RISING US RATES, POLITICAL RISK WEIGH ON ECONOMIC ACTIVITY

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1 N 73 October 2018 Page 3 Government to revive housing subsidies as real estate falters Page 4 Fiscal deficit swelled through April 2018 despite revenue gains Page 5 Non-resident banking activity gains momentum Page 6 Political delays holding up reforms - IIF Page 7 Latest data for Lebanon s key economic sectors Page 8 Key trends in the Lebanese economy RISING US RATES, POLITICAL RISK WEIGH ON ECONOMIC ACTIVITY Rising US benchmark rates lift borrowing costs in Lebanon Public debt in foreign currency to reach 61% of GDP by the end of 2018 Profits of Alpha Group banks slipped by 8.1% yoy to $1.1bn in the first half of 2018 Rising benchmark rates in the ed States and heightened regional political risk are taking a growing toll on the Lebanese economy and financial markets. The Federal Reserve raised in September its target for the federal funds rate by a quarter of a percentage point to a range of 2%-2.25% and is expected to continue tightening until the key rate reaches 3.4% by 2020, median projections by the Federal Open Market Committee showed. In parallel, the Beirut Reference Rate on US dollar reached 7.55% by August 2018, an increase of 1.79% since December Higher US dollar interest rates along with a prolonged Cabinet formation process in Lebanon are translating into higher borrowing costs for consumers, businesses, and the government, while weighing on investment demand. Five-year Credit Default Swap spreads, the cost to insure against sovereign default, surged to 828 basis points on September 17 before retreating to a September-low of 673 basis points by the end of month, data through Bloomberg showed. Bond yields displayed similar volatility during the month, which is likely to push up primary rates in future dollar-debt issuances by the government. The Ministry of Finance announced in May that it would tap international bond markets again in late 2018 or early 2019, and instructed the Central Bank to settle a $1.6bn Eurobond maturing in November in cash. Gross public debt accelerated in recent months after the new public sector salary scale came into effect, but foreign currency debt has grown less dramatically, and is projected to reach 61% of GDP by the end of On the other hand, gross debt-to-gdp is projected to increase to 150.7% of GDP in 2018 from 147.7% in, according to the Institute of International Finance (IIF). Cumulative change in rates since 2012 Credit Default Swap spreads (5yr, mid, bps) Effective FFR BRR on USD 2.1% 2.5% 2.0% 1.8% 1.5% October 1, % % % ext % Jan-13 Jun-14 Nov-15 Apr-17 Sep-18 Source: ABL, FRED, Economena, SGBL Research Aug 14-Sep 28-Sep Source: Bloomberg, Economena, SGBL Research

2 HIGHER RATES ATTRACTING FOREIGN INFLOWS Meanwhile, there are signs that higher interest rates are starting to attract more non-resident deposit inflows, in stark contrast to the cautious attitude prevailing among the resident depositor base. Deposits of the non-resident private sector at commercial banks grew by $1.5bn through July 2018, a five-year high for the period, up from $794.2m over the same period in, BdL data showed. Non-residents credit activity has also been more robust so far this year, particularly in local currency. Commercial banks claims on the non-resident private sector grew by 15.2% yoy to $6.5bn through July 2018, compared with contraction of 0.2% yoy to $52.2bn for residents. The peg provides a strong anchor and remains the basis of financial stability, according to the IIF. Total non-resident capital inflows, including foreign direct investment, are projected to increase by 2.4% to $8.5bn in 2018 and by another 6.2% to $9bn in 2019, according to the IIF. The peg to the US dollar is expected by the IIF to be maintained, supported by adequate foreign currency reserves of $43.6bn and gold reserves valued at $11.1bn in August. The peg provides a strong anchor and remains the basis of financial stability, stated the IIF....BUT WEIGHING ON CONSTRUCTION AND REAL ESTATE On the other hand, higher interest rates are weighing heavily on real estate investment with their effects accentuated by the scaling back of government subsidies for low and medium-income borrowers. Registered property sales transactions slumped by 20.6% yoy to $5.2bn through August 