ECONOMIC REPORT

2ND QUARTER 2021

TABLE OF CONTENTS STABILIZING MONETARY CONDITIONS STILL POSSIBLE, IN THE CONDITION OF RESTORED POLITICAL CONFIDENCE AND THOROUGH ECONOMIC MANAGEMENT Executive Summary 1 Economy contracting further in the first half-year Almost all sectors have witnessed a further contraction in the first half of 2021 relative to the 2020 period, Introduction 2 amid domestic political bickering, rising macroeconomic uncertainties and ascending monetary fears. The BDL average coincident indicator, a weighted average of a number of real sector indicators, reported a Economic Conditions 3 contraction of 44.1% in the first two months of 2021 relative to the same period of 2020. The Tourism and real estate sectors seem to be the only sectors regaining some strength this year amid cheap domestic prices and global travel opening up, with property sales and passengers at the airport up by double-digits this year. Real Sector 3 Net financial inflows down coupled with a rise in trade deficit External Sector 5 According to the latest figures for foreign trade, imports reported US$ 1,949 million in the first two months of 2021, contracting by 7.5% relative to same period of 2020, while exports reported US$ 384 million in the first two months of year 2021, dropping by 43.0% year-on-year. As such, Lebanon’s Public Sector 7 trade deficit recorded US$ 1,565 million, up by 9.3% relative to the same period last year. In parallel, a decline in net financial inflows by 11.9% was observed between the two periods, moving from US$ Financial Sector 8 924 million to US$ 814 million. Significant retreat in fiscal deficit in absolute and relative terms Concluding Remarks 11 While no public finance figures are yet available for the year 2021, the just released fiscal statistics for end-2020 suggest Lebanon has reported important savings in fiscal deficit in the past year amid a drastic decline in debt servicing following the State’s default on its foreign currency debt on one hand and some austerity efforts on the other hand. Public finance deficit decreased from LL 8,799 billion in 2019 to LL 4,083 billion in 2020, a contraction of 53.6%. As a percentage of expenditures, public finance deficit moved from 34.5% in 2019 to 21.0% in 2020. As a percentage of GDP, fiscal deficit contracted from 9.7% to 3.7%.

CONTACTS Narrowing banking activity contraction, rising deposit dollarization and contracting loan dollarization: The first half of 2021 was marked by a continuing contraction in activity this year, though less Research significant than that of the corresponding period of last year Assets contracted by US$ 7.0 billion in the 2021 year-to-June period, against a contraction of US$ 15.7 billion over the same period of 2020. Marwan Barakat A lower deposit contraction was reported this year amid stricter restrictions on withdrawals, mark ups (961-1) 977409 and less loan redemption. In parallel, a rising deposit dollarization was registered to a 28-year high [email protected] along with contracting loan dollarization to a 34-year low. LL and US$ deposit interest rates reached new historical lows in June. Finally, shareholders equity contracted amid net banking losses tied to Salma Saad Baba significant provisioning requirements facing Lebanese banks covering both sovereign and private (961-1) 977346 sector risks at large. [email protected] Strong equity price rebounds year-to-date, bond prices at new record lows Farah N. Nahlawi Lebanon’s equity market bounced back during the first half of 2021, registering strong price gains (961-1) 959747 on hedging activity against crisis, while Lebanese Eurobonds pursued their downward trajectory [email protected] amid lingering domestic political uncertainties and prospects of long-delayed discussions with international financial institutions and bondholders. In details, Lebanon’s equity market registered Zeina M. Labban strong price rebounds during the first half of 2021, as reflected by a 29.8% surge in the BSE price index, (961-1) 952426 following an 8.9% contraction in 2020, as market players sought to add Lebanese equities to their [email protected] holdings to hedge against potential financial losses.

Michele Sakha A new wave of currency volatility amid fundamental and psychological factors (961-1) 977102 The year 2021 has witnessed erratic fluctuations of the Lebanese Pound exchange rate on the black [email protected] market. The depreciation of the exchange rate of the Lebanese Pound is the result of a combination of psychological factors related to domestic political confidence and fundamental factors related to the demand and supply of Lebanese Pounds and US dollars on the market (Drop in dollar inflows, LL money creation, non-subsidized imports, etc). Subsequently, the year-on-year Consumer Price Index has surged by 143% in June 2021 compared to results of June 2020 as per the Consultation and Research Institute. BDL FX reserves contracted by US$ 3.5 billion in the first half of 2021 amid FX market intervention and import financing for basic products. 3rd Quarter 2019 1 2nd Quarter 2021 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] 2NDECONOMICS QUARTER 2021 LEBANON

The first half of 2021 was marked by a volatility in the Pandemic, with the first quarter reporting a rise in COVID cases in Lebanon generating consecutive lockdowns, while the second quarter reported a sharp decline in cases and deaths, leading to a number of countries removing their travel bans with Lebanon. The third quarter yet started with a resurgence again in the number of cases amid the emergence of new Corona strains worldwide, while vaccination exceeded so far 12% of Lebanon’s population.

The analysis of major macroeconomic aggregates this year suggest that private consumption has been adversely impacted by overall economic concerns, in addition to the adverse impact of the Coronavirus Pandemic on the consumption behavior. Private investment got a significant hit amid lack of economic appetite and growing concerns on the politico-economic outlook of the country at large.

