4%).

With the number of sales operations retreating more than the value of property sales transactions, the average sales value rose from US$ 134,105 in the first half of 2017 to US$ 140,971 in the first half of 2018. Moreover, property taxes adopted a declining trend as well, down by a yearly 15.7% to US$ 202.8 million in the first half of this year.

On the supply side, the construction sector likewise adopted a slowing trend, accompanying the weaker demand. In this context, figures released by the Order of Engineers of and Tripoli reveal that the area of newly issued construction permits registered 5,023,143 square meters in the first half of 2018, down by 17.8% year-on-year. A breakdown by region reveals that Mount-Lebanon topped the list accounting for 41.3% of the area of issued permits. North-Lebanon came next with 21.1%, followed by South-Lebanon (15.2%), Bekaa (9.8%), Nabattiyeh (9.1%), and Beirut (3.7%). In parallel, cement deliveries were on a decreasing path, contracting by 4.1% from 2,005,398 tons in the first five months of 2017 to 1,922,652 tons in the corresponding period of this year.

On a different note, real estate advisory agency Ramco revealed that the average size of an apartment under construction in Beirut stood at 182 sqm in 2017. This is 8% smaller than the 2016 average. The study covered a panel of 269 buildings under construction across Municipal Beirut. The agency highlights that over the past several years, the average size of new apartments has been steadily shrinking. This is one of the consequences of the slowdown of the real estate market in the capital. Since buyers’ budgets are getting smaller and smaller, developers have naturally adapted their offer by proposing smaller apartments in the hope that their products remain within the reach of the largest number of potential buyers possible.

1.1.3. Trade and Services

Tertiary sector continues growing, yet at a mild pace

Lebanon’s trade and services sector witnessed a mostly growing performance during the first six months of 2018. Tourism indicators showed improved activity, with the number of tourists adopting an upward trail. Airport activity also remained on a growth trend, alongside mixed maritime trade indicators. However, this was contrasted by a deceleration in occupancy rates in four and five stars hotels within the capital city.

Indeed, the country’s tourism sector witnessed a solid performance, with the number of tourists posting a 3.3% yearly increase in the first six months of 2018 following an increase of 14.2% posted in the same period of the previous year. CONSTRUCTION EVOLUTION OF CONSTRUCTION INDICATORS

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In fact, the number of tourists registered 853,087 in the first six months of 2018, compared to 826,129 tourists posted in the same period of 2017. Moreover, and Arab countries got the lion’s share in the contribution to the number of tourists with 35.2% (300,037 tourists) and 30.1% (244,800 tourists) respectively. These were followed by tourists from America which took over a share of 18.2% (155,446 tourists). Tourists from Asia came in after with a share of 7.6% (64,865 tourists), while those of Africa followed with a share of 6.2% (52,714 tourists).

Similarly, the picture was favorable at the level of the airport, with the total number of passengers recording a yearly 9.3% increase in the first six months of 2018. A detailed look at the activity shows that the number of incoming passengers rose by a yearly 9.7% and that of departing passengers by 8.9% to reach 1,965,969 and 1,852,144 respectively in the first six months of 2018.

As for hotel occupancy rates, the rate of four and five star hotels within the capital reached 58.6% in the first five months of 2018, against 65.5% in the aforementioned period of 2017. Beirut’s room rate rose from an average of US$ 173 in the first five months of 2017 to US$ 174 in the corresponding period of 2018, equivalent to a yearly increase of 0.6%. The rooms’ yield fell by 9.7% annually to reach US$ 102 in the first five months of 2018 compared to US$ 113 in the same period of 2017, as per Ernst & Young.

Moving on to the port sector, the Port of Beirut revealed a yearly 2.3% increase in its revenues in the first six months of 2018 compared to the same period of the previous year. The Port’s revenues reached US$ 118.7 million in the first six months of 2018. In parallel, the number of containers recorded an annual increase of 0.6% to attain a total of 431,674 in the first six months of 2018. The number of ships posted a decline of 0.5% year-on-year to reach a total of 920 vessels in the first six months of 2018. As for the quantity of goods, they decreased by a yearly 7.9% to 3,916 thousand tons in the first six months of 2018, following a fall of 4.1% reported in the first six months of 2017.