2018, including $1.5bn in Beirut, prompting substantial retrenchment by developers. Cement deliveries, a proxy for current construction activity, decreased by 2.7% yoy to 2.8m tons in the first seven months of 2018, reflecting a cautious attitude among homebuilders. The Lebanese government offered developers and homebuyers a ray of hope in September after Parliament approved $66.3m in interest subsidies for low-income borrowers, and the Central Bank announced plans to resume its own housing stimulus package in However, both initiatives may not be sufficient to cover pent up demand for housing in Lebanon or bring about a meaningful turnaround in the slumping real estate sector in the absence of political impetus for reforms. POLITICAL RISK DELAYING ECONOMIC REVIVAL With construction activity faltering and the delay in Cabinet formation hindering reforms, Lebanon s economy is forecast by the IIF to grow by just 1.3% in The absence of a fully-functioning Cabinet is standing in the way of the country s access to the $11bn of concessional loans that were pledged in April by the international community, and political wrangling is hindering economic development and much-needed reforms, according to the IIF. The fiscal deficit more than doubled to $1.9bn through April 2018 depsite gains in revenues. The Institute called on the government to implement a credible fiscal consolidation plan that would reduce the burden shouldered by the Central Bank of Lebanon and heavy reliance on deposit inflows to cover financing needs. Instead, Lebanon s public finances are caught in a high-stakes race between revenues and spending following the implementation of the new public sector salary scale and subsequent tax measures in. The fiscal deficit more than doubled to $1.9bn in the first four months of 2018, even as cash revenues climbed by 3.4% yoy to a record high of $3.8bn during the period, data by the Ministry of Finance showed. Revenues were boosted by an exceptional rise in taxes on interest income. Income from the interest tax jumped by 64.6% yoy to $335.8m through April after the government hiked the tax rate on interest income to 7% from 5% in late. Banks have been able to absorb some of the effects of higher taxes on profitability by cutting operating costs. Net profits at Alpha Group banks, the 15 lenders with more than $2bn in deposits, slipped by 8.1% yoy to $1.1bn in the first half of 2018, data compiled by Bankdata Financial Services showed. Banks reported robust growth in their core activities along with shrinking operating costs; net interest income increased by 15.8% yoy to $2.2bn through June 2018 and staff expenses fell by 1.8% yoy to $830.4m. Foreign currency debt to GDP Alpha Group net profits (1H, ) 92% % % % f Source: MoF, IMF, Economena estimates, SGBL Research Source: Bankdata Financial Services, Economena, SGBL Research

3 REAL ESTATE GOVERNMENT TO REVIVE HOUSING SUBSIDIES AS REAL ESTATE ACTIVITY FALTERS Parliament approved $66.3m for interest subsidies, BdL to resume its stimulus in 2019 Developers retrench as real estate sales activity falters Construction permits in Tripoli reach a decade high The Lebanese government offered homebuyers and developers a ray of hope in September after Parliament approved $66.3m in interest subsidies for low-income borrowers, and the Central Bank announced plans to resume its own housing stimulus package in The spending bill passed by Parliament serves as a stop gap measure targeting an estimated 5,000 applicants after the Central Bank s stimulus package for housing was fully utilized in the first few months of Banque du Liban has yet to announce the size of its own stimulus funds for housing in 2019, but the amount is unlikely to sufficiently cover pent up demand for housing in Lebanon or bring about a turnaround in the slumping real estate and construction sectors. The Central Bank had scaled back its stimulus funding in 2018 in an effort to counter pressure on the exchange rate from heightened domestic political risk. In mid-2018, BdL also introduced a 25% limit on the ratio of loans to deposits in local currency; banks have until the end of 2019 to comply with new limit, which will constrain their capacity to provide housing finance during the period. As a result, monetary conditions should continue to exert pressure on the real estate and construction