Almost all sectors have witnessed a further contraction in the first half of 2021 relative to the 2020 period, amid domestic political bickering, rising macroeconomic uncertainties and ascending monetary fears. The tourism and real estate sectors seem to be the only sectors regaining some strength this year amid cheap domestic prices and global travel opening up, with property sales and passengers at the airport up by double-digits this year.

The evolution of real sector indicators this year is actually a mirror image of a sluggish economy. The BDL average coincident indicator, a weighted average of a number of real sector indicators, reported a contraction of 44.1% in the first two months of 2021 relative to the same period of 2020. Among indicators with negative growth over the first half of this year, we mention new car sales with a decline of 49.1%, cement deliveries with a decline of 33.3% and the value of cleared checks with a drop of 22.1%. The indicators with positive growth were construction permits with a surge of 326.6%, the number of passengers at the Airport with a rise of 18.7% year-on-year, the value of property sales with an increase of 9.6% year-on-year, and the merchandise at the Port with a rise of 7.4%.

At the monetary level, the year-on-year Consumer Price Index has surged by 143% in June 2021 compared to results of June 2020 as per the Consultation and Research Institute. BDL FX reserves contracted by US$ 3.5 billion in the first half of 2021 amid FX market intervention, and import financing for basic products. In parallel, Parliament approved law to distribute prepaid cards valued at a yearly total of US$ 556 million, an average of US$ 93 per household per month for 500 thousand eligible households, parallel to potential subsidy rationalization.

Banking sector statistics for the first half of 2021 suggest a continuing contraction in activity this year, though much less significant than that of the corresponding period of last year. In fact, measured by the aggregated assets of operating banks in Lebanon, banking activity contracted by US$ 7.0 billion in the 2021 year-to-June period (the equivalent of -3.7%), against a contraction of US$ 15.7 billion over the same period of 2020 (the equivalent of -7.2%). Banks’ shareholder equity amounted to US$ 16.4 billion at end-June 2021, against US$ 19.9 billion at end-2020 and US$ 20.7 billion at end-2019. The contraction in shareholders’ equity is tied to the accumulation of bank losses, despite cost control efforts, amid significant provisioning requirements facing Lebanese banks covering both sovereign and private sector risks at large.

At the capital markets level, equity markets did not mirror the economic sluggishness of the first half year. The BSE price index reported an expansion of 30% in the first half of the year driven mainly by the improvement in Solidere prices which rose by 35% over the period, amid the investor tendency to avoid haircuts on their financial placements. This occurred within the context of a 57.4% annual increase in trading volume year-on-year, moving from US$ 119 million in the first half of 2020 to US$ 188 million in the first half of 2021.

The developments in the real sector, external sector, public sector and financial sector for the first half of the year 2021 will be analyzed thereafter while the concluding remarks are left to an assessment of the monetary conditions, the reasons for LL depreciation and the monetary challenges looking forward.

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1. ECONOMIC CONDITIONS

1.1. REAL SECTOR

1.1.1. Agriculture and Industry

Lebanon’s primary and secondary sectors relatively hit

Lebanon’s own agricultural sector continues to be underfunded and underdeveloped for, hindered by a lack of modern equipment and inefficient production techniques. Water supplies are in constant shortage due to the absence of planned irrigation programs and dams, which would otherwise allow for the use of surplus rainwater for irrigation and other functions. The sector was also hit with the suspension all imports of Lebanese fruit and vegetables by back in April.

The Food Security and Agriculture sector partners have been working to cushion the impact of the crisis on all populations, with food assistance and interventions in support to agricultural livelihoods, as per the UNHCR. However, interventions to support agriculture activities were negatively impacted by the extended lockdowns needed to contain the spread of the COVID-19 pandemic. Despite this, some results were achieved in terms of support to 1,000 vulnerable small-scale farmers through cash and vouchers schemes. In total, US$ 200,000 were disbursed to farmers to facilitate their access to otherwise unaffordable agriculture inputs, and support to agriculture cooperatives allowed 529 of their members to receive business plan preparation trainings and nutrition sessions, as per the same source.

It is noteworthy that, a French firm aims to turn tons of rotting grain at ’s devastated Port into compost. ’s Recygroup, in partnership with Lebanese firm Mondis, is to funnel around US$ 1.5 million into converting the wheat to a new use, for agriculture.

At the level of the industrial sector, Lebanon is on the verge of a major crisis involving its industrial sector.

This is due to numerous factors including the shortage of fuel and endless power cuts are taking their toll on Lebanese factories, which will soon be unable to keep their machinery running.

On a similar note, the industrial exports retreated by around 47.0% in the first two months of this year.

The numerous crises the country is going through are weighing heavily on the primary and secondary sector as the endless shortage in basic necessities for the sectors to function lead to a significant downturn in the sectors.

1.1.2 Construction

Lebanon’s construction and real estate sectors regain strength in the first half of 2021

The real estate and construction sectors in Lebanon regained strength in the first half of this year, mainly due to a better performance in the second quarter of 2021, following a slowdown in the first quarter.

In details, on the demand side, the number of sales operations went up from 27,216 operations in the first half of 2020 to 39,274 operations in the half 2021, according to the latest statistics published by the General Directorate of Land Registry and Cadastre.