1.2. EXTERNAL SECTOR

A contracting trade deficit within the context of surging exports and declining imports

Within the context of a 7% rise in financial inflows to Lebanon and amid a 5% contraction in trade deficit over the first five months of 2018 compared to the first five months of 2017, a relative improvement in the external position was recorded over the period. Financial inflows, which had been lagging in recent years behind the trade deficit, partially offset it year-to-date, leaving a smaller deficit of US$ 190 million in the balance of payments over the first half of 2018, compared to a larger deficit of US$ 1,116 million over the first half of 2017. This smaller deficit in the balance of payments comes from a growth in BDL’s net foreign assets by US$ 2,204 million, partially offsetting the US$ 2,394 million decline in banks’ net foreign assets.

It is worth mentioning that the financial inflows to Lebanon rose from US$ 6,647 million over the first five months of 2017 to US$ 7,090 million over the first five months of 2018. In parallel, the trade deficit declined from US$ 7,005 million to US$ 6,641 million between the two periods. This decline in the trade deficit by 5.2% comes within the context of a 9.9% growth in exports year-on year, and a 3.0% retreat in imports over the same period. Exports surged from US$ 1,205 million to US$ 1,324 million while imports went down from US$ 8,210 million to US$ 7,965 million between the two periods.

TRADE AND SERVICES EVOLUTION OF THE NUMBER OF TOURISTS

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The analysis of exports by product in the first five months of 2018 suggests that jewelry had the lion’s share with 26.0%, followed by metal products with 13.9%, food products with 13.8%, chemical products with 11.5%, electrical equipments and products with 9.7% and plastic products with 5.3%. The analysis of exports by country of destination suggests that UAE took the lead with 12.5%, followed by South Africa with 9.8%, with 7.4%, with 6.7%, Syria with 5.3% and with 5.1% over the period.

The analysis of imports by product in the first five months of 2018 suggests that mineral products had the lion’s share with 17.2%, followed by chemical products with 11.8%, electrical equipments and products with 11.4%, transport vehicles with 8.5%, food products with 7.1% and jewelry with 7.0%. The analysis of imports by country of origin suggests that China took the lead with 10.9%, followed by Italy with 8.7%, Greece with 7.9%, Germany with 6.2%, USA with 5.6% and with 3.8% over the same period.

1.3. PUBLIC SECTOR

A relative retreat in fiscal position over the first couple of months of the year

Following a net improvement in public finance performance in 2017, the first two months of 2018 witnessed a relative deterioration in Lebanon’s public finances as suggested by the recent figures released by Lebanon’s Ministry of Finance. In fact, after having fallen by 24.0% in 2017, Lebanon’s public finance deficit reported almost five times its low base level of last year’s corresponding period. This resulted from a significant rise of 40.4% in public expenditures (compared to a tiny 3.5% rise in 2017) in conjunction with a much lower growth in public revenues of 5.8% (compared to a 17.1% hike in 2017). As such, and within the context of an 8.7% rise in debt service, the primary balance shifted from a surplus of US$ 331 million to a primary deficit of US$ 330 million over the two-month periods.

A detailed look at public finance statistics over the first two months of the year shows that public revenues went up from US$ 1,845 million during the first two months of 2017 to US$ 1,953 million during the 2018 corresponding period, while public expenditures reported a noticeable growth from US$ 2,007 million to US$ 2,818 million between the two periods. Accordingly, the public finance deficit expanded from a low base of US$ 162 million during the first two months of 2017 to US$ 865 million during the corresponding period of 2018.

It is worth mentioning that the noticeable growth in public expenditures is tied to budget expenditures that rose by 28.5% and Treasury expenditures that increased by 187.3%. Among Treasury expenditures, expenditures by municipalities reported a considerable growth from US$ 6 million to US$ 342 million. In

BREAKDOWN OF EXPORTS AND IMPORTS BY COMMODITY*

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parallel, the growth in budget expenditures was realized as a result of a 35.6% hike in general expenditures despite the moderate growth in Treasury transfers to EDL of 3.4%. On the other hand, the tiny growth in public revenues is mainly tied to a 161.8% rise in Treasury revenues while budget revenues went down by 4.3% over the same period. The latter is due to a 46.1% drop in non-tax revenues, mostly due to Telecom revenues that went down from US$ 265 million to US$ 72 million, while tax revenues increased by 11.1% as a result of an 8.9% rise in VAT revenues and a 17.2% increase in miscellaneous tax revenues.

