OREANDA-NEWS. Fitch Ratings has downgraded Lebanon's Long-Term Foreign and Local Currency IDRs to 'B-' from 'B'. The Outlooks are Stable. The issue ratings on Lebanon's senior unsecured Foreign - and Local-Currency bonds have also been downgraded to 'B-' from 'B'. The Country Ceiling has been revised down to 'B-' from B and the Short-Term Foreign-Currency IDR affirmed at 'B'.

KEY RATING DRIVERS

The downgrade reflects the following key rating drivers:

Persistent political risks exacerbated by the ongoing Syrian war, very weak public finances and anaemic economic performance have driven the downgrade. Negative spillover effects from the Syrian war have gradually taken more of a toll on Lebanon's economy and political scene, placing an increasing strain on the sovereign's creditworthiness.

Public finances are very weak. General government debt is the third highest among Fitch-rated sovereigns at an estimated 136.7% of GDP in 2015. High debt levels have contributed to an exceptionally high and rising interest bill, at 42% of government revenues on average in 2013-15. Despite the positive effect of lower oil prices on spending, large structural budget deficits will persist due to the lack of fiscal reforms and high current spending, together with mediocre economic growth. This will contribute to further increases in the public debt stock in 2016-18.

Financing of these needs has proven resilient, but is gradually coming under greater strain. The banking system is still attracting sufficient deposits to fund government borrowing while ensuring moderate growth of credit to the resident private sector (5.9% in 2015). However, growth in total private sector deposits in commercial banks slowed to 4.1% yoy in May 2016 from 5.0% in 2015 and an average of 7.7% in 2011-2014.

Political risks remain persistently high. Lebanon has been without a president since May 2014, as Lebanon's political factions, which take differing positions on the Syrian war, have been unable to agree on a consensus candidate. The government and parliament (which has extended its term twice) have been largely paralysed during this time. Public services have deteriorated, as illustrated by the garbage crisis in 2015. In May municipal elections did take place and parliamentary elections are due in June 2017. However, it remains unclear that domestic political effectiveness can improve substantially while the Syrian war continues.

The war across the border in Syria has severely affected Lebanon's economic performance and outlook. Low oil prices, the central bank's ongoing stimulus programme and security remaining largely intact have helped the economy maintain a modicum of growth. However, Fitch expects real GDP growth to remain below 2% in 2016, with no major improvement in growth prospects before the end of the Syrian conflict. Prior to the war, growth was much stronger, enabling a decline in the public debt/GDP ratio.

Lebanon's IDRs also reflect the following key rating drivers:

Lebanon has maintained strong external liquidity despite persistently large current account deficits (estimated at 17% of GDP in 2015). Its stock of foreign reserves was USD31.2bn (excluding gold worth USD11.6bn) at end-April - down 7.7% year on year, but still a high level. Excluding gold, foreign reserves accounted for 58% of Lebanese pound (LBP) deposits. This underpins confidence in the currency peg against the USD, as illustrated by the dollarisation rate of deposits (at 64.7% at end-April), which has remained broadly stable since the outbreak of the Syrian crisis.

In keeping Lebanon's peg and financing model running, the Banque Du Liban seems to have been incurring annual losses on its foreign-currency operations and a worsening capital position as it receives minimal returns on its FX reserves due to low global interest rates, while paying out higher rates to attract US dollar deposits.

Sporadic security incidents continue--there were two bombings in June--but armed forces have been fairly successful in maintaining security and warding off an escalation of Islamic State attacks. The number of Syrian refugees in Lebanon remains very substantial at well over 1 million, relative to a previous total population of around 4.5 million.

GDP per capita and broader human development indicators are well above category peers and more in line with the 'BBB' median, although governance indicators are slightly weaker than the 'B' median. The government also has an unblemished track record of public debt repayment.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Lebanon a score equivalent to a rating of 'B+' on the Long-Term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Structural features: -1 notch, to reflect political risks not fully captured in the SRM, chiefly spillover effects from the ongoing war in Syria which has contributed to domestic political paralysis, weaker economic performance and continues to pose security risks.

- Public finances: -1 notch, to reflect the exceptionally high public debt/GDP levels in Lebanon and the lack of fiscal flexibility given the high share of total spending that goes on interest payments, personnel costs and transfers to EDL.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's assessment that upside and downside risks to the ratings are currently balanced.

The main factors that, individually or collectively, could lead to negative rating action are:

-A major destabilisation of Lebanon induced by spill-overs from the Syrian conflict, terrorist attacks or a severe intensification of sectarian tensions.

-Diminished ability of the domestic banking sector to continue to attract sufficient deposits to keep funding the government.

The main factors that, individually or collectively, could lead to positive rating action are:

-Greater confidence in the sustainability of the domestic political environment and a sustained de-escalation of the war in Syria.

-An improvement in public debt dynamics, whether through fiscal tightening or improved economic performance.

KEY ASSUMPTIONS

- Fitch assumes that sporadic security incidents will prevail as long as conflict in Syria continues, but that Lebanon will not itself descend into full-scale civil conflict.

- Fitch assumes that international oil prices will rise to an average of USD45/b in 2017 and USD55/b in 2018.