In parallel, the value of property sales transactions posted a noticeable rise of 9.6% year-on-year to reach a total of US$ 5,912.6 million during the same period of 2021. Most regions recorded an increase in the value of sales transactions, with the most significant movements coming as follows: North (+104.9%), Nabattiyeh (+54.9%) and the South (+51.8%). In this context, the average sales value retreated from US$ 198,276 in the first six months of 2020 to US$ 150,547 in the corresponding period of this year. As for the breakdown of the value of property sales, Beirut continued to capture the highest share over the period with a share of 25.0%, followed by Baabda with 20.7%, Metn with a share of 15.7% and Keserwan with a share of 11.7%. Moreover, property taxes followed a rising trend as well as, these ameliorated from US$ 218.2 million in the first half of 2019 to US$ 302.5 million, a yearly rise of 38.6%. 3 2nd Quarter 2021 3 2NDECONOMICS QUARTER 2021 LEBANON

On the supply side, construction permits, an indicator of forthcoming construction activity, posted a three digit year-on-year rise during the first half of 2021, showing a paradoxical interest in the construction sector noting the increasing prices due to the volatility of the parallel exchange rate market and the instable socio-economic and political situation.

In fact, construction permits covered an area of 3,425,278 square meters in the first five months of 2021, against an area of 802,996 square meters in the first five months of 2020. This followed a yearly contraction of 73.8% registered in the aforementioned period of 2020 and which was mainly due to the lockdown imposed in Lebanon during that period. The breakdown by region shows that most of the regions reported three digit increases in the aforementioned periods.

As for the breakdown of construction permits, Mount-Lebanon continued to capture the highest share in newly issued construction permits in the first five months of 2021 with a share of 30.4%. It was followed by South-Lebanon with 22.5%, the North with a share of 22.1%, Nabattiyeh with 12.4%, Bekaa with 11.6% and Beirut with 1.0%.

Hence, the sector seems to be faring better during the first half of the year, amid higher activity that is revealed on both the supply and demand side. The challenge is yet for such an improving activity to be sustainable looking ahead amid the country’s uncertainty outlook on the overall.

1.1.3. Trade and Services

Lebanon’s tertiary sector remains under pressure in H1 2021, with the exception of tourism

Amid continued domestic political bickering, rising macroeconomic uncertainties and ascending monetary fears, Lebanon’s tertiary sector continued to witness a weak performance during the first half of 2021, with the exception of the tourism sector regaining some strength this year amid cheap domestic prices and global travel opening up.

Figures released by the Rafic Hariri International Airport revealed that the total number of passengers recorded a yearly 18.7% increase in the first half of 2021. The number of aircraft picked up by 18.5% year- on-year in the aforementioned period. A detailed look at the activity shows that the number of arriving passengers increased by a yearly 29.6% and that of departing passengers by 9.0% to reach 730,794 and 684,205 respectively in the first half of 2021. The number of transiting passengers hiked from 15,044 passengers in the first half of 2020 to 27,773 passengers in the corresponding period of current year.

When including the latter mentioned category, the total number of passengers using the airport attained 1,442,772, up by 19.6%. Looking at the aircraft activity, landings and take-offs increased by a yearly 18.5% each, with the former amounting 7,532 planes and the latter reporting 7,520 in the first half of 2021. Regarding the freight movement within the airport, 13,262 thousand tons were imported and unloaded during the first half of 2021 while 22,501 thousand tons were loaded and exported.

Subsequently, and according to Ernst & Young’s “ Hotel Benchmark Survey”, the performance

CONSTRUCTION EVOLUTION OF CONSTRUCTION INDICATORS

2020 2021 Variation

Q1 Q2 H1 Q1 Q2 H1 Q2/Q2 H1/H1 Value of property sales 2,335 3,061 5,396 2,300 3,612 5,913 18.0% 9.6% (in millions of US$) Number of property 14,068 13,148 27,216 13,182 26,092 39,274 98.4% 44.3% sales o.w. Sales to 225 202 427 172 411 583 103.5% 36.5% foreigners Average value per property sale 166 233 198 175 138 151 -40.5% -24.1% (in US$ 000) Property taxes 99 119 218 96 206 302 72.7% 38.6% (in millions of US$)

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of Lebanon’s hospitality sector witnessed a notable acceleration in occupancy rates, average room rates and room yields during the first five months of 2021. As a matter of fact, the occupancy rate of four and five-star hotels within the capital reached 33% in the first five months of 2021, against 19% in the same period of 2020. The plunge in Lebanese currency against dollar might have opened Beirut to more price- sensitive vacationers, thereby providing an uplift to occupancy. Concurrently, the resumption of economic and entertainment activities along with the declining COVID-19 cases may have aided the hotels to secure higher turnouts when compared to the same period last year.

Furthermore, as per Global Blue, the firm that reimburses VAT to tourists at Lebanese border points, purchases by tourists in Lebanon whose VAT was claimed and which gives a fair view about tourists’ shopping trends, expanded by 232% during the first half of 2021 compared to the same period of 2020. This was mainly due to the huge increase during the second quarter of 2021.

The latest statistics released by Port of Beirut revealed an 11.6% decline in the Port’s revenues in the first six months of 2021 compared to the same period of the previous year. In parallel, the number of containers registered an annual increase of 17.4% in the first six months of 2021 against same period in 2020 to attain 248,323 containers in the first half of 2021. However, the number of ships revealed a fall of 16.7 % year-on- year to reach 614 vessels in the first six months in 2021. The quantity of goods rose by a yearly 7.4% to 2,412 thousand tons in the first half of 2021, following a fall of 36.0% reported in the same half of 2020.

