Orion Financial Solutions
Page 1 July 2003
Lebanon’s investment grade rating objective: Still elusive!
What is a rating?
Before embarking on an assessment of Lebanon’s political and economic situation and the resulting rating assigned by the world’s main rating agencies, it is important to come back to basics and explain what a rating really means:
A credit rating is an opinion, which enables investors to judge the ability of an issuer of debt securities which uses quantitative tools to arrive at a final analysis or ratings involves both qualitative and quantitative criteria. The final opinion is qualitative, however, and quantitative criteria are regarded as a tool to arrive at a final qualitative judgement.
No, a rating is not a recommendation to purchase, sell, or hold a particular bond or equity. It does not make comments on market prices, market conditions or investor behaviour, and is not the performance of an audit. A rating evaluates credit risk, which is today a vital component of an investor’s investment decision.
The rating process
Credit rating analysis is a discipline in which quantitative tools and qualitative judgement are used to predict the credit risk of an issuer or borrower. The end product of this process is a rating, which is a symbol summarising the rating agencies’ assessment of default risk. By distilling analysis into a single symbol, a rating system inherently suppresses information. The rating analysts evaluate the issuer and the financial instrument being rated in the context of the issuer’s unique risk profile.
The end process of a rating analysis is a
A rating should not be viewed as a critique of management or a government, nor as the final product of risk, allowing for easy comparisons across industry and country classifications. assessment of default risk
Ratings are voted on by committees, following a detailed review and visit to the issuer by a team of analysts. The final ratings are presented to the issuer when the rating process is completed, although it is common for the rating agency to disclose an indicative rating to the issuer/borrower prior to the rating committee’s decision.
What is the purpose of credit ratings?
Ratings have become an increasingly influential force globally. They have become a necessary and vital component of the world’s most developed capital markets, as very few debt securities are priced in the primary market without using the issuer’s credit rating as a benchmark. Even privately placed debt securities are increasingly priced on the basis of a credit rating assigned by one of the world’s private placement market for financing purposes, shadow or indicative ratings are generally used for the pricing of securities. A rating, therefore, is an unavoidable element in determining the risk premium on a security.

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Page 2 July 2003
Ratings are driven by the following factors:

A source of information for investors: Investors look to ratings as one element in the overall decision to invest in a security.

Reduces the cost of capital: As ratings allow issuers to tap a larger and more liquid source of funds. With a rating, issuers or borrowers get a lower average cost of finance and have greater control over the terms of financing.

Facilitates the diversification of financing: A rating contributes to a financial institution’s immediate and flexibility by making it easier to tap diversified sources of funds.

Regulatory requirements: reassuring transparency, and
Ratings are mandatory for issuing certain types of securities in some investment selection according to ratings. financing

Facilitates strategic alliances: A rating would facilitate strategic alliances with other international financial institutions, as any potential global partner would be more willing to cooperate with a rated player. (This is more the case for corporations and financial institutions, even those in public hands).
The rating agencies
The international ratings business is dominated by two US companies, Standard & Poor’s
Corporation (S&P) and Moody’s Investor Service (Moody’s) , both of which have been in the ratings business for over 75 years. There are a number of smaller companies, which have been established over the past 10-15 years, but none of these is comparable in size to Moody’s and S&P.
According to recent estimates, Moody’s and S&P each rate in excess of 2,000 non-US based public sector entities, corporations, utilities and financial institutions. Change has proceeded at a quick rate in
Asia and Europe, where the rating agencies have experienced faster growth during the last 5 years than in any other market. regards to the markets. Fitch is trying to catch up
There is currently a consolidation of the smaller, independent rating companies in Europe. The largest of these is the London-based Fitch (which combines five previously independent rating agencies:
Fitch, IBCA, Euronotation, Duff & Phelps and Thomson Bankwatch), which has diversified its activities from financial institutions ratings to corporate and structured finance ratings worldwide and is now regarded as the third global player in its field.

