Standard & Poor's lowered its long-term foreign and local currency sovereign credit ratings on Lebanon from B to B- keeping a negative outlook, the ratings agency said on Nov 1. S&P kept Lebanon’s short-term ratings at B. Political risk in Lebanon has risen as no new government has been formed for over six months while sectarian tensions are rising, fuelled by the spill-over from Syria, S&P underscored.

After nearly three years of weak GDP growth, dented by an internal political environment not conducive to policymaking, public finances have deteriorated and the debt-to-GDP ratio is again trending upward, S&P said.

The influx of Syrian refugees, which now account for nearly 25% of Lebanon's population, will strain the country's resources and public finances while potentially destabilising Lebanon's demographic balance, S&P warned. But Lebanon’s ratings remain supported by the banking sector, which finances the government's borrowing requirements. The latter benefit from steady deposit inflows and cash reserves, S&P noted.

The ratings agency also warned that even if a new government is formed, Lebanese policymaking will remain constrained amid a divisive political environment, which is accentuated by the regional crisis, according to S&P. Despite such a gloomy scenario, Lebanon will not be dragged into a civil war because of the strength of Hizbollah's militia and its domestic political goals, the professionalism of the Lebanese military, and the ongoing constructive efforts of Lebanese sectarian leaders to ensure a degree of stability.

Lebanon’s GDP growth will remain weak, expanding by 2% or less through 2015, as the conflict in Syria continues to depress all potential growth drivers for Lebanon, including tourism, trade, and investment, S&P noted. The Lebanese economy will not contract though as the country has proven its macroeconomic resilience in previous crises, S&P said.

But the crisis is hurting Lebanon's already structurally weak public finances. In 2013, the budget deficit will widen to 9.5% of GDP, S&P forecasts, as revenue is depressed and expenditures have increased. This is mostly due to rising public-sector wages after a one-off cost-of-living adjustment in 2012, and increased pension costs due to the rising number of pensioners.

Personnel cost accounts for more than one-third of expenditures and debt servicing drains around 40% of budget revenue, S&P said. The net general government debt will rise to 120% of GDP this year, from 116% at end-2012, before reaching 125% by 2015, according to S&P.

Confidence in the Lebanese banking system, however, underpins Lebanon's sovereign creditworthiness. Despite the regional turbulence, this confidence remains intact, supported by remittances from the Lebanese diaspora and the interest rates banks pay on deposits, S&P said.

The banking system's funding profile shows a high proportion of retail deposits. The depositor base will remain resilient, as it has done in previous instances of acute turmoil, S&P added. Banking sector deposits are reportedly around twice the level of government debt.

The banks support the government debt market in two ways, according to S&P. First, they buy Lebanese government debt directly. The general government debt was 21% of total banking system assets as of end-August. This means bank creditors held 55% of gross central government debt, equivalent to 74% of GDP. Second, Lebanese banks buy certificates of deposit issued by the central bank, which in turn buys government debt. The central bank’s certificates of deposit portfolio accounted for 32.5% of total banking system assets as of end-August, equivalent to 123% of GDP. The central bank in turn held 32% of local currency government debt.

The current account deficit narrowed to below 4% of GDP so far in 2013, S&P said, forecasting the deficit will narrow to 3% of GDP by end-2013. The current account deficit has averaged 16.6% of GDP during 2008-2011, S&P said. The central bank FX reserves will reach USD 40bn by end-2013, or 120% of short-term external debt, helping shore up confidence in the central bank's long-standing peg to the US dollar.