Lebanon Economic and business outlook Quarterly update December

Lebanon Economic and business outlook Quarterly update - December 2012 Final analysis by Nenad Pacek

Contents • • Executive summary Political update Corporate sales and profit trends Key facts Economic fundamentals Economic outlook Inflation rate, currency Forecast table

Executive summary I • • Most economic and business indicators have worsened since our last update The killing of top intelligence official Wissam al-Hassan in October has heightened the risks to national security and deepened domestic political divisions Although we do not expect the current unrest to escalate into full-blown civil war, the risk of sporadic violence in Beirut, Tripoli and elsewhere remains high Growth slowed in Q 2 of 2012 and may even have turned negative in Q 3 as government paralysis and the fallout from the Syrian crisis hit sentiment We expect growth of just 1. 2% this year and we see more downside risks for 2013 (particularly with the worsening security situation in Syria and the possibility of an Iran -Israel conflict) Our base case is that growth will reach 1. 5% in 2013 but risks are very high After a small pick-up in activity at the start of the year, most important economic drivers — tourism, construction and banking — have turned increasingly negative in recent months, while inflation is again on the rise and has hit double digits Consumption will be partly saved this year by rising public- and private-sector salaries and the increase in minimum wages – but this will keep inflation elevated and put further pressure on the already-high budget deficit

Executive summary II • • Unlike in many previous boom years, Lebanon is now predominantly a single-digit growth market for most multinationals Reflecting the increased uncertainty, our new survey of member companies in the Middle East and Africa shows that expectations for 2012 have become more varied, while forecasts for 2013 are more cautious than before B 2 C companies expect to perform slightly better this and next year owing to rising wages, but lack of confidence could easily derail such expectations But B 2 B and B 2 G will face tough times while capital infrastructure spending (particularly on much-needed electricity upgrades) is slow to progress Political tension continues to block serious public finance reform – the 2012 budget was only approved by cabinet in July and is still stuck in parliament It omits most of the major tax cuts proposed in previous drafts – the prime minister wants to avoid upsetting voters ahead of elections in 2013 Security risk will remain elevated, and we advise companies to beef up contingency plans in case of an escalation in violence Inflation rate has reached over 11% yoy, but will drop to 6. 5% next year

Political update I – Background to the current unrest • • • Lebanon is no stranger to political unrest, but seasoned executives say the current upheaval is arguably the worst seen in two decades A small coastal country made up of both Sunni and Shia Muslims (about 27% each of the population) and Christians (41%), it also shares a 330 km northern and eastern border with Syria and a southern border with Israel Over the years it has seen internal tensions and has been a chess-piece in various regional conflicts – we are seeing this happen again now with the civil war in Syria and rising Israel-Iran tensions Lebanon endured a 15 -year civil war between its Muslim and Christian factions that ended in 1990 – most do not want a return to that era The start of the civil war coincided with the arrival of Syrian “peace-keeping” troops, who stayed until 2005 when they were finally ousted after the (as yet unsolved) assassination of former PM Rafik al-Hariri The current government is led by Najib Mikati, a Sunni Muslim billionaire (educated at Insead and Harvard) who is relatively close to President Assad in Syria and is supported by Hezbollah, the Shia-dominated political group whose March 8 coalition is now the majority party in government

Political update II – Background to the current unrest • • • Hezbollah has the political and financial backing of Iran and Syria (the Alawite tribe of President Assad allies itself with Shiites) In 2006 Israel invaded southern Lebanon in response to attacks by Hezbollah Following a UN-brokered cease-fire with Israel, Lebanon’s politics calmed down somewhat during 2007 -10 and the economy grew strongly However, a national unity government led by Saad al-Hariri (son of the deceased former PM) and his March 14 coalition collapsed in early 2011 Relations between Saad Hariri (who is backed by the US, Saudi Arabia and EU) and the new government have been fraught ever since The political conflict stems largely from UN-backed indictments against four Hezbollah members allegedly linked to the assassination of the former PM However, the government has refused to arrest them Escalating political risk in 2011 -12 explains why confidence among consumers and businesses is fragile (and why growth slowed sharply in 2011, to just 1. 5%) Possible spill-over of Sunni-Shia tensions from the Syrian conflict, as well as Iran using Hezbollah in its campaign against Israel, are adding to tensions and risks