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Page 3 July 2003
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2 *
B3
Caa
Ca
C
D
The rating scales
The rating scales of the three largest rating agencies can be compared as follows:
Moody’s
S&P Fitch Investment
Quality
AAA
AA+
AA
AA-
A+
A
A-
BBB+
BBB
BBB-
BB+
BB
BB-
B+
B
B- *
CCC
CC
D/SD
AAA
AA+
AA
AA-
A+
A
A-
BBB+
BBB
BBB-
BB+
BB
BB-
B+
B *
B-
CCC
CC
C
D
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Investment
Speculative
Speculative
Speculative
Speculative
Speculative
Speculative
Speculative
Speculative
Speculative
Default
*: Lebanon’s rating situation.
As can be seen from the above table, the rating scale is split into three main parts: the investment grade part, and the speculative and default grade parts. The upper part of the above table is called the investment grade section and includes countries or institutions, which future can be considered as relatively well assured. Of course the higher a borrower gets on the rating scale, the more comfortable will be its capacity to service debt and repay principals. The BBB-/Baa3 rating is the lowest rating of the investment grade scale, and a loss of this rating by a borrower means a direct fall into the speculative or non-investment grade rating categories.
Losing its higher funding costs. Jumping down from an investment grade to speculative grade rating, even if it represents a one notch fall (from BBB- to BB+) means a significant change in funding costs. A move within the same investment grade bracket (e.g. from BBB- to BBB) means slight changes in funding costs. The latter start changing more dramatically, as an issuer is downgraded or upgraded within the speculative grade scale.

Orion Financial Solutions
Page 4 July 2003
Borrowers rated in the upper speculative grade bracket (BB+/Ba1 down to BB-/Ba3) are judged to have speculative elements and their future cannot be considered as well-assured. Borrowers in this category face major on-going uncertainties or exposure to adverse economic or financial conditions.
Borrowers or issuers rated in the B+ to B- bracket are even more vulnerable to non-payment of obligations. Countries or institutions rated in the single B bracket face significant credit risks, although a limited safety margin remains.
CCC to C rated borrowers or issuers are of a very poor standing and face the real possibility of default. the investment grade line) have defaulted in 2002. joins a group of only three countries notch higher at B and B2 respectively. Lebanon started life in the sovereign rating “club” at BB- by
S&P, BB by Fitch and B1 by Moody’s. It got downgraded by up to three notches starting in September
2000 and ending in the spring of 2002. Lebanon now joins Turkey and Pakistan as a small group of sovereigns rated B- (S&P rated sovereigns). Countries such as Mongolia, Paraguay, Romania, Ukraine and Venezuela are all rated above Lebanon at B (S&P ratings).
Lebanon’s short-term rating has also gone down to C from B, which is only one notch above the default level or D on the short-term rating scale (Moody’s short-term rating for Lebanon stands at
“Not Prime”). Short-term rating scales are as follows:
S&P
A-1+
Moody’s
P-1
Fitch
F1+
B
C
D
A-1
A-2
A-3
P-2
P-3
Not Prime (NP)
F1
F2
F3
B
C
D D
Lebanon has a unique position amongst all rated sovereigns. Indeed, it has consistently the highest fiscal deficit of all rated countries, and yet until now has been able to finance it without major problems. The Lebanese government has benefited from a “friendly” investor base (in the form of capacity to attract cash inflows. over the past five years, although its
The country is located in a politically volatile region and is trying to cope with deep internal divisions, which consistently hamper policymaking and policy implementation. Despite pressures from sovereign community maintain a fixed exchange peg (although at great cost), which has nevertheless proved efficient in keeping inflation at a very low level.

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Page 5 July 2003
The recent donor conference of Paris II in November 2002 has slightly removed the pressure on
Lebanon. The success of this donor conference, which secured the Lebanese government around
US$4.3 billion in pledges from foreign governments (mainly European and Gulf countries) and institutional investors, was mainly due to a strong commitment (and promise) by Lebanon to address the large fiscal imbalances and heavy public debt burden, and to engage in serious structural reforms, which would include substantial efforts to step up a ghostly privatisation programme. The end result of the recent government commitments, which themselves led to significant pledges towards the country, was the change in the rating outlook from negative to positive (via stable), although the rating remains unchanged at B-. Every rating agency generally attaches an “outlook” to a rating, which indicates the direction credit quality is taking.
Sovereign rating methodology
The rating assigned to a sovereign is the end product of a process which entails the analysis of both qualitative and quantitative issues. Although each rating agency has its own analytical framework, the main agencies tend to view sovereign analysis in a similar vein, with a separation of the risk into four broad areas, such as political risk, the public debt burden, price stability, external debt and liquidity.
The rating agencies’ methodology for analysing a sovereign can be summarised as follows:

Characteristics of political system

Executive leadership

Government institutions

Social indicators

External relations

Debt burden

International liquidity

Balance of payment flexibility

Economic structure

Growth performance

Economic management

Economic outlook

The rating agencies will conduct a full analysis of the sovereign’s ability to raise the necessary revenues for repayment of debt denominated in both local and foreign currency.

