CENTRAL BANK GOVERNOR RAISES ALARM BELLS ON

S E C R E T SECTION 01 OF 04 BEIRUT 003914

SIPDIS

SIPDIS

NSC FOR ABRAMS/DORAN/MARCHESE/HARDING

E.O. 12958: DECL: 12/29/2026
TAGS: EFIN ECON LE PGOV
SUBJECT: CENTRAL BANK GOVERNOR RAISES ALARM BELLS ON
FINANCIAL SITUATION, HOPES FOR UPFRONT CASH AT PARIS III

Classified By: Jeffrey Feltman, Ambassador, per 1.4 (b) and (d).

SUMMARY
--------------


1. (S) In contrast to his usual calm-within-a-storm
posture, Central Bank of Lebanon (CBL) Governor Riad Salameh
has sounded the alarm bells -- albeit private alarm bells --
on Lebanon's financial and fiscal position. In a 12/29
meeting with the Ambassador, Salameh spoke with unprecedented
candor, saying that the GOL is down to its last USD 300
million in cash and is relying on unsecured CBL letters of
credit and overdrafts to pay energy costs. Financial markets
are no longer interested in lending to the GOL, Salameh said,
and will do so only at higher costs. Salameh argued that the
GOL will need USD 2-3 billion up front at Paris III in order
to maintain credibility vis-a-vis the financial markets in

2007. Crunch time starts in February, Salameh said, when a
USD 1 billion bond issue matures. With mushrooming budget
deficits plaguing the GOL, Salameh predicted that the GOL
will need over USD 10 billion in financing in 2007, most of
which can be raised locally -- if Paris III is successful.
While saying that he was open to all ideas, he downplayed the
possibility of an IMF Emergency Post-Conflict Assistance
program, saying that the financial advantages were minimal
and the political costs high. Given the political realities
of Lebanon today, Salameh stated a preference for an
IMF-monitored reform program until a credible Lebanese
president is in place who will facilitate rather than block
reforms. Salameh also expressed deep concern about how Paris
III is marketed, arguing that the international community
should be seen as embracing Lebanon, not PM Siniora,
especially as Siniora will benefit in any case from a
successful conference. End summary.

GOL DOWN TO LAST $300 MILLION
(IN LEBANESE POUNDS)
--------------


2. (S) Salameh opened the 12/29 meeting with the Ambassador
by announcing that, while the foreign reserves of the CBL
itself remain strong, the GOL "doesn't have a single dollar
at the Central Bank." The GOL has only a USD 300 million
credit balance in Lebanese currency in the CBL, and that is
"shrinking quickly." The GOL (which is already about USD 9
billion in debt to the CBL) is repaying maturing treasury
bills in Lebanese currency "because the market isn't
interested in renewing Lebanese bills." The commercial banks
are then using the Lebanese currency to buy dollars, because
"everyone is scared of the situation." The banks also know
"the real position of the government," which increases their
reluctance to roll over treasury bills. Salameh described
the fact that "we have been able to keep the exchange markets
and the banking sector quiet" as "something almost
miraculous," given the political crisis provoked by the March
8-Aoun attempts to destabilize the government.

BUYING FUEL BY BORROWING,
POSTPONING PAYMENT
--------------


3. (S) Salameh said that the CBL itself becomes
"vulnerable" when the GOL asks for Lebanese pounds in order
to buy dollars to pay its commitments, including Eurobond
principal and interest and fuel for Electricite du Liban
(EDL). "You notice the increasing problems," Salameh said,
referring to a recent upsurge in rolling brownouts. "It's
going to get a lot worse in February, just when people need
heat." So far, Salameh said, the GOL has been able to
continue its fuel purchases by postponing payments to Algeria
and Kuwait, due to letters of credit that permit a six-month
delay. The GOL is already using the CBL to issue more l/c's
for fuel purchases, even though the treasury has reached the
legislative limit of how many treasury bills it could issue.
Parliament Speaker Nabih Berri is in no mood to open the
parliament in order to lift the GOL's debt ceiling, Salameh
said.