As far as deficit funding is concerned, the year-to-date fiscal deficit was financed by additional indebtedness. Public indebtedness data showed that the country’s gross debt reached US$ 82.5 billion as at end-May 2018, up by 3.7% from the level seen as at end-2017 and by 7.5% from the level registered at end-May 2017. Domestic debt went down by 4.7% from end-2017 and by a tiny drop of 0.5% from end- May 2017 to reach a total of US$ 46.8 billion as at end-May 2018. Lebanon’s external debt went up by 17.4% since year-end 2017 to reach US$ 35.7 billion, following the last large scale swap operation in May 2018.

The increase in gross public debt was accompanied by an increase in public sector deposits at the Central Bank, which rose by 4.7% from end-2017 and by 4.2% from end-May 2017, standing at US$ 6.2 billion as at end-May 2018. As to the public sector deposits at commercial banks, they went down by 4.3% from end-2017 and by 3.5% from end-May 2017 to reach US$ 4.1 billion as at end-May 2018. As such, the ratio of total State creditor accounts to total debt stood at 12.5% as at end-May 2018, down from 13.3% at end-May 2017 (12.8% at end-2017). The net public debt, which excludes the public sector’s deposits at the Central Bank and commercial banks from overall debt figures, increased by 4.2% from end-2017 and by 8.5% from end-May 2017 to reach a total of US$ 72.2 billion at end-May 2018. As such, public debt to GDP is estimated at 151.6% as at end-May 2018, up from 147.2% a year ago.

1.4. FINANCIAL SECTOR

1.4.1. Monetary Situation

Lebanon’s monetary conditions remain strong despite overall macroeconomic challenges

Lebanon’s monetary conditions remained strong during the first half of 2018, despite overall economic challenges, with the country’s defense lines at one of their most solid levels. The Central Bank of Lebanon’s foreign assets reached a new record high at end-June, helped by BDL’s swap operations and continuous FC-to-LP conversions. Concurrently, the LP primary Tbs market continued to attract healthy subscriptions over the first half of the year, mainly supported by BDL’s new operations.

The Central Bank of Lebanon’s foreign assets grew by US$ 2.2 billion during the first half of 2018 to reach US$ 44.2 billion at end-June. This is mainly explained by the swap operation undertaken by BDL with the Ministry of Finance in May 2018, through which the Central Bank of Lebanon exchanged US$ 5.5 billion of LP Treasury bills in its LP securities portfolio with newly issued Eurobonds, before selling US$ 3 billion of Eurobonds to local banks, in addition to healthy conversions in favor of local currency, as depositors sought to benefit from attractive rates on new LP saving products offered by commercial banks. Within

PUBLIC SECTOR DEFICIT FINANCING PUBLIC INDEBTEDNESS

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this context, it is worth mentioning that the BDL’s foreign assets growth was partly offset by the redemption of a US$ 700 million sovereign bond on June 12, 2018 paid in cash by the Central Bank. Still, the Central Bank’s foreign assets-to-LP money supply coverage ratio rose from 80.0% at end-2017 to 81.8% of LP money supply at end-June 2018, which is two times the average of reserve adequacy in similarly rated countries (an average of 41%), outlining the Central Bank’s strong capacity to defend the currency peg.

The Lebanese Pound remains pegged to the US dollar at a rate of LP/US$ 1,507.5. Within this context, the Central Bank Governor said that the Lebanese Pound is stable and will remain stable in the long-term, signaling a nation-wide decision to maintain the currency peg.

In parallel, the financial system’s total subscriptions in LP Treasury bills reached LP 15,640 billion during the first half of 2018, as compared to LP 10,406 billion during the same period of 2017, up by 50.3% year-on-year. This is mainly supported by BDL’s operations launched since September 2017 and that imposed on Lebanese banks to use the proceeds of LP facilities provided by BDL at 2% to purchase LP Treasury securities from the primary market, in addition to BDL’s subscription in three-year Tbs for an amount of LP 2,000 billion at a rate of 1% mid-June 2018, within the context of May 2018’s swap operation that required BDL to subscribe in LP Tbs for an amount LP 8,250 billion (the equivalent of US$ 5.5 billion) at a 1% interest rate.