The question of country risk is addressed, as well as the internal political and social stability and the degree of harmony characterising the country’s external relations.
50% 50% 100%
The final opinion is qualitative, and depends crucially on the agencies’ assessment of the political, social and economic management of the country. This is because ratings are forward looking and not based purely on current economic figures.

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Page 6 July 2003
Lebanon’s current rating rationale
Lebanon is currently rated B- by S&P, B2 by Moody’s and B by Fitch. This low rating reflects the following aspects of Lebanon’s sovereign risk:
 The most important constraint to Lebanon’s rating remains the large fiscal deficit and the public debt burden, which remains at around 175% of GDP, and is the highest amongst rated sovereigns. The fiscal deficit, although projected to decline to below 10% in 2003, is still regarded to be high.
 The country’s external financing or liquidity remains heavily strained, although improvements are expected in the form of an acceleration of the privatisation programme, financial aid and securitisation. The central bank is believed to have negative net foreign exchange reserves, which can only be replenished with external, non-debt, capital inflows
(e.g. receipts from securitisation and privatisation). Constant political disputes and disagreements, which have been characterising power circles for many years, can only have the highly negative effect of significantly sidetracking reforms and pushing the country further towards bankruptcy.
 Uncertainty as to the government’s ability to generate additional revenues (despite the introduction of the VAT in 2002) and diversify the economy.

Political infighting and the uncertain geopolitical environment are jeopardising privatisation efforts and reforms to reduce debt and the deficit. These two factors could bring about a substantial drop in confidence from international investors in the government’s ability to carry out reforms.
Until recently, there were deep concerns as to the government’s ability to reverse the growth of the public debt burden through the implementation of a credible fiscal programme. These concerns appear today to have been slightly alleviated with the official donors conference of Paris II. A much improved government budget (which includes a more attractive fiscal programme) has recently been presented to potential donors, who have expressed a greater satisfaction than in previous attempts. A rise in revenues due to better than expected returns from the newly introduced value added tax (VAT) and from better than expected tourism, improved inflows of foreign (mainly Arab) funds into the banking regards to growth system, and, above all, goodwill and support from the French (and some other European) government, is unlikely to are all factors which might have been the trigger in initially attracting official donors to the conference table in Paris. overnight
However, despite the success of Paris II, it would still be far too premature to expect a positive reaction from the rating agencies, which would come in the form of a rating upgrade. Indeed, rating agencies are still waiting for concrete results, as the government fulfils the promises made during the
Paris II conference. A rating upgrade would probably be achieved if the Lebanese government quickly produces a successful privatisation transaction or shows positive results from recent fiscal reforms.
However, were this upgrade to occur, it would most probably not go beyond one notch.
Rating agencies need drastic rates (on both the creditor and debtor sides), would provide a serious boost to growth and investment.
Such a programme would also benefit the banking sector, which would be able to concentrate more on traditional banking activities (such as corporate and retail lending) rather than continuously subscribing to risky government debt.

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Page 7 July 2003
It would be worth noting however, that the rating agencies still believe that Lebanon would be unable to secure sufficient budgetary financing in 2002 and 2003, without increasing the debt-servicing cost.
They believe that the introduction of the VAT and some modest expenditure-reducing measures, privatisation programme and to obtain international financial support. uncertainties and a continuously challenging domestic political environment. things stand today, is definitely not on the rating of the country was able to withstand normal economic, political, commodity and interest-rate cycles, and business and political leaders withstood such a crisis and exogenous shocks with relative ease.
What does Lebanon need to do?
Until very recently, it was widely believed by international, regional and domestic investors that
Lebanon’s public sector debt was unsustainable. This belief, although diminished slightly, is still very much alive. Indeed, very few people can see how the country can meet its fiscal target and undertake good news, Lebanon should not forget the little appetite for Lebanese debt securities, as these lack the necessary liquidity on the international capital markets, are generally priced in an unattractive way given the rating, and are regarded way too risky.
Normally, such a situation would force any government to follow the typical route of devaluation, the restructuring of domestic debt and default on external debt. However, the Lebanese government is still resisting, buoyed by recent better-than-expected government revenues figures and support stemming from Paris II. Devaluation and default are also considered taboo issues for the Lebanese government, who believes that once one of the two occurs, it will take years for foreign and local investors to regain confidence in the ability of any successive governments to put things right.
Devaluation and default appeared at
The recent bout of government revenues, the renewed faith of official donors towards the country, and one stage to be the absence of any significant government debt maturity in the next six months, have definitely bought the government a vital respite, which should be taken advantage of as efficiently and quickly as situation and establish a springboard for a rating upgrade: through