Last but not least, total value of cleared checks, an indicator of consumption and investment spending in the Lebanese economy, declined by 22.1% year-on-year in the first half of 2021 mirroring the regression in spending during the above mentioned period.

The value of cleared checks reached US$ 20,603 million in first half of 2021 down from US$ 26,456 million in same half of previous year. A breakdown by currency shows that the bank’ clearings in Lebanese Pounds amounted to LP 13,905 billion (-3.0%) in first half of 2021 while those in US$ amounted to US$ 11,379 million (-32.8%). Moreover, the number of cleared checks registered 1,881,673 in the first half of 2021, down by 38.1% from 3,041,067 checks in the corresponding half of 2020. The average value per check rose by 25.9% year-on-year in H1 2021 to attain US$ 10,949 in the aforementioned H1 of 2020. It is worth noting that the value of returned checks registered US$ 275 million in the first half of 2021 down by a yearly 51.7%. The number of returned checks stood at 15,361 in the first half of 2021, down from 79,671 in the same period of 2020.

1.2. EXTERNAL SECTOR

Net financial inflows down by 12% coupled with a 9% rise in trade deficit

According to the latest Customs figures for foreign trade, imports reported US$ 1,949 million in the first two months of 2021, contracting by 7.5% relative to same period of 2020, while exports reported US$ 384 million in the first two months of year 2021, dropping by 43.0% year-on-year. As such, Lebanon’s trade deficit recorded US$ 1,565 million, up by 9.3% relative to the same period last year.

In parallel to a larger trade deficit in January and February 2021, Lebanon’s balance of payments witnessed a

TRADE AND SERVICES

2020 2021 Variation Q1 Q2 H1 Q1 Q2 H1 Q2/Q2 H1/H1

Number of ships 388 349 737 311 303 614 -13.2% -16.7% at the port Number of containers at 102 110 212 124 124 248 13.2% 17.4% the port (in 000s) Merchandise at the Port (in 1,131 1,114 2,245 1,271 1,140 2,412 2.3% 7.4% 000 tons) Planes at the Airport 10,805 1,899 12,704 6,492 8,560 15,052 350.8% 18.5% Number of passengers at 1,152 40 1,192 537 878 1,415 2121.5% 18.7% the Airport (in 000s) Cleared checks 16,075 10,381 26,456 9,997 10,606 20,603 2.2% -22.1% (in millions of US$)

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widening deficit from US$ 505 million in first two months of 2020 to US$ 751 million in the same period current year. This is mainly due to a decline in net financial inflows estimated at 11.9% between the two periods, moving from US$ 924 million to US$ 814 million.

In details, the breakdown of imports by product reveals a slump in weapons by 100%, followed by a significant decline in leather and furs by 60%, similarly to shoes and hats by 54.5%, followed by mineral products with 38.8%, textile and textile products with 38.2%, Jewelry by 23.1%, livestock and animal products with 9.9% and electrical equipment and products with 5.9% during first two months of 2021 relative to first two months of 2020. On the other hand, the main items that have displayed an increase in imports were transport vehicles with 74.0%, followed by fats and oils with 66.7%, Cement and stone products with 64.7%, followed by plastic products with 63.6%, wood and wood product and antiques with 50% over the same period.

The breakdown of imports by country of origin over the same period shows that among the major partners, imports from Romania dropped the most by 45.5%, followed by Italy with 22.4%. Imports from South Korea hiked by 450%, followed by USA with 324.2%, Brazil with 257.1%, China with 215.1%, Japan with 214.3%, Spain with 183.3% and Netherlands with 175.0% year-on-year over the first two months of 2021.

In parallel, the breakdown of exports by product reveals a slump in shoes, hats and feathers with 75.0%. followed by a significant decline among the major categories like Jewelry with 67.7%, leathers and furs with 66.7% and 50.0% decline for each of Textile and textile products, Cement and stone products, Mineral products and Audiovisuals when compared to first two months of year 2020. It is worth noting that live animals and animal products alongside with Antiques displayed an increase of 300% over same period, representing 3.1% of total exports.

The breakdown of exports by major countries of destination suggests that exports to reported the most significant decline of 62.6% year-on-year, followed by with 53.3%, Nigeria with 50.0%, France with 40.0% and Germany with 33.3% over the first two months of 2021. On the other hand, South Korea revealed the highest increase in exports with 175.0%, followed by Italy with 150.0%, Egypt with 111.1%, with 90.9% and Kuwait with 83.3% year-on-year over the first two months of 2021.

It is worth mentioning that exports through the Port of Beirut represent the bulk of exports with US$ 184 million in first two months of 2021, falling by 15.0% relative to same period of 2020, followed by exports through the Airport with US$ 131 million in first two months of 2021, declining by 32.8% year-on-year. Then comes the exports through Port of Tripoli with US$ 24 million registering an increase of 41.2% year-on-year. Finally, the land exports through Syria reached US$ 35 million in first two months of 2021, contracting by 75.0% over the same period.