Political update III – Latest developments • • Sectarian tensions in Lebanon escalated in mid-October, when Wissam al-Hassan, a top intelligence official opposed to the Syrian leadership, was killed by a car bomb in Beirut Hassan, a Sunni Muslim, previously led an investigation into the killing of former PM Rafik al-Hariri; this August, his unit arrested a pro-Assad former Lebanese minister for allegedly organising various bomb plots in Lebanon His assassination triggered violence in Beirut and the northern city of Tripoli (which is majority Sunni), in which at least seven people were killed Mourners at Hassan’s funeral tried to storm the offices of PM Mikati, and the opposition March 14 bloc called for the government to resign Mikati said he offered to step down but was persuaded to stay in office by President Michel Suleiman to avoid destabilising the situation further; the PM says the parliamentary election scheduled for 2013 will go ahead as planned It is unclear whether Hassan’s killing marks the start of a sustained campaign of bombings and assassinations aimed at spreading the Syrian civil war into Lebanon The UN now estimates that Lebanon--like Turkey and Jordan--now has more than 100, 000 Syrian refugees

Political update IV – Outlook and impact on business and economy • • The killing of Wissam al-Hassan in October, in the heart of Beirut, has heightened the risks to national security, deepened domestic political divisions and hurt consumer/corporate confidence (and economy) Although we do not expect the current unrest to escalate into a full-blown civil war, the risk of sporadic violence in Beirut, Tripoli and elsewhere remains high Tensions between government and opposition, and within the cabinet, will remain for the foreseeable future, and there will be limited progress on policy or reform until the parliamentary elections expected in 2013 Tensions between Lebanon and Israel are also rising, owing to territorial overlaps in maritime zones each has recently declared for exploration of oil and gas Together with the risks of spill-over from the Syrian conflict and Israel-Iran tensions, business and consumer confidence will be low for the next 1 -2 years at least Given its history, Lebanon remains a resilient market and we advise companies selling there to keep doing so – but those planning investments in the near term should think twice Companies are advised to have low growth expectations and proper contingency plans in place not only for revenues but also for their staff safety and security

Corporate results and expectations, all sectors, 2012 -13 • Although business slowed down in 2011 after a number of boom years, Lebanon was still predominantly a growth market for multinational firms • But our new survey of MEA member companies confirms that Lebanon is now in the bottom half of the region‘s markets, along with Jordan • The picture for 2012 is more polarised than in our last survey in June • Overall, the share of firms expecting single-digit revenue growth has fallen from 65% to 40% - more firms are now expecting flat or declining revenues, but 30% are now expecting double-digit growth • This polarisation also shows up in profit expectations for 2012 • Firms are more cautious than before in their forecasts for 2013 • About 70% now forecast revenue and profit growth, compared to 80 -85% in our June survey, but even this could prove too optimistic • And companies continue to beef up their contingency plans

Corporate sales and profit growth, 2010 -2011, including expectations for 2012 as seen by companies in Dec 2011

Corporate sales and profit trends 2012 -2013, based on June and December 2012 survey

Consumer goods companies – results and expectations, 2012 -13 • Consumer goods remains one of the stronger sectors in Lebanon, with our new survey showing some 80% of B 2 C multinationals expecting to grow revenues this year • But 50% of all companies will grow in the low single digits (1 -5%), pointing to an easing of expectations since our June poll • And unlike during the previous boom times, 20% of companies expect a smaller top line this year compared to 2011 • Profit expectations for 2012 are now all over the scale, ranging from a drop of more than 10% to a rise of more than 30% • Companies expect Lebanon to be a largely single-digit growth market for both sales and profits in 2013 • Firms should be aware of the risk of deteriorating consumer confidence in case of any further escalation of violence (see Political update, earlier)