Establish political stability: There is an urgent need to establish a consensus within a fragile coalition. Such a consensus should be strengthened very quickly as well as in a public manner. Indeed, political transparency is key and the public, particularly foreign investors, needs to know that there are no more political conflicts within the ruling coalition and that there is a clear and firm intention to carry out an efficient recovery programme.

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Page 8 July 2003

Induce social stability: Social instability is unwelcome and could destroy in an instant all the efforts achieved in other areas, such as the strengthening of political stability, the increase in government revenues, and the slow and onerous restructuring (or refinancing) of debt.
Therefore, it is vital for the government to continuously reassure the public through convincing arguments, and through the maintenance of transparency. Continuous public reassurance and transparency are strong signs of democracy and would increase the any social community or political group in its communication efforts. immediate steps to be taken that can stabilise
Efforsts to create jobs and to slow down the flight of brain capital should be significantly stepped up. Indeed, the government is today concentrating too much on fiscal and monetary economics, whilst ignoring almost totally social economics. The latter are a key driver behind growth and economic recovery.

Cope with the external environment: Lebanon will have to navigate skilfully in very rough regional and international diplomatic waters. The regional environment has never been worse and the country cannot afford a faux pas if it wants to carry out an efficient fiscal adjustment programme.

Kick-start privatisation and fiscal reforms: Until now, Lebanon has been sluggish (at best) in its attempts to carry out fiscal restructuring and privatisation. The government also appears to have chosen the worst possible timing to generate additional fiscal savings via privatisation or fiscal reform. As far as privatisation is concerned, the timing is indeed awkward: emerging market IPOs are virtually dead, whilst strategic institutional investors are either not attracted by the Middle Eastern market or simply have too many problems of their own (e.g. the
European telecom sector, particularly in France and Germany is currently in the doldrums) to contemplate investments overseas. In addition, factors such as divisive domestic politics, the unclear and most often deteriorated financial situation of companies to be privatised, labour union staunch resistance and endemic disputes between the government and the rare foreign bidders, make privatisation an insurmountable task.
It is therefore vital for the government to carry out successfully up to a couple of privatisation transactions, as this would kick start the privatisation programme in a serious manner and show a clear political will, and would bring in much needed cash into the coffers (the partial privatisation of the telecommunications and the electricity sectors could very well bring in revenues in the range of US$2 billion-US$3 billion).
These initial steps, if

Explore actively the growth route: achieved successfully,
A clear option for the Lebanese government is to grow itself out of a debt trap. Such an option is always available for sovereigns and companies, preach for the diversification of revenues and for the protection of cash flow. Lebanon has more or less lost sight of its growth-orientation and has focused more on a fiscal disciplineoriented strategy. The introduction of the VAT and attempts to boost the tourism sector are moves in the right direction, but remain insufficient. The government should seriously tackle the strengthening and the restructuring of existing inefficient sectors, and lay out a detailed strategy for the establishment of new sectors of activity likely to boost government revenues significantly. Of course, such attempts should be constantly communicated to the public, as well as to official donors and international investors and regulators.

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It is worth noting that the above steps are only the immediate steps to be taken by the Lebanese government, in order to stabilise the current rating situation. Such steps, if undertaken efficiently, together with the provision of much needed financial aid by official donors in the next Paris II summit, would probably have the effect of moving Lebanon up one or two notches on the rating scale. But it would take more efforts by the country in the long-term to attain the elusive investment grade rating.
In order to achieve such a rating objective, strong emphasis must be placed on the following issues:

Progress on the development of a more democratic political system: The country must work hard to achieve a political and democratic maturity that will appear convincing to international investors and donors. This progress encompasses the development of effective and robust democratic political institutions, the transparency and cohesiveness of the political decision-making process, and the political commitment to economic reform and the ability to implement it.