sectors in the near future. Registered property sales transactions slumped by 20.6% yoy to $5.2bn through August 2018, including $1.5bn in Beirut, prompting substantial retrenchment by developers. Cement deliveries, a proxy for current construction activity, decreased by 2.7% yoy to 2.8m tons in the first seven months of 2018, reflecting a cautious attitude among homebuilders. Real estate sales (Jan-Aug 2018) 34.7% 28.7% $5.15B 17.3% 19.3% Beirut Baabda Metn Others Source: GDLRC, Economena, SGBL Research The short-term outlook reflects similar reduction in investment appetite, in light of political uncertainty but also on the back of higher financing costs. Average US dollar lending rates jumped by 71 basis points to 7.96% over the 12-month period through July Rising rates are also precipitating a shift away from investment and into high-yielding bank deposits. Execution orders, which are issued shortly before ground works begin, fell by 10.3% yoy to 4m sqm in the first eight months of 2018, data by the Order of Engineers and Architects of Beirut showed. Execution permits for the construction of residential buildings fell at a more moderate pace of 7.8% yoy to 2.9m sqm over the same period. The silver lining for the construction industry is Tripoli s renewed appeal to investors. The area of construction permits issued for Tripoli grew by 30% yoy to a record high of 242,926 sqm through August. Execution orders issued for the city by the Order of Engineers and Architects of Tripoli also bucked the national trend, jumping by 21.3% yoy to 196,831 sqm over the same period, pointing to an imminent uptick in building activity in the country s second most populous city. The silver lining for the construction industry is Tripoli s renewed appeal to investors. Real estate sales (Jan-Aug, ) Source: GDLRC, Economena, SGBL Research Construction permits: Tripoli (Jan-Aug) Thousands of sqm Source: OEAB, OEAT, Economena, SGBL Research

4 FINANCE FISCAL DEFICIT SWELLED THROUGH APRIL 2018 DESPITE REVENUE GAINS Revenues climbed to a record high of $3.8bn through April 2018 Debt service payments grew at a moderate pace of 5.5% yoy to $1.5bn by April 2018 Exit from the debt overhang requires large revenue and expenditure measures - IIF Lebanon s public finances are caught in a high-stakes race between revenues and spending following the implementation of the new public sector salary scale and subsequent tax measures in late. The fiscal deficit more than doubled to $1.9bn in the first four months of 2018, even as cash revenues climbed by 3.4% yoy to a record high of $3.8bn during the period, data by the Ministry of Finance showed. Revenue gains in early 2018 point to a significant dividend from higher taxes. Income from the interest tax surged by 64.6% yoy to $335.8m through April after the government hiked the tax rate on interest income to 7% from 5%. Higher administrative fees also led to a doubling in notary fees to $15.9m in the first four months, while the new tax introduced on cement production brought in $5.9m to the state s coffers. Revenues from the Value Added Tax, the government s largest source of income, grew by 8.7% yoy to a record $964.3m through April following an increase in the tax rate to 11% from 10%. On the other hand, transfers of the surplus from the Ministry of Telecommunications (MoT) fell by 30.8% yoy to $252m through April, but are likely to catch up later in the year. Treasury is projected to receive an estimated $1.4bn in transfers from MoT in 2018, but those transfers have historically been uneven throughout the year. Meanwhile, cash spending swelled by 26.4% yoy to $5.7bn in the first four months of 2018, buoyed by a higher wage bill and oil prices. Transfers to Electricite du Liban jumped by 44.1% yoy to $521.7m and are projected by the budget to reach $1.4bn by end of the year. Fiscal performance indicators () 2018f Total revenue Tax revenue Non-tax revenue Treasury revenue Total expenditures Wages and salaries Debt service Transfers to EdL Treasury expenditure Overall balance Primary balance In percent of GDP Total revenue Total expenditures Overall balance Primary balance Source: IIF, Economena, SGBL Research Debt service increased at a moderate pace of 5.5% yoy to $1.5bn by April, while gross public debt accelerated by 8.5% yoy to $82.9bn by the end of June. A considerable