As a result of May’s 2018 swap operation, the Central Bank of Lebanon’s LP securities portfolio registered a net contraction of LP 1,495 billion during the first half of 2018 to reach LP 42,627 billion at end-June.

On the other hand, the total LP Certificates of Deposits portfolio expanded significantly by LP 12,041 billion during the first half of 2018 to reach LP 47,906 billion at end-June, mainly helped by BDL’s new operations that allowed banks to subscribe in longer-term LP Certificates of Deposits against conversion of foreign currency funds into local currency. This followed a much lower growth in LP CDs portfolio of LP 1,234 billion in 2017.

Finally, as a measure of disintermediation, the share of LP Tbs held by the public to LP Money Supply (M2) reached 13.7% at end-June 2018, up from 13.6% at end-2017. As for crowding out effects, the share of the State in bank credits rose from 37.3% at end-2017 to 38.5% at end-June 2018, mainly reflecting banks’ purchase of US$ 3 billion Eurobonds from BDL.

1.4.2. Banking Activity

Sound bank deposit and earning growth yet coupled with lending contraction

Lebanon’s banking sector witnessed healthy activity and earning growth in this year’s first half amid sound deposit inflows, higher placements at BDL and subscriptions in securities on the back of increased capitalization, but lending activity remains slightly contractionary year-to-date even though it somewhat gained ground in the last couple of months. Measured by the aggregated assets of banks’ domestic operations, total sector activity rose by 6.7% in the first six months of 2018 to reach a new high of US$ 234.6 billion at end-June.

In details, customer deposits, the traditional activity driver in the sector accounting for close to three quarters of banks’ balance sheets, progressed by US$ 4.7 billion in the first half of this year, in line with average first half growth of the previous five years, and reached US$ 173.3 billion at end-June 2018. This has been favored

MONETARY SITUATION EXCHANGE MARKET INDICATORS

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by a pick-up in deposit collection as banks offered enticing returns on deposits in the local currency and amid higher interest rates cross-currencies in general following the further tightening of the US Federal Reserve’s monetary policy.

Latest banking sector figures suggest a yearly increase in the average LP deposit interest rate by 114 basis points between May 2017 and May 2018 to reach 6.71% and a yearly increase in the average US$ deposit interest rate by 49 basis points to reach 4.11%. Corrollarily, the spread between LP and FX deposit rate rose from 1.95% at end-May 2017 to 2.60% at end-May 2018. In parallel, the spread between US$ deposit rate and 3-month Libor rate declined from 2.41% to 1.79% over the same period.

So far this year, deposit growth is being driven almost equally by Lira and FX deposits (42% and 58% of total deposit growth respectively) whereas last year, the increase in deposits parked at banks was overwhelmingly driven by FX deposits. This reflects continuous conversions to the benefit of the local currency on the forex market amid the enticing packages offered by banks to depositors in the local currency (including those who convert foreign currency deposits to the local currency). Also, deposit growth was noticeably driven by more than one third by the non-resident sector, whereas last year’s similar period saw residents almost exclusively contributing to the increase in deposits.

As part of the BDL’s latest swap operation, banks deposited more funds at the Central Bank to benefit from advantageous facilities, hence readily available liquidity in the form of domestic reserves on banks’ uses side surged by 13% so far in 2018. Within this context, banks’ primary liquidity position remained strong, with the FX primary liquidity to FX deposits ratio at a more than comfortable 57.6% at end-June 2018. Also part of the recent Central Bank swap operation, Lebanese banks acquired sovereign Eurobonds from BDL, which explains the increase in banks’ FX bond portfolio by US$ 2 billion (circa 13%) this year.

However, while deposits are increasing and most of it is invested in liquid uses and government bonds, lending activity slightly contracted in the first half of this year. This is also due to the scarcity of lending opportunities in a sluggish economic growth environment locally. As a matter of fact, lending activity contracted by US$ 128 million in this year’s first half, yet surging in the months of May and June 2018, within the context of steadily rising deposit funds, leaving the year-to-date lending volumes barely in contraction mode. This year as well, new loans continued to be granted in local currency, well reflecting the return of the Lira as a standard of deferred payment following BDL’s policies over the past few years of fostering Lebanese pound-lending activity.