Food/beverage companies – results and expectations, 2012 -13 • In terms of top-line growth, many food/beverage multinationals still have decent expectations for 2012 • Some 55% expect double-digit revenue growth this year - increases to the minimum wage and public sector pay have helped • But more than 30% now expect flat or declining revenues, whereas in our June survey all firms had expected to grow • Profits are not keeping pace with top-line growth, since 50% of firms don‘t expect profits to rise this year • Competition is intense and profit expectations reflect this – although firms that do expect higher profits are projecting double-digit increases • All firms expect 2013 revenues to be level with or higher than 2012 • More companies expect profit growth in 2013 than in 2012, but mostly in the single digits

Industrial B 2 B companies – results/expectations, 2012 -13 • Industrial B 2 B companies are currently steady but unspectacular • None are currently reporting negative top-line growth for 2012, but 80% say revenue is generally flat or rising at single-digit rates • The profitability picture is very similar • This is largely unchanged from our June survey and is among the weaker results in MENA • Companies expect a very similar performance in 2013, both for sales and profit growth • Cost-control measures will remain important in the absence of significant revenue growth

Pharma/healthcare companies – results and expectations 2012 -13 • Expectations for pharma/healthcare companies in 2012 have changed since June, when 65% of them expected single-digit revenue growth • Now fewer than 30% anticipate single-digit growth, the same number think revenue will be lower than in 2011, and more than 40% expect a 15%+ jump in revenue • Profit projections for 2012 have shifted in the same way since June • For 2013, more than 80% of companies are forecasting single-digit increases in both revenue and profits • In Lebanon only consumer goods has a higher percentage of companies expecting growth next year

IT companies – results and expectations, 2012 -13 • IT firms in Lebanon had a tough 2011, with half of them seeing no revenue growth and others managing just single-digit growth • The situation has got even worse in 2012, with almost 60% of IT companies not expecting sales growth this year - by far the highest figure of any sector (the next worst is industrial B 2 B, where 40% of firms don’t expect to grow this year) • Reflecting tight cost controls, some 60% of IT firms expect to increase profits this year - but only at single-digit rates • 2013 doesn’t look much better at the moment, with 50% of firms not expecting any revenue growth, and profit growth flat or single-digit • Just like in other sectors, IT executives are aware of political fragilities that can worsen and undermine even these modest expectations

Corporate sales and profit growth in 2012, by sector, based on Dec 2012 survey

Corporate sales and profit expectations for 2013, by sector, based on Dec 2012 survey

Key facts • • • Estimated population of 4. 2 m $42 bn economy at market exchange rates, one of the smallest in MENA GDP person of almost $10, 000 – twice that of Jordan but much lower than GCC Services constitute over 70% of GDP (banking, tourism) Tourism usually brings in $7 bn a year (but sharply lower in 2011 -12) Producer of various consumer goods, chemicals, textiles, paper, metals, tobacco, construction materials, and fruit/vegetables But dependent on imports (exports cover less than 25% of all imports) History of political risk and volatility, but also entrepreneurialism and resilience (though many academics and businesspeople choose to leave during tough times) Remittances from the Lebanese diaspora account for 20% of GDP (officially), bringing in some $8 bn per year in recorded transactions Power shortages are common, but a new electricity bill could improve the situation Lebanon has one of the slowest and least reliable internet connections in the region, partly owing to the control of the state-owned telecoms monopoly

Economic fundamentals • • Lebanon is one of the most indebted countries in the world – brought about by years of civil war and regional conflict – but is regularly supported by donors, external assistance and domestic banks (otherwise it would have defaulted on its debts a long time ago) All debt and deficit indicators are way above global averages The budget deficit was estimated at 6% of GDP last year, and the current-account deficit at more than 20% of GDP (partly owing to Lebanon’s chronic trade deficit) Public debt was about 136% of GDP at end-September 2012, down from 180% in 2006 but still one of the highest levels in the world Fortunately almost 90% of public debt is domestically held, reducing Lebanon’s exposure to international investor sentiment But Lebanon’s external debt is estimated at 110% of GDP, also one of the highest in the world Still, the central bank’s total foreign exchange reserves ($35 bn in assets and $16 bn in gold) cover 120% of Lebanese pounds in circulation, giving it ample means to defend the currency if necessary