BREAKDOWN OF EXPORTS AND IMPORTS BY COMMODITY (2M-21)

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1.3. PUBLIC SECTOR

Significant contraction in fiscal deficit in absolute and relative terms

While no public finance figures are yet available for the year 2021, the just released fiscal statistics for end- 2020 suggest Lebanon has reported important savings in fiscal deficit in the past year amid a drastic decline in debt servicing following the State’s default on its foreign currency debt on one hand and some austerity efforts on the other hand. Public finance deficit decreased from LL 8,799 billion in 2019 to LL 4,083 billion in 2020, a contraction of 53.6%. As a percentage of expenditures, public finance deficit moved from 34.5% in 2019 to 21.0% in 2020. As a percentage of GDP, fiscal deficit contracted from 9.7% to 3.7%.

Most of the savings in fiscal deficit was driven by the decline in interest payments over the year, moving from LL 8,068 billion in 2019 to LL 2,917 billion in 2020. This was almost fully driven by the drop in interest payments on foreign currency debt by 92.8%, while interest on local currency debt retreated by 44.3% over the period. Net of debt servicing, the primary deficit actually doubled, moving from LL 433 billion to LL 977 billion. As a percentage of expenditures, the primary deficit rises from 1.7% in 2019 to 5.0% in 2020. As a percentage of GDP, the primary deficit rises from 0.5% in 2019 to 1.0% in 2020.

The contraction in fiscal deficit is the result of a 23.8% drop in public expenditures, while public revenues declined by 8.0% year-on-year. Public expenditures moved from LL 25,479 billion in 2019 to LL 19,425 billion in 2020. Public revenues contracted from LL 16,680 billion to LL 15,342 billion over the same periods. The contraction in public revenues comes as a result of a severe economic sluggishness, which was estimated by the IMF at -25% in terms of real GDP contraction.

The contraction in public spending is driven by the decline in budgetary expenses by 27.2% in 2020, while Treasury expenses rose by 19.8% year-on-year. The drop in budgetary expenses is mainly tied to the drop in interest payments over the year by 63.8%, along with a contraction in transfers to EDL by 38.6% amid the drastic decline in international oil prices last year that compressed the fuel oil bill of EDL. It is worth mentioning that crude oil prices contracted on average by 22.4% in 2020 relative to 2019.

The retreat in public revenues is likewise due to a contraction in budgetary revenues by 13.9%, while Treasury revenues almost doubled between the two periods. In turn, the contraction in budgetary revenues is driven by a drop in tax revenues by 16.4%, while non-tax revenues barely changed by 4.3%, with Telecom revenues that represent the bulk of non-tax revenues reporting an expansion by 6.4% last year. It is worth mentioning that almost all items of tax revenues witnessed a contraction in 2020, with VAT revenues dropping by 42.8%, custom revenues declining by 28.4% and miscellaneous tax revenues contracting by 16.4% year-on-year. Paradoxically, real estate registration fees rose by 109.5% year-on-year amid the significant increase in property transactions last year within the context of a rising resort to the real estate sector as a safe haven.

In parallel, the public debt data published by the Ministry of Finance in Lebanon showed that the country’s gross debt reached US$ 97.8 billion at end-April 2021, up by 5.3% from level seen at end-April 2020. Domestic debt increased by 4.2% from end-April 2020 to reach a total of LP 91.8 billion at end-April 2021. Lebanon’s external debt rose by 7.1% from end-April 2020 to stand at around US$ 36.9 billion at end-April 2021.

SUMMARY OF FISCAL PERFORMANCE PUBLIC INDEBTEDNESS

LL billion 2019 2020 Var 20/19

Total public revenues 16,679,804 15,341,876 -8.0% Total public expenditures 25,478,607 19,425,187 -23.8% Total Cash Deficit / Surplus -8,798,803 -4,083,311 -53.6% In % of Total Expenditures -34.5% -21.0% 13.5% In % of GDP -11.1% -4.3% 6.8% Total Primary Deficit / Surplus -432,949 -977,129 125.7% In % of Total Expenditures -1.7% -5.0% -3.3% In % of GDP -0.5% -1.0% -0.5%

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In this context, the public sector deposits at the Central Bank rose by 14.9% from end-April 2020 to register US$ 5.0 billion at end-April 2021. The public sector deposits at commercial banks picked-up by 21.8% from end-April 2020 to register US$ 5.8 billion at end-April 2021. As such, net public debt, which excludes the public sector deposits at the Central Bank and commercial banks from overall debt figures, increased by 3.8% from end-April 2020 to reach a total of US$ 86.9 billion at end-April 2021. It is finally worth recalling that the State had defaulted on its foreign currency debt in March 2020, with the non-payment of maturing Eurobonds.

1.4. FINANCIAL SECTOR

1.4.1. Monetary Situation

Noticeable currency depreciation on black market amid continuous FX reserves burn

The first half of the year 2021 saw the Lebanese pound plummet to unprecedented low levels amid continuous FX reserves burn and elevated domestic political uncertainties, while the Lebanese Parliament approved a draft law to distribute ration cards to poor households, parallel to potential subsidy rationalization.

While Lebanon is reeling under dire economic and living conditions, BDL’s foreign assets pursued their nosedive during the first half of the year 2021, reaching US$ 20.6 billion at end-June as compared to US$ 24.1 billion at end-2020, which marks a large contraction of US$ 3.5 billion amid continuous deficit monetization from BDL, ongoing essential goods subsidies and new “Sayrafa” platform financing. When excluding BDL’s Eurobond holdings estimated at US$ 5.0 billion and facilities provided by the Central Bank to banks, BDL’s liquid FX reserves are estimated to have fallen below the US$ 15 billion threshold.