portion of debt service payments is collected by the Central Bank which held an estimated $4.7bn of sovereign Eurobonds at the end of May 2018 and an additional $23bn in Treasury bills by the end of June. The outlook for the remainder of 2018 looks dismal in light of the burgeoning deficit, underscoring the need for transformative fiscal reforms. The public debt-to-gdp ratio is projected to increase to 150.7% of GDP from 147.7% in, according to the Institute of International Finance (IIF). An exit from the debt overhang will require strong fiscal effort and structural reforms to reduce the deficit significantly on a sustainable basis, using both expenditure and revenue measures, stated the IIF. The public debt-to-gdp ratio is projected by the IIF to increase to 150.7% in In particular, the Institute called for restraining the state s wage bill, reforming the public pension fund, restructuring the electricity sector to reduce budget transfers to EdL, increasing tax compliance, raising fuel taxes, and selling real estate holdings. Fiscal deficit (12-month moving sum, ) Apr-06 Apr-09 Apr-12 Apr-15 Apr-18 Source: MoF, Economena, SGBL Research Public revenues (Jan-Apr 2018, % yoy) Tax on interest 64.6% Tax on wages/salaries 14.7% Value Added Tax 8.7% Administrative fees -1.5% Tax on profits -2.0% Customs -3.0% Capital gains tax -15.5% Real estate registration -22.3% Telecom services -30.8% Source: MoF, Economena, SGBL Research

5 BANKING NON-RESIDENT BANKING ACTIVITY GAINS MOMENTUM Deposits of non-residents grew by $1.5bn through July 2018, a five-year high Non-resident capital flows to increase by 6.2% to $9bn in IIF Tier I capital adequacy ratio reached multi-year high of 15.3% in Attractive interest rates and higher oil prices lifted non-residents inflows to the Lebanese banking sector in the first seven months of 2018, in stark contrast to the cautious attitude prevailing among residents. Deposits of the non-resident private sector at commercial banks grew by $1.5bn through July 2018, a five-year high for the period, up from $794.2m over the same period in, Central Bank data showed. By contrast, deposits of the resident private sector grew by $2.9bn through July 2018, their smallest increase for the period in over 12 years. Higher oil prices have historically contributed to growing financial inflows from oil-exporting countries, especially Gulf Cooperation Council countries which host a large Lebanese expatriate population. Brent crude oil prices climbed by 39.1% yoy to an average of $71.3 per barrel in the first eight months of 2018, adding to liquidity in Gulf states. At the same time, decade-high local and foreign currency rates in Lebanon are helping draw in more deposits from non-residents, especially in Lebanese Pounds. The dollarization rate of non-residents deposits decreased to 87.1% in July 2018 from 87.9% at the end of, reflecting a shift to local currency. Average interest rates on local currency deposits jumped by 138 basis points to 6.94% in the 12-month period through July 2018, and those in foreign currencies increased by 50 basis points to 4.14%. Furthermore, spreads between interest rates in Lebanon and the London Interbank Offered Rate (LIBOR) are sufficiently large to attract adequate nonresident deposits, mainly from the Lebanese Diaspora, stated the Institute of International Finance (IIF). Total non-resident capital inflows, including foreign direct investment, are projected to increase by 2.4% to $8.5bn in 2018 and by another 6.2% to $9bn in 2019, according to the IIF. Non-residents credit activity has also been more robust so far this year, particularly in local currency. Commercial banks claims on the non-resident private sector grew by 15.2% yoy to $6.5bn through July 2018, compared with contraction of 0.2% yoy to $52.2bn for residents. Ratio of Tier 1 capital to risk-weighted assets 13.8% 13.9% 13.5% 14.8% 15.3% Source: IIF, Economena, SGBL Research On Pages 2 and 5 of Issue 72, we inadvertently attributed the consumer confidence study and indices to the American University of Beirut. To be precise, it is Byblos Bank/AUB Consumer Confidence Index. The Central Bank s decision to scale back subsidies led to a downturn in housing loan activity and translated into slowing investment demand in the construction sector. More cautious lending practices are also weighing on domestic credit activity as banks focus on strengthening liquidity and improving risk-weighted returns by placing more of their liquidity with the Central Bank. The banking sector s Tier 1 capital ratio reached a multi-year high of 15.3% at the end of, data by the monetary authorities via the IIF showed. Private sector deposits (Jan-Jul, ) Bank claims on the private sector () 30% 2.8 Non-residents Residents 20% 15.2% Source: BdL, ABL, Economena, SGBL Research 10% 0% -0.2% -10% Non-residents Residents -20% Jul-10 Jul-12 Jul-14 Jul-16 Jul-18 Note: Values starting are according to IFRS 9. Source: BdL, ABL, Economena, SGBL Research