All in all, banks continue to collect deposits from a dedicated and growing customer base while maintaining a healthy liquidity status and adequate capitalization (equity rising by a further 6.5% in 1H2018) and ensuring strict lending monitoring with low NPLs. They thus remain apt to withstand any potential pressure or difficult operating environment locally or regionally.

BANKING ACTIVITY

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1.4.3. Equity and Bond Markets

Lebanon’s capital markets under downward price pressures during the first half-year

Activity in Lebanon’s capital markets was tilted to the downside during the first half of 2018. The equity market, which suffers from a lack of liquidity and efficiency, registered price falls, increased price volatility and declines in total turnover amid lingering uncertainties over the cabinet formation. In parallel, the fixed income market saw downward price movements amid extended international offer that was accompanied by a low domestic bid, with Lebanon’s five-year CDS spreads seeing significant expansions over the first half of the year.

In details, the ended the first half of the year 2018 on a negative note, as reflected by a 7.9% plunge in the price index, mainly dragged by double-digit price falls over the second quarter of the year due to ex-dividend activity and a stalemate in cabinet formation. Price drops during the first half of 2018 were coupled with increased price volatility, as the latter, measured by the ratio of the standard deviation in prices to the mean of prices reached 2.8%, as compared to 2.3% during the first half of 2017. Given price declines and in the absence of any listing or delisting activity, the BSE market capitalization fell by a similar 7.9% during the first half of 2018, moving down from US$ 10,578 million at end-December 2017 to US$ 9,745 million at end-June 2018.

The BSE total trading value fell by 47.3% year-on-year, moving from US$ 320 million during the first half of 2017 to US$ 169 million during the first half of 2018 (excluding block trades and OTC activity of circa US$ 257 million). Banking shares captured 60.5% of total activity during the first half of this year, followed by Solidere shares with 28.7% and the industrial shares with 10.8%. The BSE total turnover ratio, measured by the annualized trading value to market capitalization, continued to lag way behind regional, emerging markets and global turnover ratios, reaching 3.5% during the first half of the year 2018 as compared to 6.0% during the same period of the previous year.

In parallel, the Eurobond market came under downward price pressures during the first half of 2018 before bouncing back over the month of July. The price contraction comes amid a relatively low domestic demand and an extended foreign selling. In fact, international institutional investors were net sellers during the first half of the year, mainly tracking a wide sell-off mood in emerging markets, as growing concerns over a global trade war compounded the impact of a more hawkish US Federal Reserve and a strengthening US dollar.

Under these conditions, the Lebanese weighted average bond yield expanded by 255 bps during the first half of 2018 to reach 9.09% at end-June. In parallel, JP Morgan EMBIG Lebanon Z-spread widened by 252 bps over the covered period to reach 732 bps at end-June 2018, and compared to a much lower Z-spread of 381 bps in emerging markets, as per JP Morgan EMBIG. This prompted Lebanese banks to return to

FINANCIAL SECTOR (NON-BANKS) CAPITAL MARKETS PERFORMANCE

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the Lebanese bond market in July 2018, especially as the FC sovereign Eurobonds-to-FC deposits ratio reached 13.6% at end-June 2018, as per latest statistics, as compared to an average of 17.8% over the past ten years. The return of the domestic bid resulted into a relative bond price rebound. Within this context, it is worth highlighting that there was no change in the country’s economic fundamentals that generated such fluctuations to the downside and then to the upside.

As to the cost of insuring debt, Lebanon’s five-year CDS spreads, a measure of market perception of sovereign risk at large, expanded by 202 basis points during the first half of 2018 to reach 723 basis points at end-June, before contracting to 607 basis points at end-July 2018.

2. CONCLUSION: FIGHTING FISCAL EVASION CONSIDERED KEY FOR ANY FISCAL SOFTLANDING EFFORT

With fiscal adjustment increasingly considered to be a prerequisite for the resilience of the Lebanese economy and markets in the medium to long term, there are rising questions on where the major fiscal effort has to come from in an economy that has the third highest debt ratio in the World and that has a public finance deficit that falls within the Top decile of deficit ratios worldwide.