Amid dwindling BDL’s FX reserves, a complete loss of confidence, severe shortage in foreign currencies, excessive LP money creation, and lingering cabinet uncertainties, the Lebanese pound dipped to new record lows against the US dollar on the black FX market during the first half of 2021, crossing the LP/US$ 17,000 level at end-June 2021 as compared to LP/US$ 8,400 at end-2020. Under these circumstances and in the aim of preserving remaining FX reserves, the Lebanese Parliament approved at end-June 2021 a draft law to distribute prepaid ration cards to needy households, which would pave the way for potential subsidy cuts on essential goods.

Within this context, it is worth mentioning that the black FX market continued to witness strong currency swings over the month of July 2021, and saw the Lebanese pound plummet to an all-time low of LP/US$ 23,000, before recovering to LP/US$ 18,600 at end-July, mainly on hopes that the appointment of a new PM- designate would speed up the formation of a new cabinet that would implement long-overdue reforms and unlock much-needed international aid.

That being said, Lebanon’s currency trading market remained governed by a multiple exchange rate system during the first half of 2021, which includes the official exchange rate of LP/US$ 1,507.5, the LP/US$ 3,900 rate set by banks for FC deposit withdrawals, the new “Sayrafa” rate set at LP/US$ 12,000 and the LP/US$ exchange rate on the black FX market.

MONETARY SITUATION EXCHANGE MARKET INDICATORS

Flows in US$ million 1H-20 1H-21 Progression

Vol Vol Vol

Net foreign assets (excluding gold) -3,970 -1,844 2,126

Net claims on the public sector (excluding -7,044 -1,790 5,254 valuation adjustments) Claims on the private sector -7,390 -3,835 3,555

Uses=Sources -18,404 -7,469 10,936

Money (M3) -5,038 1,450 6,488

Valuation adjustment and other items -13,367 -8,919 4,448

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In parallel, the financial system’s total subscriptions in LP Treasury bills amounted to LP 7,205 billion during the first half of 2021 against LP 6,115 billion during the corresponding period of 2020, up by 17.8% year- on-year, following a 19.3% contraction in 2020, noting that longer-term higher-yielding tenors of five-year, seven-year and ten-year categories accounted for two-thirds of subscriptions over the first half of the year.

Concurrently, the Central Bank of Lebanon continued to play the role of an intermediary between banks and the sovereign during the first half of 2021, as reflected by a LP 643 billion rise in its LP securities portfolio, following a larger expansion of LP 3,011 billion in 2020. As far as interest rates are concerned, LP Tbs rates remained stable during the first half of 2021, ranging between 3.50% for the three-month category and 7.0% for the ten-year category, following across-the-board rate cuts in 2020.

As to Certificates of Deposits, the total LP CDs’ portfolio remained in contractionary mode during the first half of 2021, moving from LP 45,211 billion at end-December 2020 to LP 43,245 billion at end-June 2021, down by LP 1,966 billion. This followed a LP 2,832 billion contraction in 2020.

Looking forward, should the appointment of a new PM designate lead to the formation of the long-awaited “mission” government that would promptly enact much-needed economic reforms and secure international financial aid, this might help restoring confidence and containing FX pressures on the black FX market.

1.4.2 Banking activity

Narrowing activity contraction, rising deposit dollarization and contracting loan dollarization:

Banking sector statistics for the first five months of 2021 suggest the following activity highlights, sector performance and financial trends:

-A continuing contraction in activity this year, though much less significant than that of the corresponding period of last year: Measured by the aggregated assets of operating banks in Lebanon, banking activity contracted by US$ 7.0 billion in the 2021 year-to-June period (the equivalent of -3.7%), against a contraction of US$ 15.7 billion over the same period of 2020 (the equivalent of -7.2%).

-Lower deposit contraction this year amid stricter restrictions on withdrawals, mark ups and less loan redemption: Customer deposits, the main driver of banking activity, reported a contraction of US$ 4.9 billion over the first six months of 2021, against a contraction of US$ 14.4 billion over the similar period of last year. The lower contraction this year is due to stricter restrictions on withdrawals, mark ups and less loan redemption. Loans contracted by US$ 4.3 billion over the 2021 first six-month period (against a redemption of US$ 8.4 billion over the same period last year).

-Contraction mostly tied to resident activity: The breakdown of deposits and loans by customers’ residence shows that most of the contraction is tied to resident activity. In fact, resident deposits contracted by US$ 4.0 billion over

BANKING ACTIVITY

in millions of US$ 2019 2020 1H-20 1H-21

Var: Total assets -32,703 -28,739 -15,686 -6,964 % change in assets -13.1% -13.3% -7.2% -3.7% Var: Total deposits -15,418 -19,723 -14,361 -4,904 o.w. LP deposits -13,119 -10,772 -8,947 -827 o.w. FC deposits -2,299 -8,952 -5,414 -4,078 % change in total deposits -8.8% -12.4% -9.0% -3.5% Var: Total credits -9,617 -13,601 -8,351 -4,302 o.w. LP credits -2,710 -959 -505 -1,367 o.w. FC credits -6,907 -12,642 -7,846 -2,935 % change in total credits -16.2% -27.3% -16.8% -11.9%

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the 2021 six-month period, while non-resident deposits dropped by US$ 0.9 billion. Likewise, loans to the resident sector contracted by US$ 3.8 billion, against a contraction of US$ 0.5 billion for loans to non-residents.

