Sustainability of budget deficits and public debt in Lebanon: a stationarity and co-integration analysis

Abstract

This paper presents a thorough empirical analysis of fiscal developments in Lebanon over the past three decades. After an evaluation of major fiscal and monetary developments, the paper uses the Present Value Constraint framework to analyze whether debt and deficits are sustainable. Unit root and co-integration tests reveal that public debt in Lebanon is not sustainable. It is also shown that Lebanon could be heading towards a debt and exchange rate crisis, which could degenerate into a banking crisis similar to the one observed in Argentina, unless timely fiscal adjustment measures are introduced in the near future.

Keywords:

• debt
• budget deficits
• sustainability
• JEL Classification: E62
• E69
• F34
• C32

Acknowledgments

Financial support from the University Research Board of the American University of Beirut is greatly acknowledged. The author is also grateful to the Editor of the Journal and an anonymous referee for very valuable comments and suggestions on an earlier draft.

Notes

1.	Insolvency of a given economy means also that the present value of the sum of future income minus expenditure is larger than the initial level of indebtedness.
2.	Physical assets ruin was estimated, by the United Nations, to be around $US25 billion.
3.	The 14 million wide Lebanese expatriate base contributed 20% of total capital inflows in 1998 (Lebanese Ministry of Finance, 1999). Available online at www. finance.gov.lb.
4.	Agenor and Montiel (1996, p. 123) argued that the government is solvent if the present value of the future resources available to it for debt service are at least equal to the face value of its initial debt stock. Thus, satisfying the present value budget constraint, implying that the government is solvent.
5.	However, Wilcox (1989) found that debt was unsustainable over the 1960–1984 sample period.
6.	Inflation has been contained in Lebanon since the early 1990s and the Lebanese government has rarely used seigniorage revenues to finance its budget deficit.
7.	Equation (1) may be interpreted in nominal or real terms. However, the empirical literature on debt sustainability suggests that the use of macroeconomic variables in real terms may be more robust and empirical tests are more likely to be satisfied if one considers real debt (i.e. nominal debt divided by a price index such as the consumer price index). Hence, r t and Z t may be interpreted as the real interest rate and real primary surplus.
8.	According to equation (1), if the government runs a primary surplus equal to zero (Z t = 0), the stock of debt will grow at a rate equal to the interest rate: If the government runs a primary deficit (Z t <0), the stock of debt will grow at a rate exceeding the interest rate. If the government runs a primary surplus (Z t > 0), the stock of debt will grow more slowly than the interest rate. If the surplus more than offsets payments on existing debt (i.e. the conventional surplus, Z t + r t B t −1 is positive), then the debt will actually shrink over time.
9.	While the PVC in levels or in ratios to GDP is unchanged, the conversion of fiscal variables from levels to ratios and implementing stationarity tests may constitute an important impediment. The series in levels may be integrated of order 1, I(1), when converted to ratios they may become stationary, or I(0) series. Equivalently, for co-integration-based tests, one requirement for two series to be co-integrated is that both be integrated of order 1, thus, using I(0) ratio series may lead to the conclusion that the series are not co-integrated when, in fact, they are.
10.	It is now well known in the econometrics literature that the Dickey–Fuller type tests may have serious shortcomings in the presence of structural breaks in the data (see Perron, 1989, 1997). Perron shows that Dickey–Fuller tests may fail to reject the unit root hypothesis if the series present a break-in-the-trend. Since the data used in the above analysis span the periods 1960–2002, structural breaks may not be ruled out. The ADF tests are, therefore, supplemented with the PP unit root tests.