Public debt and fiscal sustainability: the cyclically adjusted balance in the case of Lebanon

ABSTRACT

Lebanon’s high debt-to-GDP ratio and persistent overall budget deficit expose the entire financial system to vulnerability. Unless the country generates enough revenue to meet its gross financing needs, the prospect of borrowing more remains strong. Given the complexity of the Lebanese economy and debt structure, the formulation of fiscal and monetary policy is difficult and costly. Hence, policymakers are continuously confronted with difficult choices and must select the choice that is the least destructive. The choice between short-term economic stability and medium-term fiscal sustainability is a clear example of the dilemmas that confront policymakers. In addition, procyclicality and its repercussions on economic growth and the lack of responses to fiscal needs are matters of significant importance for public debt and fiscal sustainability. Hence, this study provides an in-depth analysis of the difficulties facing the Lebanese economy as it tries to sustain its public debt and the overall fiscal deficit. The study calculates the cyclically adjusted balance to analyze the appropriateness of fiscal policy and to assess the role of the automatic stabilizers. Additionally, the study employs a multivariate vector autoregression to forecast the variables in the simple debt model and to identify the impulses needed from various endogenous shocks. The derived results demonstrate that fiscal policy is predominately procyclical, that policymakers risked short-term economic stability for the sake of medium-term fiscal sustainability, and that unless the government adjusts its fiscal behavior, triggers automatic stabilizers, and negotiates a better deal with resident lenders, the economy will further deteriorate.

KEYWORDS:

• Financial crisis in Lebanon
• public debt and fiscal sustainability
• cyclically adjusted balance
• debt restructuring in Lebanon
• stochastic simulation

Acknowledgments

Special thanks to the journal chief editor and to the anonymous reviewers for their valuable comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 According to the World Fact Book, Lebanon’s debt-to-GDP ratio ranks third after Japan and Greece for the year 2017.

2 A good example of mismanagement by the Lebanese government is the mismanagement of electricity. It has been estimated that electricity consumes 40% of the government budget.

3 According to Transparency International’s Global Coalition Against Corruption, Lebanon’s position during 2018 relative to other countries in the index was 138/180.

4 Gross financing needs is the amount of financing necessary to cover future debt obligations, such as the deficit plus amortization of debt. The gross financing need can be positive or negative.

5 For an elaborative explanation about calculating the CAB, please refer to (Fedelino et al., 2009).

6 Automatic stabilizers are automatic changes in government revenue and spending that are attributable to cyclical movements in unemployment and real output.

7 NOB= Revenue – Expenses.

8 NLB = Net Operating Balance (NOB) – Net Acquisition of Nonfinancial Assets.

9 CA= (S-I) = (S_g-I_g) + (S_p-I_p).

10 NLB = S_g-I_g.

11 CA = NLB+ (S_p -I_p).

12 NLB = Net acquisition of financial assets (NAFA) - Net incurrence of liabilities.

13 Overall Balance (OB) = NLB – privatization proceeds and fixed assets disposal policy loans.

14 According to the United Nations High Commissioner for Refugees (UNHCR), there were over 1 million Syrian refugees who had been registered in Lebanon in 2016.

15 Output Gap= ((real output - potential)/potential), where potential output is calculated by using the Hodrick–Prescott filter.

16 The automatic stabilizer is the difference between the primacy balance as a percent of GDP and the cyclically adjusted primary balance as a percent of potential GDP.

17 1 US dollar is officially the equivalent of 1505 LL.

18 Lebanon’s civil war started in 1974 and ended in 1991.

19 The criteria consist of the Akaike information criterion (AIC), the final prediction error (FBE), the Hanna-Quinn information criterion (HQ), and the sequential modified (LR) test statistic. The aforementioned tests suggest that a lag of the order of 2 is sufficient.

20 In the lag specification, practitioners have often used 4 lags, or p = 4 when working with quarterly data.

21 If the solution for the characteristic polynomial has a root equal to 1, then either some or all of the variables in the VAR process are integrated of the order 1. The VAR stability condition check indicates that none of the variables are equal to 1.

22 Bai-Perron test for L + 1 vs. L sequentially identified three breaks.

23 The test statistics are rejected at the critical value of 6.9%.

24 During the 2016 fiscal year, the Lebanese government paid around $5 billion to service its debt.