It is not enough to
Progress on achieving long-term financial stability and economic growth: This definitely stabilise the situation. includes the effectiveness of fiscal/monetary and exchange policies in maintaining low inflation and interest rates and a stable, convertible exchange rate. long and hard to
 achieve investment
Allow for the development of the private sector in the economy: Which encompasses the progress in privatising the existing state sector in its entirety, laying down the appropriate rules that would encourage private enterprise start-ups, restructure public (prior to their privatisation) and private enterprises (the private sector will have to be provided with specialised and competent financial and advisory institutions), set up a special body that will ensure the proper development of effective corporate governance, and monitor and enhance the evolution of general social attitudes towards taxation and payment discipline.

Liberalising economic activity: This includes the proper monitoring and regulation of prices, and the easing of entry (fiscally and bureaucratically) for foreign and domestic entrants, and for foreign trade and foreign investment activity.

Improve the soundness of the financial sector and increase its sophistication and diversification: Develop the regulatory framework further, achieve considerable progress on financial intermediation, develop the insurance sector, develop and reform capital/securities markets with a high degree of conviction and vigour, establish and develop a diversified non-bank financial institutions rating requires the sector.

Develop market institutions: grouping of competent, seasoned
This includes the development of an effective institutional and legal legislation and bankruptcy, contract and collateral laws, etc. brought from overseas
As can be seen from the above tasks, the achievement of an investment grade rating takes considerable time and effort. It also requires a large grouping of competent and experienced individuals, who will be able to work collectively and ethically, with the benefit of the state as a prime objective. Crucial to the country would also be the government’s ability to stop the exodus of its educated youth and encourage the massive return of experienced and competent individuals living and working overseas.
A country, which stays passive (and sometimes encourages) the exodus of its population reserve can only fail in the long-term.

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Page 10 July 2003
Economic Fundamentals: Objectives
Lebanon’s economic figures will have to attain a certain level in order for the rating agencies to improve the rating of the country. Although the final opinion is qualitative, and depends crucially on the agencies’ assessment of the political, social and economic management of the country, and ratings are forward looking and not based purely on current economic figures, the actions of the government will be the driver behind each figure. Government political and economic policies will be reflected in the figures, which for an investment grade country should achieve the following levels:
Lebanon 2003 Sovereign Risk
Indicators
Economic Data:
Criteria
GDP per Capita (US$)
Savings/GDP (%)
Investment/GDP (%)
Unemployment (% of workforce)
General
Government Data:
Inflation Rate (%)
Net Debt (% of GDP)
Debt (%), Net of Govt. Deposits
Debt (% of GDP), Gross
Fiscal Performance (% of GDP),
Surplus/(Deficit)
Fiscal Performance (% of GDP),
Primary Balance
Current Account Receipts/GDP (%)
Balance of
Payments Data:
External Debt Data:
Net FDI/GDP (%)
Current Account Balance/Current
Account Receipts (%)
Net Borrowing/Current Account
Reseipts (%)
Reserves/Imports (% of reserves)
Gross Financing Gap (% of reserves)
Net External Liabilities/Current
Account Receipts (%)
Gross External Debt/Current Account
Receipts (%)
Net External Debt/Current Account
Receipts (%)
Narrow Net Ext. Debt/Current
Account Receipts (%)
Net Public Sector External
Debt/Current Account Receipts (%)
Net Investment Payments/Current
Account Receipts (%)
Net Interest payments/Current Account
Receipts (%)
Source: Standard & Poor’s
* 1999-2003 Average
4,935
N/A
N/A
N/A
1.8
138.0*
144.0
164.0
(8.4)
6.2
23.0
12.6
(64.8)
10.8
15.7
105.0
280.0*
371.0
(245.0)*
(82)*
(148)*
9.3
6.2
Investment
Grade Average
> 6,000
> 25
Around 30
< 10
< 3.0
< 40
< 60
< 50-60
Max. (3.0)
> 1.0
< 50
0.0-5.0
1.0-5.0
Around 1.0
8.0-10.0
< 80
<100
<100
Around 50
<50
(15) to 30
Around 5
Around 5