-Rising deposit dollarization along with contracting loan dollarization: Deposit dollarization reached a 28-year high of 80% in June, while loan dollarization reported a 34-year low of 58.4%. The rise in deposit dollarization is tied to the more significant withdrawal pace in LL than in FX, in addition to continuing conversions from LL holdings to FX holdings. The drop in loan dollarization is due to the fact that borrowers are settling more FX loans than LL loans in view of the expected depreciation of the Lebanese Pound on the official market. Over the first six months of 2021, FX loans dropped by US$ 2.9 billion, while LL loans declined by US$ 1.4 billion.

-LL and US$ deposit rates at new historical lows in June: The LL deposit rate reached 1.84% in June 2021, i.e a contraction of 80 bps year-to-date (following a 472 bps contraction in 2020), while the US$ deposit rate reached 0.39% in June 2021, i.e a contraction of 45 bps year-to-date (following a 368 bps contraction in 2020). As such, the spread LL and FX deposit rates reached a low of 1.45% (against 1.70% in December 2020 and 2.74% in December 2019) and the spread between US$ deposit rate and 3-month Libor reached a low of 0.24% in June 2021 (against 0.70% in December 2020 and 2.71% in December 2019).

-Lower sovereign exposure amid contracting Eurobond portfolio: Banks Eurobond portfolio continued to contract this year to reach US$ 8.2 billion at end-June2021, against US$ 9.4 billion at end-December 2020 and US$ 13.8 billion at end-December 2019. As a percentage of customer FX deposits, bond portfolios dropped from 11.4% at end-2019 to 8.4% at end-2020 and to 7.6% at end-June 2021. As such, the bond portfolio held by banks stand today at 0.50 times equity against a ratio of two times equity a decade and a half ago.

-Contracting shareholders equity amid net banking losses: Banks’ shareholder equity amounted to US$ 16.4 billion at end-June 2021, against US$ 19.9 billion at end-2020 and US$ 20.7 billion at end-2019. The contraction in shareholders’ equity is tied to the accumulation of bank losses, despite cost control efforts, amid significant provisioning requirements facing Lebanese banks covering both sovereign and private sector risks at large.

1.4.3. Equity and Bond Markets

Strong equity price rebounds during the first half of 2021, bond prices at new record lows

Lebanon’s equity market bounced back during the first half of 2021, registering strong price gains on hedging activity against crisis, while Lebanese Eurobonds pursued their downward trajectory amid lingering domestic political uncertainties and prospects of long-delayed discussions with international financial institutions and bondholders.

In details, Lebanon’s equity market registered strong price rebounds during the first half of 2021, as reflected by a 29.8% surge in the BSE price index, following an 8.9% contraction in 2020, as market players sought to add Lebanese equities to their holdings to hedge against currency losses on the black FX market.

FINANCIAL SECTOR (NON-BANKS) CAPITAL MARKETS PERFORMANCE

2015 2016 2017 2018 2019 2020 Jun-21

Beirut Stock Exchange

Market capitalization (In millions of US$) 10,496 10,951 10,578 9,117 7,540 7,176 9,321

Total trading volume (In millions of US$) 498 885 608 376 197 233 188

Annualized trading volume/Market capitalization 4.7% 8.1% 5.8% 4.1% 2.6% 3.2% 4.0%

Price index 104.6 106.9 98.2 83.9 69.7 63.5 82.5

% change in index -1.2% 2.1% -8.1% -14.6% -16.9% -8.9% 29.8%

Lebanese Eurobonds

Total volume (In millions of US$) 25,535 26,123 26,123 30,964 28,314 31,314 31,314

Average yield 6.1% 6.5% 6.5% 10.0% 30.0% 57.0% 74.0%

Average life (In number of years) 6.1 6.2 6.7 7.8 7.5 7.1 6.6

5-year CDS spreads variation (bps) 26 57 42 229 1,649 - -

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A breakdown by sector shows that Solidere “A” and “B” shares registered significant price gains of 34.1% and 34.8% respectively to reach US$ 24.81 and US$ 24.65 respectively at end-June 2021, their highest levels since end-December 2009. As to banking stocks, six out of 20 listed stocks registered price rises, while three stocks posted price contractions and 11 stocks saw no price change during the first half of 2021. A closer look at individual stocks shows that Bank Audi’s “listed” shares and GDRs, BLOM’s “listed” shares and GDRs, and ’s “listed” shares registered strong price rebounds ranging between 45.5% and 80.0%, while Byblos Bank’s Preferred shares 2008 and 2009 posted price contractions of 23.0% and 3.8% respectively, and Bank Audi’s Preferred “I” shares posted price retreats of 2.2%. This brought the price growth across banking stocks to 15.9% on average during the first half of 2021. Amongst industrial and trading stocks, Ciments Blancs Nominal’s shares and Holcim Liban’s shares posted price increases of 9.8% and 17.2% respectively, while RYMCO shares saw no price change over the covered period.

The strong price rebounds on the BSE over the first half of 2021 were coupled with increased price volatility. The price volatility, measured by the ratio of the standard deviation of prices to the mean of prices, reached 6.0% on the during the first half of 2021 as compared to 5.3% during the same period of 2020.