GOL NEEDS OVER USD 10 MILLION IN 2007;
FINANCIAL CRUNCH BEGINS IN FEBRUARY
--------------


4. (S) Ticking numbers off from his head, Salameh said that
the GOL will need in 2007 about USD 3.4 billion in foreign

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currency for debt and debt service. Assuming steady or
slightly declining energy costs, the GOL will need an
additional USD 700 million in foreign currency to cover the
letters of credit in the energy sector. In addition, there
is about USD 4 billion in local bonds that will need to be
rolled over. Given that the 2006 budget deficit is now
approaching USD 3 billion because of the ongoing political
crisis and the war, one must assume that the 2007 budget
deficit will be of similar size. Add to that, Salameh said,
about USD 1 billion in anticipated EDL deficits, and the GOL
will needs over USD 10 billion in financing in 2007 alone, of
which more than USD 4 billion will need to be in foreign
currency. The crunch begins in February, when a USD 1
billion Eurobond issue matures.


5. (S) The Ambassador noted that the Governor had
previously cited approximately USD 9 billion in financing
needs for 2007 -- roughly USD 7 billion to roll over existing
debt and an additional USD 2 billion in GOL and EDL deficits.
Yes, Salameh nodded, but the "situation has deteriorated
considerably" since the March 8-Aoun insistence on changing
the GOL. And, because of the uncertainty caused by the March
8-Aoun demonstrations, bankers will insist on much higher
interest rates, worsening the situation over the long term.
The Ambassador noted that local banks have little choice but
to continue the financial engineering, lest a GOL default
lead to commercial bank defaults. Salameh agreed but said
that "the costs will be very high for us and there's only so
much we can pressure them (the banks) to do."

ARGUING FOR UPFRONT CONTRIBUTIONS --
OF $3 BILLION -- NEEDED AT PARIS III
--------------


6. (S) Paris III, Salameh said, is "the only way out." But
if GOL officials return from Paris without sizable amounts of
cash upfront, "the monetary situation will be weakened
considerably. Everybody is waiting to see what happens at
Paris III." Given current realities, Salameh insisted that
it will not be good enough to have commitments that will be
disbursed upon performance. Given the political situation,
"no one" will trust that the reforms will be forthcoming. So
promises of cash based on reform will lead to a loss of
confidence in the financial markets. Instead, cash upfront
will stabilize the situation and lead to the ability of the
GOL to promote the reforms. The Ambassador used the example
of Paris II to express skepticism that cash upfront will lead
to reform. Salameh countered that, if the USG and others
really mean to support Lebanon, "you have no other choice."
It is certain that a financial and monetary collapse will
lead to greater instability, he said, and "we will all be in
worse shape."


7. (S) Salameh expressed hope for USD 3 billion in grant
assistance and concessional loans to be given to Lebanon
upfront at Paris III. The Ambassador expressed skepticism
that the international community would risk that much money
without better assurances of movement on credible reforms.
Then USD 2 billion, Salameh countered, "even 1.5 billion, but
not less." Such a sum would calm the financial markets and
"allow us to maintain the current interest rates." Salameh
shook his head sorrowfully in recalling that Paris II
resulted in greatly lowered interest rates, "and now we'll be
lucky to continue paying the same," even with what he
anticipated to be lowered interest rates in the United States
in 2007. Already, he said, rating agencies are giving
Lebanon negative ratings, and higher interest rates
exacerbate financial problems for Lebanon over the long term.
Paris III can reverse this worrying trend and "create a
positive shock for the market." Given his view that the GOL
needs about USD 9 billion over the next four years in order
to bring debt levels down to a sustainable level, Salameh
argued that significant room remains to provide incentives
and conditions for reforms, even after the upfront payments.