6 POLITICAL DELAYS HOLDING UP REFORMS - IIF Upgrading infrastructure could raise potential growth from 2.7% in to 5% by 2023 The peg provides a strong anchor and remains the basis of financial stability Lebanon enjoys better monetary conditions than Turkey Lebanon s economy is forecast to grow by 2.1% in 2019, but would expand by only 1.3% in 2018 following delay in forming a new Cabinet and in the implementation of reforms, stated the Institute of International Finance (IIF), a US-based global association of the financial industry. The delay is standing in the way of the country s access to the $11bn of concessional loans that were pledged in April by the international community, and political wrangling is hindering economic development and much-needed reforms, according to the IIF. The Institute warned that a delay of more than a few months in forming a new cabinet could derail policy implementation and put the economy on a cliff edge. Instead, the IIF called for urgent significant fiscal consolidation to support the pegged exchange rate, put public debt on a firm downward trajectory, and help restore investor confidence. The fiscal deficit is projected to widen to 9.7% of GDP in 2018, and the public debt-to-gdp ratio is forecast to increase from 148% in to 151% in 2018, according to the Institute. SCOPE TO IMPROVE BUSINESS ENVIRONMENT In particular, the IIF stated that Lebanon has substantial scope to improve the business environment. It called for decisive action to enhance governance and the rule of law to help reduce corruption, strengthen business confidence, and provide a boost to investment. Lebanon needs to grow by at least 4%, as compared with an average growth of 1.7% in the past seven years, to absorb new entrants into the labor force, to reduce high unemployment and bring down government debt relative to GDP to more sustainable levels, according to the IIF. The unemployment rate is projected to increase for the sixth year in a row to 10.5% in 2018 and further to 11% by Main macroeconomic and financial indicators 2018f 2019f Nominal GDP () Real GDP (% change) Private consumption Public consumption Total investment Exports of goods and services Imports of goods and services CPI inflation, average (%) Current account (% of GDP) Official reserves () Fiscal balance (% of GDP) Government debt (% of GDP) Government debt (% of M3) Source: IIF, Economena, SGBL Research PEG SUPPORTED BY ADEQUATE RESERVES Implementing a credible fiscal consolidation plan would also reduce the burden shouldered by the Central Bank of Lebanon and heavy reliance on deposit inflows to cover financing needs, according to the IIF. It stated that the peg of the Lebanese Pound to the US dollar provides a strong anchor and remains the basis of financial stability. The peg is expected by the IIF to be maintained, supported by adequate foreign currency reserves of $43.6bn and gold reserves valued at $11.1bn in August. The Institute advised authorities to maintain tight monetary policy in order to reduce inflationary pressures, support the peg to the dollar, and help attract adequate nonresident deposits. Inflation is forecast to average 5.7% in 2018 and claims on the private sector are expected to inch up by just 0.9% during the year, according to the IIF. KEY STRENGTHS COMPARED TO TURKEY The IIF pointed out that international markets have become more volatile and risk premia for a broad range of emerging markets, including Lebanon, have increased, but argued that Lebanon enjoys several key strengths compared with Turkey. In particular, the Institute noted that net foreign assets of the banking system in Lebanon is in a large creditor position, monetary policy is tight, and credit growth will be less than 1% in Monetary policy in Lebanon has been and remains independent despite political bickering, a key advantage, noted the IIF. Another advantage lies in the negligible exposure of Lebanese corporates to international markets as they cover their financing needs from highly liquid local banks. Furthermore, over 80% of the funding of the Lebanese banking sector comes from deposits, including nonresident deposits of the loyal Lebanese Diaspora, stated the IIF. Real GDP growth rate 2.7% 2.0% 0.2% 1.7% 1.8% 1.3% 2.1% 3.0% f 2019f 2020f Source: IIF, Economena, SGBL Research