In line with significant price gains and in the absence of any listing or delisting activity, the BSE market capitalization expanded similarly by 29.9% over the first half of 2021, moving from US$ 7,176 million at end- December 2020 to US$ 9,321 million at end-June 2021. The BSE total trading value amounted to US$ 187.9 million during the first half of 2021 as compared to US$ 119.4 million during the corresponding period of 2020, up by 57.4%, noting that Solidere shares continued to capture the lion’s share of activity (89.9%). Accordingly, the BSE total turnover ratio, measured by the annual trading value to market capitalisation, reached 4.0% during the first half of 2021 as compared to 3.6% a year earlier.

In contrast, Lebanese Eurobond prices crashed to new record lows during the first half of 2021, ranging between 12.25 cents per US dollar and 12.63 cents per US dollar at end-June amid a long-simmering political standoff, dwindling foreign currency reserves and rising uncertainties about discussions with the IMF and bondholders. This followed large price falls in 2020 in the aftermath of Lebanon’s default on its foreign debt payment on March 9, 2020.

At current bond price levels, the haircut on Lebanese sovereigns is estimated above 87%, which is among the highest in emerging markets. It is worth mentioning that Standard and Poor’s said in a recent report that its observations of 17 emerging-market sovereign defaults between 1999 and 2010 showed that the average haircut on government debt stood at 42%.

Looking forward, Lebanon’s capital markets await the formation of a new government that would revive IMF talks and help securing a long-awaited international financial support, which would pave the way for constructive discussions with bondholders.

CONCLUSION: A GLANCE AT THE LEBANESE POUND EXCHANGE RATE BEHAVIOR, CAUSES AND FORTHCOMING CHALLENGES

The year 2021 has witnessed erratic fluctuations of the Lebanese Pound exchange rate on the black market. The behavior of the exchange rate of the Lebanese Pound is the result of a combination of psychological factors related to domestic confidence and fundamental factors related to the demand and supply of Lebanese Pounds and US dollars on the market.

The main reason for the rise of the exchange rate of the US dollar relative to the Lebanese pound on the black market is tied to domestic political uncertainty, especially within the context of the political bickering related to Cabinet formation. Such political cloudiness depresses the confidence factor among Lebanese and prompts them to convert whatever they can to US$ cash and store it for darker days. Political uncertainty adds to the domestic shortage of foreign currencies amid the considerable drop in dollar inflows to the country within the context of a significant US$ 10.5 billion balance of payments deficit in 2020 (a record high for Lebanon), a deficit that continued over the first few months of 2021, though at a less

11 2nd Quarter 2021 11 2NDECONOMICS QUARTER 2021 LEBANON

significant pace. Recent monetary/banking figures show a balance of payments deficit of US$ 1.8 billion over the 2021 six-month period, as shown by the decline in net foreign assets of the financial system (BDL and banks).

The inflow contraction is coupled with excessive Lebanese pound money creation amid annual growth in currency in circulation by 194 percent over the past year, moving from LL 10 trillion at beginning-2020 to LL 30 trillion at end-2020, and a further spectacular rise in the first few months of 2021 to reach LL 38 trillion at end-June. The excessive money creation is tied to the monetization of the fiscal deficit on behalf of the Central Bank in the absence of the traditional debt financing that would sterilize monetary outgrowth. In addition, the creation of Lebanese Pounds within the context of BDL circular 151 (and BDL circular 158 looking ahead) create further pressures on market disequilibria, despite the number of restrictions introduced on possible LL cash withdrawals.

There is also the domestic US$ demand that is created by non-subsidized imports, although the latter’s effect has been slightly reduced recently by the creation of the Sayrafa platform on behalf of the Central Bank that partly meets the demands of importers. It is worth mentioning that out of US$ 11.3 billion of imports in 2020, US$ 5 billion were subsidized by BDL and most of the remaining US$ 6.3 billion were mainly financed by the black market. The eventual subsidy lifting is likely to increase further such a FX demand component.

Such fundamental factors behind currency depreciation add to the speculative aspect driven by the manipulation of the black market exchange rate by exchange dealers and electronic platforms and that adds to market volatility. Although there has been a rising grip on the speculative activity of the latter, there is still a persisting deviation between prevailing black market prices and the real effective exchange rate tied to economic and monetary fundamentals.

Lately, there have been growing talks about establishing a currency board regime in Lebanon, though the latter is believed to be subject to a mix of pros and cons. The advantages of using a currency board includes stabilizing the currency through linking the supply of domestic currency to existing FX reserves, thus controlling inflation, some establishing economic credibility, and lowering real interest rates.

The main disadvantages of a currency board entail the drawbacks of a pegged exchange rate regime relative to a freely freely floating one, the difficulty of providing the initial reserves that are needed to establish the board, in addition to the risk of the sudden abandonment of the system. So disregarding whether Lebanon establishes a currency board or not, the main challenge is to increase the size of its FX reserves in relation to its monetary base. For that sake, what is needed, first and foremost, is to get international assistance, which is in turn linked to the formation of a credible government in the eyes of the international community and the enactment of needed structural and financial reforms.

Looking forward, the currency’s perspectives would fundamentally depend on the domestic political outlook and the corollary economic management of Lebanon’s twin deficits, i.e. Lebanon’s fiscal deficit and external deficit at large. There is a still possibility to stabilize the US dollar’s exchange rate in the condition of a return of political confidence factor, of the launch of needed structural/financial reforms, of thorough economic management of Lebanon’s twin deficits and of ensuring monetary discipline at large.

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. 12 2nd Quarter 2021 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]