Economic performance 2009 -11 • • As we have mentioned many times in the past, Lebanon’s strong growth of 9% in 2009 and 7% in 2010 was not sustainable It was largely driven by real estate and residential construction, inflows into the banking sector (attracted by high interest rates), capital flows from the Gulf, and booming private consumption linked to strong tourism Growth was also massively uneven – Beirut was a “country within a country” The government has said growth was “probably” 5. 2% last year, but most analysts (including ourselves) estimate it to be much lower than this Most leading indicators were sharply down, including capital inflows (by one fifth), tourism (by up to one quarter), and corporate and government investments (by over 15%) Credit growth was down too, despite banks’ solid liquidity and profitability The IMF estimates that GDP growth was just 1. 5% last year Official numbers are unlikely this year – Lebanon has yet to publish full 2010 GDP results!

Economic outlook I – GDP and growth drivers • Official GDP numbers do not exist, but recent data and anecdotal evidence from our members point to a further deterioration since our last report • Growth slowed in Q 2 and may even have turned negative in Q 3 as government paralysis and the fallout from the Syrian crisis hit sentiment • Following ongoing problems in Syria and some spill-over into Lebanon plus subsequent lack of confidence, real GDP growth will reach just 1. 3% this year, with downside risks • Tourist arrivals fell 15% in Jan-Sep (from -7% yoy in H 1) - security fears hit the summer season hard and high-spending GCC states advised citizens against travel to Lebanon • The construction sector had a tough Q 3, with construction permits down 14% yoy in Q 1 -3, real estate sales 9% lower, and cement deliveries down 8% (Jan. Aug) • The trade gap widened by 14% yoy in Jan-Sep – imports rose by 11% but exports grew just 2% as the Syrian conflict hit exports over land - and the recent turmoil will further dampen FDI inflows

Economic outlook II – GDP and growth drivers • Government capital spending has virtually stalled (see next slides) - increases in public- and private-sector pay should support some modest consumer spending but will keep inflation high (11. 2% yoy in October) • Prospects for growth in 2013 are not good • Considering weakness in export markets, most likely ongoing hit on tourism, possible escalation of violence, budget problems and most importantly very weak consumer and corporate confidence we have moved our GDP forecast for 2013 to just 1. 5% (but downside risk are larger than usual) • This base case assumes that politics and confidence will not deteriorate from currently very shaky levels

Economic outlook III – government spending • • • Political tension continues to block serious public finance reform – the 2012 budget was only approved by cabinet in July and is still stuck in parliament The economic slowdown is depressing revenue, while higher public-sector pay has angered many in the private sector who would rather see more capital spending We anticipate a deficit this year equal to 8. 5% of GDP The government‘s draft 2013 budget plans to cut the deficit to $3. 1 bn from more than $3. 5 bn this year Revenue is projected to rise by 20% next year, helped in part by increasing the VAT rate from 10% to 12%, while spending grows at the slower rate of 10% But these projections look too optimistic – the government could yet fall, and in any case 2013 is an election year The bulk of funding will come via debt issuance – including a possible $2 bn Eurobond The government may ask the banks, which are still in good financial shape, to participate in planned infrastructure projects, including electricity and water The IMF said in September that the main risk to Lebanon’s economy is poor policymaking, not the conflict in Syria

Economic outlook IV – government spending • • Lebanon‘s poor infrastructure continues to hold back growth and deter investment, and companies should not expect movement any time soon Lebanon must spend at least $20 bn to improve its infrastructure, to be financed via public-private partnerships The government said a PPP law is nearly ready – this follows a proposal from the Lebanese Economic Organisation, a lobby of various banks and industry leaders But the 2012 budget allocates insufficient funds to this purpose, while the recent escalation of tensions will keep many private investors on the sidelines Power supply remains a huge problem owing to technical faults, industrial unrest and a system that only supplies about 50% of actual demand even at full capacity An electricity bill worth over $1. 2 bn, passed earlier this year, should bring opportunities over time, but progress is likely to be very slow The state-owned electricity provider costs the treasury $1. 5 -2 bn per year, so resolving the problem would also massively improve government finances In the meantime, however, companies should keep their generators and plan for more blackouts (for up to several hours a day, sometimes even in Beirut)