STILL SKEPTICAL ABOUT
A FORMAL IMF PROGRAM
--------------


8. (S) The Ambassador asked Salameh for his views regarding
an IMF program. Claiming that he himself hadn't made up his
mind as to what was best, Salameh said that he looked forward
to further discussions with Core Group members on this topic.
Acknowledging the Ambassador's point that he had not been

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enthusiastic about an IMF program, the Governor conceded
that, "given our history," many countries will "feel more
comfortable" with an IMF program. Some countries may need an
IMF program in order to justify politically or even legally a
contribution to Lebanon. "Some parliaments require it," he
said. Nevertheless, he said that he did not believe that the
current political situation in Lebanon would permit the
reform package that would qualify Lebanon for a Standby
Arrangement (SBA). As for an IMF Emergency Post-Conflict
Assistance (EPCA),Salameh claimed that, because amounts are
linked to a country's quota, Lebanon would only gain about
USD 300 million in IMF resources, an amount too small to
justify the political costs an EPCA could entail.


9. (S) While admitting that he was far from being an
expert, the Ambassador responded that he understood an EPCA
to include relatively soft conditions. Salameh said that the
EPCA will move "automatically" to a SBA after a relatively
brief period, and that the fiscal requirements of an SBA
remain politically impossible. After much fairly predictable
back-and-forth over the need for Lebanon sooner rather than
later to come to grips with the need for real reform, Salameh
said -- as he has before -- that he preferred a reform
program monitored by Fund staff. Salameh said that he has
had two recent phone conversations with the IMF Middle East
and Central Asia Director Mohsen Khan. Khan, Salameh said,
"seems to have hardened his position, perhaps under the
influence of you and the French."

USING POLITICS TO MAKE THE ARGUMENT (AGAIN)
FOR GENEROUS UPFRONT PARIS III CONTRIBUTIONS
--------------


10. (S) Returning to what he attributed as USG political
goals in Lebanon, Salameh said that he didn't understand why
the USG would want a "contradiction" between, on the one
hand, being tough and stingy at Paris III (by conditioning
all assistance on reforms) and, on the other hand, wanting to
protect Lebanon during a time of real political and financial
peril. After all, Salameh said (jabbing his finger toward
the official portrait of Lebanese President Emile Lahoud),
"you know, and I know, that we can't talk about real reform
until he is gone." A credible Lebanese president will
support reform, while Lahoud will continue to block reform
"until his last day in office." If the international
community withholds financial support from Lebanon until
Lahoud vacates Baabda Palace because Lahoud won't support
reform, "then we are punished three times" -- first, by not
getting needed financial resources "to keep going"; second,
by having to put up with the unpalatable Lahoud; third, by
not having reforms.

MARKETING PARIS III AS SUPPORT
FOR LEBANON, NOT SINIORA
--------------


11. (S) Salameh said that he recognizes and welcomes the
fact that the support of many countries at Paris III will
derive from the political imperative to support the Siniora
government during a time of crisis, not because the donors
are particularly confident about the ability of the Siniora
government to implement the reform package. Siniora's
credibility internationally is "a tremendous asset for us,
and we should use it." Nevertheless, he cautioned, the
donors should not sell Paris III as support for the Siniora
cabinet per se. Paris III must be seen as being good for all
Lebanon, he said. "Don't look as though you are bailing out
your friend Fouad Siniora to protect him from Hizballah," for
that will discredit the conference and further complicate the
ability to get a reform program implemented. After all, if
Paris III is successful, then Siniora and his cabinet will be
strengthened. But let that be the natural result of Paris
III, Salameh urged, rather than the stated purpose of Paris
III.

COMMENT
--------------


12. (S) Salameh, of course, has been a master of financial
engineering during his long tenure at the CBL. He is not
always transparent -- as we understand it, not even the IMF
knows the real net balance of the foreign currency reserves
at the CBL -- but he has been remarkably successful in
calming the financial markets even during times of severe

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crisis such as Rafiq Hariri's murder and the
Hizballah-Israeli war. The recipient of various
international banking awards and praise, Salameh postures
himself as professional, calm, even bland. That is why his
rather alarmist presentation to the Ambassador today was so
striking. A presidential aspirant, he certainly does not
want to see Lebanon go belly up financially on his watch, but
we do not believe that he would be sounding these alarm bells
with us if he saw other solutions. We will meeting Finance
Minister Jihad Azour next week to hear his views, which we
expect to be both rosier and less detailed.
FELTMAN