7 Key indicators Cleared cheques Real estate transactions Construction permits Cement deliveries Tourist arrivals Airport traffic Balance of payments Money supply: M3 BSE volumes Passenger car sales Hotel occupancy (average) Sqm, m Tons, m m m m % , May , Jun , Jul ,665 n.a % % % 1.26% 6.13% 4.87% % % -0.68% 15.60% YTD , PYTD , Indices Consumer Confidence Index - ARA Consumer Price Index Purchasing Managers' Index BdL Coincident Indicator May Jun Jul % 7.57% -1.94% 0.89% %YTD -34.8% 2.96% -1.52% -3.64% Trade Imports Exports Trade balance Port of Beirut volumes TEUs, m May Jun Jul % 0.39% 44.52% 12.62% YTD PYTD Financial and monetary Commercial bank assets Claims on the resident private sector Claims on the non-resident private sector Claims on the public sector Resident private sector deposits Dollarization rate (average) Non-resident private sector deposits Dollarization rate (average) Private sector deposits with commercial banks Private loans / deposits Public sector deposits BdL foreign assets BSE market capitalization Gross public debt % % % May Jun Jul % -0.21% 15.20% 35.51% 2.07% 1.96% 5.36% -0.24% 2.75% -0.87% -0.10% 1.78% -9.15% 7.80% YTD %YTD % % % % % % % % % % % % % % Public finance Revenues Value Added Tax Telecommunications Income taxes Customs taxes Expenditures Transfers to EdL Debt service Primary balance Fiscal balance Feb Mar Apr % 5.87% % -6.25% 5.49% % % % % YTD: year-to-date, PYTD: previous year-to-date. Source: MoF, BdL, BSE, ARA, Customs, Markit, EY, RHIA, CAS, Economena, SGBL Research YTD PYTD

8 Deposit dollarization rates Deposit dollarization rates of non-residents retreated at a faster pace than those of residents in the first seven months of 2018, as higher returns on the Lebanese Pound drew in more foreign inflows. Meanwhile, residents have not been as responsive to higher local currency rates; their deposit dollarization rate fell by just 0.2% to 63.5% by the end of July. 64% 62% 60% 58% 56% Residents Non-residents Source: BdL, Economena, SGBL Research Outstanding Eurobonds and foreign reserves () 90% 63.5% 88% 87.1% 86% 54% 84% Jul-10 Jul-12 Jul-14 Jul-16 Jul-18 Lebanon s external profile remains a source of strength for the country s credit profile. Banque du Liban s holdings of foreign currencies, other than gold and foreign currency securities, reached $33.1bn at end of June 2018 compared with $32.5bn in outstanding Eurobonds. 40 Value Added Tax from internal operations in At 16.2%, wholesale trade was the largest contributor to the government s Value Added Tax (VAT) revenues from internal operations in. VAT revenues from real estate and construction activities reached $123.4m during the year, equivalent to 13.1% of the total, followed by retail trade with a share of 12.8%. 38.3% $944.6M 3.3% 3.6% 8.1% 4.6% 16.2% 13.1% 12.8% Wholesale trade Real estate and construction Retail trade Hotels and restaurants Manufacture of F&B Motor vehicles and retail sale of automotive fuel Manufacture of other non-metallic mineral products Other business activities Source: MoF, Economena, SGBL Research Revenues from the tax on interest income (Jan-Apr, $m) Public revenues from the tax on interest income jumped by 64.6% yoy to a record $335.8m in the first four months of The government raised the interest tax rate to 7% from 5% in late at the same time as interest rates were rising. Interest income taxes are projected by the government s budget law to reach $863m in Outstanding Eurobonds BdL: foreign currencies 15 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18 Source: BdL, Economena, SGBL Research Source: MoF, Economena, SGBL Research ONE CARD GETS YOU ANOTHER USE YOUR SGBL MASTERCARD FOR THE CHANCE TO WIN A $200 GIFT CARD FROM KHOURY HOME *Terms and Conditions apply Offer valid till 30/11/ 2018