There is no doubt that Lebanon’s resource mobilization (actual public revenues to GDP ratio) of circa 20% over the past year is low relative to international norms (36% for advanced economies and 26% for emerging market and developing economies). This is partly because Lebanon has relatively lower tax rates but more importantly this is tied to the large fiscal evasion gap that Lebanon suffers from. While it is increasingly difficult to raise taxes in a slowing down real sector environment, the reinforcement of resource mobilization should come from fighting tax evasion, which is a prerequisite for any fiscal softlanding scenario for Lebanon.

As a matter of fact, we estimate Lebanon’s fiscal evasion gap at circa US$ 5 billion in 2017, the equivalent of 10% of GDP. Such a gap is almost equivalent to Lebanon’s budget deficit and it mainly comes from a number of taxes, such as income taxes, VAT and custom duties, EDL revenues and property taxes.

The largest source of tax evasion is tied to income taxes, estimated at circa US$ 2 billion, the equivalent of 3.9% of GDP. It mainly emanates from fiscal evasion in taxes on salaries and profits. The former’s estimate is based on a total of salaries accounting for 35% of GDP with an average tax rate of 10%, yielding to potential taxes on salaries of US$ 1.5 billion, while actual collection stands at US$ 0.6 billion, leaving US$ 0.9 billion of evasion. As to taxes on profits that account for 30% of GDP, tax evasion is estimated at US$ 1 billion, after adjusting the actual profit tax figures from the tax paid by banks on financial engineering operations and that is estimated at US$ 775 million.

The second source of fiscal evasion is that related toVAT, estimated at circa 3% of GDP, the equivalent of US$ 1.5 billion. The VAT gap analysis undertaken by the IMF points to a significant VAT erosion over time. The IMF analysis measures the overall gap between actual VAT receipts and receipts under a perfectly enforced VAT levied on consumption. In particular, the VAT compliance gap estimates the impact of imperfect compliance within the current tax system. As the structure of the Lebanese economy is oriented towards private consumption and high share of imports, the potential gains from well mobilizing VAT revenues are significant.

The third source of fiscal evasion is that related to custom duties. On the basis of a 13% average customs on the import bill of US$ 20 billion, potential custom duties should amount to US$ 2 billion, while actual duties levied amount to US$ 1.5 billion, leaving a fiscal evasion gap of US$ 0.5 billion, the equivalent of 1% of GDP.

The fourth source of fiscal evasion is the unpaid electricity bills and theft through illegal connection on the wires. The gap here is estimated at US$ 0.7 billion, which accounts for almost 40% of potential electricity revenues that should be collected by EDL. Fiscal evasion here represents circa 54% of the Treasury transfers to EDL last year, which is estimated at US$ 1.3 billion for full-year 2017.

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The fifth source of fiscal evasion is property taxes and that is tied to property undervaluation in real estate registration. It is estimated that properties are registered at an average of 20% below their true value. As such, property tax evasion is estimated at US$ 0.2 billion, the equivalent of 0.4% of GDP.

Finally, on the basis of a 5% broad evasion estimate on all other revenue categories (US$ 1.8 billion), an increment of US$ 0.2 billion could be added to the fiscal evasion estimate, the equivalent of 0.4% of GDP. It mainly emanates from evasion from excise taxes, telecommunications bills and administrative fees.

The above analysis suggests that even a partial elimination of the fiscal evasion gap can lead to a significant improvement in fiscal performance. As the State has committed to a reduction in fiscal deficit by 5% of GDP over the next five years, bridging a quarter of the fiscal evasion gap over the period would ensure circa 50% of the fiscal adjustment target that Lebanon needs to achieve over the next half a decade to ensure the much needed softlanding in its public finances and which remains the most significant vulnerability of Lebanon’s economy of nowadays.

The content of this publication is provided as general information only and should not be taken as an advice to invest or engage in any form of financial or commercial activity. Any action that you may take as a result of information in this publication remains your sole responsibility. None of the materials herein constitute offers or solicitations to purchase or sell securities, your investment decisions should not be made based upon the information herein. Although Bank Audi sal considers the content of this publication reliable, it shall have no liability for its content and makes no warranty, representation or guarantee as to its accuracy or completeness. 2nd Quarter 2018 12 Bank Audi sal - Group Research Department - Bank Audi Plaza - Bab Idriss - PO Box 11-2560 - Lebanon - Tel: 961 1 994 000 - email: [email protected]