Economic outlook V – private sector spending • • A 35% increase in the minimum wage in January 2012 will add about € 1. 8 bn to total salaries in the country – some of this will surely be spent (helping some B 2 C firms) And imports of consumption products posted double-digit yoy growth in Jan-Sep But some of the wage increases will be eaten away by high inflation, and leading indicators suggest that retail activity fell in Q 3 amid weakening sentiment Banking activity is also slowing down - bank loans grew by $2. 9 bn in Jan-Sep, 24% less than the increase in the same period of 2011 Lebanese banks are well capitalised and liquid (they were sitting on $122 bn of deposits at end-September, with deposits growing at a similar rate to 2011 ) They are also profitable (domestic net profits of Lebanese banks rose by 8% yoy in the first 8 months of 2012) But they are highly exposed to construction, real estate, tourism and government paper – all of which are potentially risky given current political sentiment A potential problem for the future (as we saw in CEE markets in recent years) is that about 74% of all loans are denominated in foreign currencies

Economic outlook VI – private sector spending • • Conditions in the private sector remain tough, reflected in Moody’s decision in October to keep its negative outlook on Lebanese banks The ratings agency pointed to weak GDP growth and business sentiment in 2012 -13, a projected rise in non-performing loans from 4% at end-2011 to more than 6. 5%, and falling profitability related in part to higher bad-loan provisions – including in Lebanese banks’ Syrian subsidiaries SMEs (including distributors of multinational companies) have had problems with access to loans as banks continue to allocate 25 -50% of their money to buying government debt, which until recently has been seen as relatively risk-free FDI inflows were a respectable $4 bn in 2011 (from almost $5 bn in 2010) But only a small proportion of new investments ended up in industry, and FDI is likely to be much lower in 2012 and 2013 because of worsening sentiment The government is planning tax incentives for exporters, but again we will need to wait and see if this happens or not In the meantime we expect the B 2 B and B 2 G segments to find business in Lebanon particularly tough

Inflation rate, currency • • Inflation has risen significantly since our last report, to 11. 2% yoy in October from 10. 3% in September (it was just 2% yoy in June thanks to falling oil prices) The surge mostly reflects rising costs of food and fuel imports, wage increases, and a big one-off jump in housing costs following fresh survey data on rentals The one-off rise in housing costs will drop out in mid-2013 and inflation rate will average 6. 5% next year The currency peg to the dollar is likely to stay, and dollar-denominated bank deposits (65% of the total at end-Sep) are well below the recent peak of 77% at end-2007 Risks to the peg could rise if political risks intensify and domestic banks start selling their government debt holdings in panic S&P downgraded Lebanon’s outlook to “negative” in July The central bank had to intervene during 2011 (at around 1, 501) to keep the peg in place (its first interventions since autumn 2008) The current-account deficit is among the highest in the world at more than 20% of GDP (if the Lebanese pound had been floating freely, it would have experienced significant depreciation a long time ago)

Lebanon – forecast table, selected indicators Base case – executives should be aware of the risks mentioned throughout this report GDP (real, y. o. y. %)* Inflation (annual average %) Budget balance (% of GDP) Current-account balance (% of GDP) Exchange rate (USD, average) 2009 9. 0 1. 2 -9. 0 -9. 5 1508 2010 7. 0 3. 5 -7. 5 -23. 0 1508 2011 1. 5 5. 1 -6. 0 -23. 7 1508 2012 1. 2 7. 0 -8. 5 -25. 5 1508 2013 1. 5 6. 5 -8. 0 -24. 0 1508 Note: * GDP figures for 2010 and 2011 are IMF estimates; official government data expected in 2013 earliest 2014 2. 0 3. 0 -7. 5 -24. 0 1508

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